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Market Update

Disney's Cable Networks and Parks Exhibit Pricing Power

Shares of the media giant look slightly undervalued after the firm reported strong fiscal first-quarter results.

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 Walt Disney (DIS) reported strong fiscal first-quarter results, with the cable networks and parks showing off their pricing power. The stock has been on a strong run recently, but we still think it is slightly undervalued relative to our $45 fair value estimate. Excluding the inherently lumpy film studio, overall sales and operating profit increased 4.3% and 11%, respectively.

Cable network revenue improved 8% thanks to growth at ESPN and the worldwide Disney Channels, which are now in more than 100 global markets, up from 19 a decade ago. We estimate that advertising growth at ESPN was 8% higher after adjusting for two fewer major college bowl games and fewer NBA games in the quarter. ESPN has a dominant position in live sports, and the cable networks remain the key growth driver for Disney. On a trailing-12-month basis, cable network operating margins improved to a recent high of 41.4%. We view the increase in sports rights fees, especially for the NFL and college football, as manageable and believe the cable networks can maintain their current profitability of around 40% over the next five years.

In early January, Disney and  Comcast (CMCSA) announced a sprawling new long-term agreement that covers 70 Disney services, highlighted by ESPN, Disney Channel, and the launch of Disney Junior on Comcast. The agreement will allow Comcast customers to access a broad range of Disney networks on an authenticated basis. It is our understanding that Comcast's deal for rights to the ESPN family of networks did not expire until 2014, so including these expensive rights in the new long-term agreement highlights the importance of live sports and ability of ESPN to pass the rising costs of sports rights through to distributors.

The parks and resorts continue to exhibit pricing power, as revenue growth of 10% was driven by higher per capita spending and attendance. Disney was able to generate some operating leverage off the strong growth, with segment profit margins up 120 basis points to 17.5% from 16.3% in the year-ago quarter. Looking ahead, management said hotel bookings at the parks were pacing up a mid-single-digit percentage.

Management now expects total capital expenditures in fiscal 2012 to increase by several hundred million, which implies a number a bit shy of our $4 billion estimate, based on the new cruise ship, revamping portions of domestic parks, and the beginning of investment in the China Disney property. We realize some investors continue to be disappointed by the high level of capital expenditures for the parks, but we view most of this spending as necessary investment in a long-lived asset. We think investors should look past the current level of spending, as we expect it to start moderating after 2012.

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Michael Corty does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.