Disney’s magical pricing energy can’t overcome inflation proper now

A Disney performer 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 now act more like Netflix, with streaming subscriber growth being the main catalyst for stocks, but with Disney + additions declining in the third quarter, real world costs continue to rise. And that means that even Disney has an inflation problem, at least in the short term, that is hurting its margins.

Disney has pricing power that most companies envy, but that doesn’t improve investor sentiment. The stock has been negative for the year and was crushed Thursday and was way below 20% + gains in the S&P 500 index even before the disappointment in gains.

Now may be a time for long-term investors who have 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. The Genie + app, launched to reopen the parks after Covid at a cost of $ 15, was purchased by a third of Walt Disney World guests per day. Disney CEO Bob Chapek said on the conference call Wednesday that he was not sure people are realizing the “gravity” of this success.

“This is a very, very significant increase per capita for us, but also in margins,” said Chapek. He expects “sustainable yield advantages”.

Walt Disney World visitor numbers rose double-digit in the third quarter, while per capita spending increased by around 30% compared to fiscal 2019 and costs, among other things, due to inflationary pressures.

Inflation on the minds of Wall Street analysts

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

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

For Disney, there is inflation, which is not macroeconomic, but rather related to the intense competition for content in the streaming wars, as McCarthy noted. “Just because of the competition for talent, anything related to production, the cost of the content has increased,” she said.

And that exacerbates the real inflation problem for Disney, which said it spent $ 3.6 billion on investments last fiscal year and will increase that by $ 2.5 billion in 2022 is key to one future blockbuster Disney + subscriber adds quarterly numbers moving the stock up. But “this capex number really caught our eye,” said Tuna Amobi, CFRA research analyst.

Disney noted in its earnings that despite strong efforts to cut costs, management believes that certain costs will remain elevated in FY22 compared to pre-pandemic times due to inflationary wage pressures and costs associated with new projects.

Some analysts are dismissing inflation as an issue for Disney.

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

Park wages are rising and fewer people are being let in due to Covid safety precautions, but she said the parking business is doing well this year even if margins are lower.

Parks revenue surpassed estimates ($ 4.17 billion versus $ 3.96 billion analyst estimate), but operating income fell far short of expectations and international parks suffered losses. According to Atlantic Equities, profits of $ 640 million were well below the consensus of $ 901 million. This marked the first time since the pandemic began that all of Disney’s theme parks were open for the full quarter, but even so, the unit’s small profit wasn’t close to analysts’ predictions, according to CNBC earnings analysis.

And inflation as a keyword was found throughout Disney analysts’ earnings reviews.

Atlantic Equities wrote it was “more interested in what the company’s profitability will be when it is at full capacity,” and while Genie’s success was among the highlights in earnings, the added cost pressures have been notable and inflation is perhaps the most worrying . “

The park’s performance delivered “optimism, not clarity,” wrote Wells Fargo. “Inflation is a risk (wages, product COGS). It buys from Disney but wrote,” There isn’t enough data yet to argue with conviction. “

JP Morgan was also optimistic, but twice noted inflationary headwinds: “Although there are higher costs associated with new attractions and inflationary pressures in the short term, we are confident that the parks will be more profitable given the improvements the company has made The pandemic can emerge to implement, along with innovations like Genie +. The previous Parks business has rallied above expectations and we expect the segment emerging from COVID-19 to promise more profit in the longer term, despite short-term cost pressures from inflation. “

Disney park managers plan to respond to rising costs

Disney’s CFO had no easy solution to the rising costs.

“We see it right in our parking business primarily through the hourly wage inflation we’ve seen through contract renegotiations and our commitment to pay our parking workers well. And then we have things on the cost side of the goods, ”McCarthy told analysts.

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

“There are many things worth talking about. We can adjust suppliers. We can replace products. We can reduce the serving size, which is probably good for some people’s waistlines. We can look at the prices if we need to, we’ll just go straight over and raise the prices. … we’re really going to try to get the algorithm right to cut down where we can and not necessarily do things the same way. As I mentioned earlier, we also use technology to reduce some of our operating costs, and that gives us a little headroom to absorb some inflation as well. But we are really trying to use our heads here to find a way to alleviate some of these challenges that we face. “

That’s what Wall Street wants to hear, Amobi said, but there will also be a realignment of expectations for the company, which trades at a high premium to its entertainment competitors.

“They would be expected to find ways to alleviate margin pressures from inflationary costs,” he said. “The question is how far you can go and when.”

“You can’t just assume that all of these things will weaken completely. You talk about things that could last for several quarters. But they want to give the impression that they are not sitting around idly. … to be seen, “added Amobi.

Morgan Stanley analysts wrote that the parks recovery must be directed against the “rapid return of the parks cost base”. This cost base is returning from its 2019 fiscal year level with multi-year labor cost inflation, including an increase in the minimum wage for park employees. We clearly have upside potential in our parks revenue expectations, but the journey to past peak margins will likely take longer than the journey to past peak earnings. “

A company with as strong pricing power as Disney has offered in the past increases cost problems as they arise and it will be some time before it becomes clear the lasting impact inflation is having on margins.

“The pricing power makes it even more surprising and says even more about the inability of companies to pass those costs on to consumers,” Amobi said.

Measured by the annual price increases for its parking passes, Disney has always been able to outperform inflation by several orders of magnitude. “That should serve them well, but that doesn’t mean the pressure on margins will ease,” he said.

This quarter showed that the biggest catalyst for stocks, streaming growth, isn’t going to move in a straight line, and that shouldn’t come as a surprise as it was seen in Netflix performance. Now Disney also has a not entirely clear inflation problem – how much of it will be sticky (like wage inflation) and how much of it will be “temporary” and pass within a few quarters, making it easier for management to hit its financial targets.

McCarthy noted on the call with analysts that Disney had already done a lot of work after returning from the pandemic, “fundamentally changing” some of its business operations on both the revenue and cost sides to optimize margins . But the overall margins for the global business for Disney Parks, Experiences and Products were just under 12%, well below the pre-Covid level.

Wage inflation, raw material costs, labor costs, and the cost of goods and services are all inflationary factors that Disney is exposed to.

“I’ve said this before, and I’ll say it again, that I believe that not only are we going to come back, but more likely that previous margin levels in our parks because of some of the things we … In the long run, these fundamental changes will be result in higher overall margins, “said McCarthy.

Investor negative sentiment towards Disney could prove temporary – there have been moments in recent years when ESPN fears prematurely lowered the stock before it rebounded – but the stock’s recent performance shows that investors need to be reassured.

“We believe investors will be more likely to wait and see the stock for a short term at best,” concluded Barclays.

With all of the macro data on the rise in inflation over the past few months and this week’s 30-year year-over-year high in consumer price inflation, no company or investor is immune.

“Inflation will be paramount for some time, and may even delay reaching pre-pandemic margins. They will get there, but it will take longer to get there, ”said Amobi. “In the case of Disney, some costs might turn out to be temporary and others much more permanent, and nobody knows … we always knew we’d deal with them sooner or later.”

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