Coronavirus Weighs on Disney But Long-term Outlook Appears Intact
Walt Disney's (DIS) business is in the crosshairs of the coronavirus outbreak, with access to theme parks (38% of sales) and movie theaters (studio films account for 16% of sales) appearing increasingly likely to be temporarily cut off.
This demand shock comes at a less than ideal time as only a year ago Disney closed its $71 billion acquisition of 21st Century Fox, doubling its leverage in the process.
While the company's long-term outlook and brand remain solid, it's less clear if the looming coronavirus-related hit to short-term cash flow could threaten Disney's credit rating and increase pressure on management to pay down debt.
In light of this uncertainty and a desire to remain conservative, we are downgrading Disney's Dividend Safety Score from Very Safe to Safe.
As you can see, Disney's leverage ratio exceeded 3.0x following its 2019 acquisition of Fox. Management has prioritized reducing debt to get the firm's leverage ratio in line with a mid-single A credit rating (below 2.5x), suspending share buybacks and opting to freeze its semi-annual dividend to help get there.
Source: Simply Safe Dividends
The coronavirus will temporarily interfere with Disney's deleveraging efforts. Not only could demand drop significantly for a couple of months, but theme parks and movie production are high fixed costs businesses, making the hit to earnings more severe when revenue falls.
For example, in 2009 Disney's revenue fell 4.5%, but its operating income declined nearly 25%.
It's unclear how severe of an impact the coronavirus will have on Disney and how the rating agencies will view this event. However, in February 2020, Standard & Poor's wrote (emphasis added):
Given the longer path to deleveraging and increased economic uncertainty in the outer years, operating performance and financial policy decisions over the next 12 months will be key factors in assessing the company's progress towards meeting our 2.5x threshold.
We could lower our rating on Disney, or tighten our leverage threshold for the current rating, at any point over the next two years if we believe the company will be unable to reduce its leverage below our 2.5x downside threshold by the end of fiscal year 2021.
This could occur if a global economic downturn triggers a sharp decline in the company's revenue and EBITDA that it is unable to offset with a corresponding reduction in its debt or if secular trends worsen leading to significant operating declines across any of its business lines.
Disney has generated an average of about $9 billion of annual adjusted free cash flow in recent years, leaving close to $3 billion available after paying its $6.3 billion dividend.
Based on the company's current net debt load near $50 billion and forward EBITDA estimates, which have not yet factored in the coronavirus's effects, we estimate Disney would need to pay down about $5 billion of debt to hit 2.5x leverage. Until the coronavirus outbreak, that seemed pretty reasonable.
However, if the company's operating cash flow fell by around 25% due to widespread theme park closures and studio film releases being delayed for a period of time, it's possible that Disney's free cash flow would only cover the dividend with nothing leftover for deleveraging this year.
Off of this lower EBITDA base, we estimate that debt reduction would need to total $15 billion to hit 2.5x leverage, though cash flow would be expected to recover whenever the demand situation improved, eventually reducing leverage.
It's too soon to say how rating agencies and Disney might respond to such a situation. If the firm wanted to continue paying down debt while investing in long-term initiatives like Disney+ (which is losing money today) during a period of unprecedented demand uncertainty, the $6.3 billion dividend could be reviewed.
