Disney’s magical pricing power can not cope with inflation right now

A member of the Disney roles welcomes guests to Magic Kingdom Park at Walt Disney World Resort on July 11, 2020.

(Photo by Matt Stroshane / Walt Disney World Resort via Getty Images)

Disney may be trading more like Netflix now, with growth in streaming subscribers the all-important stock catalyst, but as Disney + adds declined in the third quarter, real-world costs continue to rise. And that means, at least in the short term, that even Disney has an inflation problem that weighs on its margins.

Disney has pricing power that most companies envy, but it does not improve the mood of investors. The stock is negative compared to the year and will be crushed on Thursday and was far behind the 20% + increases in the S&P 500 index even before the earnings disappointment.

Now may be a time for long-term investors with the patience to buy in, but Disney is a show-me story into the first half of 2022, and rising costs are part of the headwind.

In some ways, Disney’s recent performance shows how strong its brand is with consumers. Launched to the parks that reopen after Covid for $ 15, the Genie + app was purchased by a third of Walt Disney World guests a day. Disney CEO Bob Chapek said in Wednesday’s earnings call that he’s not sure people realize the “gravity” of this success.

“It’s a very, very significant increase for us in per caps, but also in margins,” Chapek said. He expects “long-term benefits in terms of dividends.”

Walt Disney World turnout grew in double digits in Q3, while per capita consumption. per capita increased by approx. 30% compared to the 2019 level, and the company’s management expects that consumption per. costs from, among other things, inflationary pressures.

Inflation in the minds of Wall Street analysts

The business of parks, experiences, and products saw margins weaken in the third quarter, and analysts on the Disney earnings call asked about the inflation problem.

“It’s in the minds of every CFO and every senior management team of companies out there,” said Disney CFO Christine McCarthy. “Inflationary pressures are something we all look at and try to assess and think about how we get through.”

For Disney, there is inflation that is not macroeconomic, but related to the intense competition for content in the streaming wars, as McCarthy noted. “Because of only the competition for talent, for everything involved in productions, the cost of content has increased,” she said.

And that exacerbates the real-world inflation problem for Disney, which said it would spend over $ 5 billion on investment this fiscal year. No one is going to toot Disney to spend more on content as that’s the key to a future blockbuster Disney + subscriber adds a quarterly figure that moves the stock up. But “that capex figure really jumped out at us,” said Tuna Amobi, CFRA Research analyst.

Disney noted in its earnings that despite strong efforts to limit costs, management expects certain costs to remain high in FY22 relative to pre-pandemic due to inflationary wage pressures and costs related to new projects.

Some analysts dismiss inflation as a problem for Disney.

“Disney has pricing power. Inflation only kills you if you can not raise prices,” said Laura Martin, an analyst at Needham & Co. Streaming costs are an issue, she said, “but it’s content inflation.”

Wages are rising in parks and fewer people are allowed in as a result of Covid security measures, but she said the park business is doing well this year, albeit with lower margins.

Park revenues topped estimates ($ 4.17 billion vs. $ 3.96 billion analyst estimates), but operating profit fell far short of expectations and international parks experienced losses. Profits of $ 640 million were well below the $ 901 million consensus, according to Atlantic Equities. This was the first time since the pandemic started that all of Disney’s theme parks were open throughout the quarter, but despite that, the unit’s small profits were not close to what analysts expected, according to CNBC’s earnings analysis.

And inflation as the key word was all over analyst Disney’s earnings summary.

Atlantic Equities wrote that it is “more interested in what the company’s profitability will look like when running at full capacity,” and although Genie’s success was among the highlights of the result, additional cost pressures were remarkable and “inflation is perhaps the most worrying. “

The park’s performance provided “optimism, not yet clarity,” Wells Fargo wrote. “Inflation is a risk (salary, product COGS). It has a purchase at Disney, but wrote,” there is not enough data yet to argue for it with conviction. “

JP Morgan was also bullish, but twice noted the inflationary headwind: “Although there are increased costs associated with new attractions and inflationary pressures in the short term, we are convinced that parks can emerge from the pandemic with better profitability given the improvements the company makes. has been able to implement together with innovations such as Genie +, its old Parks business has returned to expectations and we expect the segment to come out of COVID-19 with more profit upwards in the long run, despite some price pressure in the short term from inflation. “

Disney park managers are planning answers to rising costs

Disney’s CFO did not have a simple solution to offer in response to the rising cost.

“Where we see it directly in our park business is primarily through hourly wage inflation, which we have seen through contract renegotiations and our commitment to pay our park workers well. And then we have things on the cost of goods side,” McCarthy told analysts.

She told Wall Street that last week she spoke with Disney’s Park senior team about reactions to inflation.

“There are lots of things worth talking about. We can adjust the suppliers. We can replace products. We can cut the portion size down, which is probably good for some people’s waist. We can look at the prices where necessary. But that’s we do not want to go straight across and raise prices … We will really try to get the algorithm right to cut where we can and not necessarily do things the same way. As I mentioned, we also use technology to reduce some of our operating costs, and it gives us a little bit of leeway to absorb some inflation as well. But we’re really trying to use our heads here to find a way to mitigate some of these challenges that we have. “

That’s what Wall Street wants to hear, Amobi said, but there will also be a reset of expectations for the company, which has traded at a big premium for peers in the entertainment space.

“What you would expect them to do is find ways to alleviate the margin squeeze from inflation costs,” he said. “The question is how far they can go and when.”

“You can not just assume that all those things will cushion completely. You’re talking about things that can take several quarters of an hour. But they want to give the impression that they are not sitting passively. … how far they can perform is left to be seen, “Amobi added.

Morgan Stanley analysts wrote that the parks’ recovery should be weighed against “the rapid return of the Parks cost base. This cost base returns from its FY19 levels with several years of wage cost inflation, including a step up in the minimum wage for park employees. We have clearly upside to our expectations for our revenue in Parks, but the road to past peak margins is likely to take longer than the road to past peak revenues. “

A company with such strong pricing power as Disney has commanded has historically led to magnification of cost problems as they arise, and it will take time before it becomes clear what the lasting impact on profits is from inflation.

“The price power makes it even more surprising and tells you even more about companies’ inability to pass on these costs to consumers,” Amobi said.

Disney, measured by the annual rise in the price of its park cards, has always been able to surpass inflation by several orders of magnitude. “It should serve them well, but that is not to say that the pressure on margins will ease,” he said.

This quarter showed that the biggest stock catalyst, streaming growth, will not move in a straight line, and that should come as no surprise, as it has also been seen in the Netflix performance. Now Disney also has a less clear inflation problem – how much of it will be sticky (like wage inflation), and how much of it will be “transient” and pass within a few quarters, making it easier for management to hit its financial goals.

McCarthy noted during the call with analysts that Disney has already done a lot of work since recovering from the pandemic, and “fundamentally changed” some of the ways it does business on both the revenue and cost side to optimize margins. But the overall margins of the global business for Disney parks, experiences and products, at just under 12%, were well below the levels before Covid.

Wage inflation, commodity input costs, talent costs, and the price of goods and services are all inflation factors that Disney is very exposed to, and that was evident in a quarter when parks returned and margins were recovering, but from a low base.

“I have said it before and I will say it again that I believe we will not only get back to, but have a high probability of exceeding the previous margin levels in our parks because of some of the things we “have done … In the long run, these fundamental changes will result in higher margins overall,” McCarthy said.

The negative investor sentiment at Disney may prove to be transient – there have been moments in recent years when ESPN’s fear of wire cutting lowered the stock rapidly before a recovery – but the stock’s current performance shows that investors need to be convinced again.

“We believe investors are likely to take a more wait-and-see approach to the stock at best in the short term,” Barclays concluded.

Given all the macro data points that inflation has risen in recent months and this week’s 30-year high of year-on-year consumer price inflation, no company or investor is immune.

“Inflation will be paramount for a while and may even delay the achievement of pre-pandemic margins. They will get there, but it will take longer to get there,” Amobi said. “In the case of Disney, some costs may turn out to be temporary and some much more permanent, and no one knows it … we always knew we would take care of this sooner or later.”

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