Walt Disney Co (DIS): 3 Risks To Consider Despite The Strong Dividend Growth

Disney (DIS) is one of the most iconic companies in the world and has rewarded shareholders with 11.7% annual dividend growth over the last 20 years.

However, that hasn’t stopped the stock from slumping more than 20% since hitting an all-time high in late 2015.

Today, Disney’s stock trades for about 15.3x forward earnings estimates.

It’s unusual to find such a high quality business trading at a seemingly reasonable price.

I wrote my initial thesis on Disney in mid-February 2016 (click here to read it). With the stock’s continued slump, now is a good time to dig deeper into some of the concerns I have with the business.

Let’s take a closer look at the issues weighing on Disney and whether or not a possible buying opportunity could be around the corner.

Walt Disney Co (DIS)

I have three primary concerns:

  1. CEO succession plan creates uncertainty
  2. Studio Entertainment profit growth could be near a cyclical top
  3. ESPN’s future could take years to determine

The first and third issues identified above could materially impact Disney’s long-term earnings power and are largely up in the air.

I’m not concerned with the second risk factor’s impact on Disney’s earnings potential, but I believe it has potential to unfavorably impact the company’s near-term earnings growth over the next couple of years. I would actually view this as a buying opportunity if it materializes.

Let’s dive in.

Risk 1: Disney’s CEO Succession Plan Creates Uncertainty

Disney’s Chief Executive Officer Robert Iger, 65, has plans to retire in June 2018 after leading the company since 2005.

His planned retirement has already been delayed three times, and it’s possible yet another extension could be around the corner.

In April 2016, Iger’s intended successor, Chief Operating Office Tom Staggs, unexpectedly resigned from the company.

The board is now expected to focus more heavily on outside CEO candidates since most of Disney’s other senior executives have no more than a few years of experience at the company (Staggs had been with Disney more than 25 years).

Disney is in the middle of navigating a rapidly evolving media landscape. The company’s risk profile would seem to rise if Iger sticks with his 2018 retirement plans and an outsider is brought in to run the company, in my view.

A lot can change in two years (Iger could also delay his retirement yet again), but I would prefer to have greater clarity on the company’s succession plans and strategic roadmap given the secular changes reshaping media companies (more on that below).

Risk 2: Studio Entertainment Profit Growth Could Be Near a Cyclical Top

Disney’s Studio Entertainment segment primarily makes money from producing the company’s films.

While this segment accounted for less than 15% of Disney’s overall revenue last year, it has great strategic importance for the overall company.

When Disney delivers a hit film, the company can leverage its popular characters across its different businesses and technology platforms to create a long stream of income.

Mickey Mouse is still bringing in tons of cash nearly 90 years after its initial launch, for example.

The value of popular characters cannot be overstated, but there is little certainty involved with forecasting how successful a new film might be.

Film producers incur substantial production and marketing costs to create and advertise movies before they are released in theaters.

Many films have flopped in the box office and lost tens of millions of dollars as a result of their steep production costs and lack of popularity.

Simply put, some years are going to be (much) better than others depending on which movies Disney releases and how popular they become.

Take a look at the chart below to see the Studio Entertainment segment’s income volatility if you don’t believe me.

Disney’s film unit has been on fire recently. In fact, seven of the company’s top 10 all-time highest grossing movies were released in the last three years.

Big hits include Star Wars: The Force Awakens, Frozen, Iron Man 3, Finding Dory, and Avengers: Age of Ultron.

As a result, Studio Entertainment profits have more than tripled since 2013 and are up even more over the last decade despite an overall decline in revenue.

Walt Disney Co (DIS)

Source: Simply Safe Dividends, Disney Annual Reports

As a result, the segment’s operating margins are the highest they have ever been and more than twice as high as their average over the last decade:

Walt Disney Co (DIS)

Source: Simply Safe Dividends, Disney Annual Reports

While investors might look over this segment because of its size (Studio Entertainment only accounted for 14% and 13% of Disney’s 2015 sales and operating income, respectively), it has been a major contributor to profit growth.

Disney’s overall operating income has increased by approximately $4.0 billion since 2013. Despite its relatively small contribution to overall revenue, Studio Entertainment was responsible for 33% of Disney’s income growth over this period.

If we include the operating profit growth from Consumer Products, which makes a lot of money from licensing Disney’s famous characters, about 50% of the company’s total increase in operating income since 2013 was driven by Studio Entertainment and Consumer Products – divisions that combine for less than 25% of Disney’s total revenue.

Most recently, Studio Entertainment’s operating income surged 66% last quarter. If its profits had remained flat, Disney’s overall operating income growth would have been just 1% compared to its actual growth of 8%.

What I’m trying to highlight is that much of Disney’s earnings growth over the last 1-2 years has been driven by an unbelievably successful slate of new films and record-high margins in Studio Entertainment.

It’s hard to know if Disney’s film growth and profitability will be sustainable. Don’t get me wrong – Disney is unquestionably the best in the business when it comes to developing storylines and characters and finding ways to monetize them.

Its franchise characters also have lasting value that reduces the risk of future film releases flopping.

However, I can’t be convinced that 27%+ Studio Entertainment margins are a new normal – just look at the previous chart showing Disney’s Studio Entertainment margins over the last decade.

The company has made several key acquisitions in its Studio Entertainment segment that have helped propel its businesses over the years:

2006: Pixar ($7.4 billion deal)

2009: Marvel ($4 billion)

2012: Lucasfilm ($4 billion)

These deals undoubtedly increased the value of Disney’s intellectual property and brought a slew of new characters to be used in future films.

I would be thrilled if recent Studio Entertainment results were the “new normal” for Disney, but as a conservative investor, I just can’t get comfortable (at least not yet).

What if mean reversion were to occur over the next couple of years and Studio Entertainment’s revenue and operating income shifted to $7.5 billion and $900 million, respectively?

This would represent an operating margin of 13%, which is in line with the segment’s 10-year average, and revenue slightly higher than the long-term average.

Under these assumptions, Disney would see its operating income from the Studio Entertainment segment decrease by roughly $1 billion.

After applying a 36% tax rate, the impact on Disney’s diluted earnings per share would be a

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