Disney’s magical pricing energy cannot outpace inflation proper now

A Disney performer greets guests at Magic Kingdom Park at Walt Disney World Resort on July 11, 2020.

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

Disney could now trade more like Netflix, with streaming subscriber growth being the main catalyst for stocks, but as Disney + adds declined 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 is negative for the year, and to be crushed on Thursday, and was way behind the 20% + gains of the S&P 500 index even before the disappointment.

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 per day per ticket, was purchased by a third of guests at Walt Disney World every day.

Disney CEO Bob Chapek said on the conference call Wednesday that he was not sure people are realizing the “gravity” of this success.

“For us this is a very, very significant increase in the per capita figures, but also in the 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 about 30% over fiscal 2019. The company’s management assumes that per capita spending will remain well above pre-pandemic levels in fiscal 2022, but this will be offset by increased costs due to inflationary pressures, among other things.

Inflation on the minds of Wall Street analysts

The Parks, Experiences and Products division saw margins decline in the third quarter, and Disney earnings call analysts asked about the inflation problem.

“It’s a concern of every corporate CFO and senior management team,” said Christine McCarthy, Disney CFO. “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 content has increased,” she said.

And that makes the real inflation problem worse for Disney, which said it spent $ 3.6 billion on investments last fiscal year and will increase that by $ 2.5 billion in 2022. as that’s key to a future blockbuster quarterly number from Disney + subscribers that will propel the stock higher. But “this capex number really caught our eye,” said Tuna Amobi, CFRA research analyst.

Disney noted in its earnings that despite strong cost-cutting efforts, management believes that certain costs will remain elevated in fiscal 2022 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 of $ 4.17 billion surpassed analyst estimates of $ 3.96 billion, but operating profit 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 Disney 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 all over the Disney earnings summaries of analysts.

Atlantic Equities wrote that it was “more interested in what the company’s profitability will be when it is at full capacity” and that while Genie’s success was among the highlights in earnings, additional cost pressures were felt and “inflation may be.” most worrying. “

The park’s performance delivered “optimism, not clarity,” wrote Wells Fargo. “Inflation is a risk (wages, product COGS). Disney is buying it but wrote,” There is not 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, given the improvements the company has made, the parks will come out of the park with better profitability 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 a lot of things worth talking about,” said McCarthy. “We can adapt 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 necessary. .. We’re really going to try to get the algorithm right, to cut where we can and not necessarily do things the same way. “

“As I mentioned earlier, we also use technology to cut some of our operating costs, and that gives us a little headroom to absorb some inflation as well,” she said. “But we’re really trying to use our heads here to find a way to alleviate some of these challenges we face.”

That’s what Wall Street wants to hear, Amobi said, but there will also be a reorientation of expectations for the company, which is trading at a high markup 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 are talking about things that could last for several quarters. But you want to create the impression that you are not sitting around idly,” added Amobi. “How far they can take remains to be seen.”

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 what lasting impact inflation will have on margins, if at all.

“The pricing power makes it even more surprising and says even more about how companies can’t pass these 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 in a straight line. That shouldn’t come as a surprise, as it was also evident in Netflix performance. Now Disney also has an unclear 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 meet its financial goals?

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.

“As I’ve said this before, and I’ll say it again, I believe that because of some of the things we have … in the long run, these fundamental changes will result in higher margins overall,” 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 current performance shows that investors need reassurance.

“We believe investors will, at best, wait and see the stock for a short time,” concluded Barclays.

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

“Inflation will be paramount for some time, and maybe even delay reaching margins before the pandemic. They will get there, but it will take longer to get there,” Amobi said. “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.”