The No. 1 Reason Disney Stock Is Still Attractive

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Whether we’re talking about Disney’s (NYSE:DIS) ability to keep up with Netflix (NASDAQ:NFLX) when it comes to video streaming or ESPN’s ability to remain relevant with cord-cutters, there’s one metric that makes Disney stock attractive.

Can you guess what that is?

Three words. Free. Cash. Flow.

Disney announced on Nov. 28 that it was increasing its semi-annual dividend by 4 cents a share to 88 cents with the January 2019 payment. As a result of the increase, it now pays out $1.76 annually, yielding 1.6%.

“Given our record financial performance in fiscal 2018, we are pleased to increase our dividend to shareholders, while continuing to invest for future growth with our pending acquisition of 21st Century Fox and the ongoing development of our direct-to-consumer business,” said Bob Iger, Disney’s Chairman and CEO in the press release.

Disney Stock and Its Record Financial Performance

The key to Iger’s corporate speak were the words “record financial performance.”

In 2018, despite all the uncertainty created by the back-and-forth battle with Comcast (NASDAQ:CMCSA) over Twenty-First Century Fox’s (NASDAQ:FOX, NASDAQ:FOXA) entertainment assets, Disney managed to generate $12.6 billion in net income — 40% higher than a year earlier — on the back of $59.4 billion in revenue, which was an 8% increase over fiscal 2017.

Both the top- and bottom-line have never been higher. But that’s not what’s got me so psyched about Disney stock.

What interests me is the 13% increase in free cash flow from $8.7 billion in 2017 to $9.8 billion in 2018. Again, like revenue and net income, this financial metric has never been higher. The only disappointing aspect in 2018 is the rate at which it converts net income to free cash flow.

In 2017, its FCF conversion ratio was 97%. In 2018, it converted just 78% of its net income to free cash flow, an almost 20 percentage point decline in its FCF ratio. In the past decade, it has managed to convert between 70% and 108% of its annual net income to free cash flow with 2017 being one of its best years.

Why Am I So Concerned?

Because it drives the capital allocation decisions a company makes in a given year. The more free cash flow it generates, the greater flexibility Bob Iger has when pulling the different capital allocation levers available to him.

In 2017, DIS paid out $2.45 billion in dividends and repurchased $9.37 billion of its stock, requiring additional debt to return the $11.82 billion to shareholders. In 2018, it paid out $2.51 billion in dividends and repurchased $3.58 billion in Disney stock, leaving it with $3.74 billion to pay down debt, potential acquisitions — I can think of one big one — and invest in existing parts of its business.

Free cash flow is the linchpin for success. Well-run companies maximize and grow their free cash flow. Over the past decade, DIS has increased its free cash flow by 12.9% compounded annually. By comparison, it has grown revenues by 5.7% annually.

If you’re an income investor who depends on dividends, DIS stock’s annual growth in free cash flow, ought to be very reassuring.

The Bottom Line on DIS Stock

As Disney continues to integrate Fox’s assets into the fold, Iger’s vision for the future will become more apparent.

My InvestorPlace colleague Vince Martin believes the problems Disney faces at ESPN — declining subscribers and affiliate fees — make the growth opportunities such as the Disney Plus streaming service and the added firepower from the X-Men and Deadpool movie franchises not nearly as exciting.

In Martin’s opinion, the ESPN problem makes DIS stock less valuable.

In the past, I’ve suggested Disney spinoff ESPN. Martin’s argument against Disney stock certainly makes me wonder if now’s not the perfect time for the company to part ways with its long-time cash cow.

Either way, Disney’s free cash flow generation keeps me on the side of the longs.

As of this writing Will Ashworth did not hold a position in any of the aforementioned securities.

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