Mind the GAAP: Profits Prioritized
Investors want to see real earnings, not projected or adjusted profits. And definitely not losses anymore. By Benjamin Tan
In 2023, Walt Disney ($DIS) will be marking its centenarian milestone: “Disney 100 Years of Wonder” is expected to be its largest global celebration in its history. A century of cultural relevance is pretty solid proof of institutional ability to maintain brand value and allocate capital over multiple cycles. As a blue-chip name, Disney is in the top tier, up there with the likes of Goldman Sachs ($GS) and 3M ($MMM). Disney stock has remained in the Dow Jones Industrial Average index since 1991.
Yet, looking at its recent share price performance, things do not look celebratory. Disney stock dropped more than 13% to close at $86.75 on November 9th, the day after earnings were released. That was the lowest closing price since March 20th, 2020, when markets crashed at the outset of COVID-19.
One may infer that Disney’s future, as suggested by its post-earnings share price, is deemed to be almost as bleak as pandemic era. Never mind the rollout of Disney+ or how many additional Marvel blockbusters have been created since early 2020. As far as recent markets are concerned, Disney is more black-and-blue than blue-chip. It would probably have been more joyous for all stakeholders if centennial celebrations were held in 2021, when Disney shares were near $200.
“Show me the money”
So what about Disney earnings that sank the stock? The main culprits appear to be a lower guide for FY 2023 operating profits, larger-than-expected Q4 operating losses at its streaming business ($1.47bn) and underwhelming profitability at Parks, which made a 15% operating margin compared to 30% in Q3 2022.
Profitability is everything in a risk-off environment. Equity investors continue to seek shelter in names that can generate consistent (and preferably growing) earnings. Hence, Apple ($AAPL) of late is doing much better than Amazon ($AMZN) and Alphabet ($GOOG), both of which reported lower operating profits in Q3 due to a combination volatile revenues and ballooning overheads from aggressive growth initiatives. With cost of capital rising in the near-term, investors are demanding profits today - not in the coming quarters, and definitely not years.
Disney’s structural pivot into streaming was initially applauded by the markets, especially with the resounding success of Disney+ worldwide since Q4 2019. It is an essential reinvention to stay relevant in a direct-to-consumer (DTC) and digital economy. Costs to create a challenger to Netflix ($NFLX) were going to be immense, and breakeven would only happen many years later, especially with a much lower ARPU to target the widest possible audience. Yet, when Q4 2022 earnings came out, markets were no longer prepared to stomach larger DTC losses, despite Disney management assuring they had peaked in Q4 2022 and that the business would turn profitable by FY 2024. The original narrative around the future of Disney 2.0, even with the unprecedented speed at which Disney+ subscribers had grown, is no longer given credit by the markets.
In the coming weeks, I will be doing a deeper dive into Disney, including a sum-of-the-parts analysis, with Sam Fargo of Money Buff. Subscribe to make sure it lands in your inbox:
Growth is Deprioritized in Current Markets
If Disney, with a combined subscriber base comparable to Netflix, cannot convince markets to ascribe meaningful value to its streaming business, imagine the narrative challenges faced by next-generation technology companies that are still investing for growth without any bottom-line to show.
Up-and-coming software companies have therefore fared far worse than Disney. The likes of Crowdstrike ($CRWD), Zscaler ($ZS), Snowflake ($SNOW) and Datadog ($DDOG) are all trading at a fraction of their 2021 valuations. None of these companies have ever reported GAAP net profits before. Adjusted earnings, though positive for all of them, do not seem to provide the same buffer against bearishness as GAAP profitability does. Bold growth plans are not appreciated either. When Cloudflare ($NET) declared a $5bn revenue target in 5 years but promised to keep investing, markets sent its stock down by more than 10% for threatening to keep those GAAP losses mounting. Even if software companies can point to the likes of Salesforce ($CRM) and Amazon Web Services as models of eventual profitability, markets do not care. Current profitability is everything.
Scale, Balance Sheet and Momentum from Past R&D Matter More
Markets are playing it safe by over punishing losses and rewarding current profitability. Sure, it is hard to predict which GAAP-loss-making next-generation companies will survive in the next 5 years, let alone wager on future profitability at scale. Present valuation is just an aggregation of discounted future cash earnings, which become even more uncertain in the current macro environment amid heightened market skepticism.
When markets turn cold towards growth stories, raising capital by the ones who need it the most becomes difficult. During the 2000 Dotcom Crash and 2008 Financial Crisis, many high-growers with talented founders did not survive because they ran out of liquidity. Amazon and Tesla, two of the biggest success stories today, managed to stay afloat due to the timeliness of raising sufficient cash cushions at the right times to survive multiple winters. Both flirted with bankruptcies over the years before scaling into dominance and profitability.
Many next-generation technology companies raised boatloads of capital (via convertible bonds) and made heavy R&D investments to expand their addressable markets during the good times. Some are already at scale, generating free cashflows and have multiple cost levers to pull to manage cash burn. If their products have the right market fit and are sticky enough, continuing to reinvest existing profits to outrun cash-starved competition and expand cross-selling efforts for higher wallet share might just be the right strategy. For the fittest challengers, even if GAAP numbers get razed in the short-run and share prices continue to wobble as a result of reporting bad-looking numbers, their future might actually turn brighter because of the current winter.
Join Consume Your Own Tech Investing to receive a welcome email with the following:
Latest Top 10 conviction Consumer and Tech positions in my portfolio
Book recommendations on investing, consumer and technology sectors
One article delivered into your inbox every Tuesday
Preview of upcoming articles
Follow me on Twitter @ConsumeOwnTech and Commonstock @ConsumeOwnTech
Also, check out Daily Market Briefs, a fast growing daily newsletter that brings 16,000+ readers up to speed with the top finance and business stories around the world in under 1 minute!