One Big Reason to Buy This Entertainment Powerhouse

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

"The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage." --Warren Buffett

According to Buffett, competitive advantage is the single most important factor to consider when it comes to selecting the best stocks for the long term, and Disney (NYSE: DIS) is one outstanding company in that sense.  The value of its brands and characters and the emotional connection the company has built with its customers make it an extraordinary business in terms of competitive strength.

Mickey Mouse, Tinker Bell, Snow White, Winnie the Pooh, Tarzan, Pinocchio, Pocahontas, Nemo, Hulk and Spider Man are just some of the most famous and recognizable names that make Disney a unique company with truly irreplaceable assets. These may not be flesh and blood people, but investors can rest assured that they have a very real economic value.

Disney is a diversified entertainment company with different business lines like theme parks, television, filmed entertainment and merchandise licensing. In addition to the rights to profit from some very famous characters, the company owns powerful brands like ABC, ESPN and Pixar among others. The company profits from this invaluable property in multiple ways: movies and TV shows, home video, merchandising, video games and theme parks among others.

The business is cyclical, as entertainment spending and advertising tend to fluctuate heavily with economic growth. But Disney is reporting new historical highs in revenue and operating margins have completely recovered from the damaging effects of the last recession.

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Parks revenue has been slowly but steadily improving with growing numbers of park visitors over the last few quarters. The media business is as good as ever thanks to the strength of ESPN, and blockbusters titles like The Avengers are producing better profitability for the movie segment too. As revenues continue climbing in the middle term, investors in Disney should also benefit from rising profit margins.

The company will need to adapt to changing technologies; low cost streaming technologies and discount rental kiosks can be a very efficient distribution methods, but they tend to generate lower revenues per transaction when compared to DVD sales.

That's why companies like Netflix (NASDAQ: NFLX) mean both an opportunity and a challenge for Disney, and there have been important frictions regarding rentals policies between the two companies. Disney decided this year not to provide its discs to the nation's largest rental companies until 28 days after they hit store shelves, adopting a policy similar to those of 20th Century Fox, Universal Pictures and Warner Bros.

Disney believes the delay can help boost home entertainment revenue by steering consumers toward more profitable DVD purchases and video-on-demand rentals, and it has reportedly been asking for better terms than those offered to its competitors. Disney and Netflix couldn’t reach a deal in those negotiations, so Netflix is reportedly buying copies of recent Disney releases from other retailers rather than directly from the studio

The company has been betting on the future of streaming via Hulu, an alliance with NBC Universal and Fox Broadcasting. The rationale for Hulu seems more strategic than monetary, the company understands than streaming will be a big trend in entertainment over the following years, and it doesn't want to depend too much on a single partner like Netflix.

The fact that Amazon (NASDAQ: AMZN) has been aggressively pushing its own subscriber-based streaming service is good news in that sense, as increased competition in streaming leaves Disney in a better negotiating position. And Disney is actively negotiating with Apple (NASDAQ: AAPL) too, according to Bloomberg the Cupertino giant is interested in giving subscribers online access to programming through the computer maker’s Apple TV device.

Disney currently offers ESPN3 to subscribers via Microsoft´s (NASDAQ: MSFT) X-box game console, so the company is diversifying its bets by dealing with all the major players when it comes to streaming and digital TV. This is a smart decision; Disney is a content company and should stay agnostic when it comes to the future possibilities for different platforms.

Piracy is another considerable challenge for Disney and other companies in the industry, especially in emerging markets where growth opportunities are very attractive, but law enforcement regarding piracy can be problematic to say the least. Disney can tackle this issue over time, since it has diversified business lines, abundant financial resources and overall fundamental strength.

Valuation wise, the company doesn't look like a complete bargain, but the price tag is still reasonable for such a high-quality business showing strong earnings potential. The company trades at a P/E ratio of 17, which is in line with its historical average. Although the dividend yield of 1.2% is nothing to write home about, dividends payments have been on the rise lately, and Disney has a very conservative payout ratio of 20% which leaves ample room for further increases.

The price seems quite average; what's extraordinary in this case is the company’s competitive advantage, the most important factor according to Warren Buffett himself.

acardenal owns shares of Disney, Apple and Amazon. The Motley Fool owns shares of Apple,, Walt Disney, Microsoft, and Netflix. Motley Fool newsletter services recommend, Apple, Netflix, and Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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