Walt Disney Co (NYSE: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.

I wrote my initial thesis on Disney in mid-February 2016. 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.

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.

Disney DIS Dividend Risk

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:

Disney DIS Dividend Risk

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 hit of approximately 40 cents – or about 7% of the consensus earnings estimate for the company in 2017.

Depending on the multiple assigned to Disney’s lost earnings from Studio Entertainment in a “mean reversion” scenario, the hit to the stock price could be around $5 to $6 per share.

While far from disastrous, the removal of this major growth driver would really weigh on overall earnings growth. I previously mentioned that Disney’s income growth last quarter would have decreased to just 1% if Studio Entertainment profits were flat (much less if they declined).

I want to be clear that I don’t worry about the long-term prospects of Disney’s Studio Entertainment business. In fact, I expect it to remain a core driver of the overall Disney enterprise.

I would just prefer to get involved with the company when Studio Entertainment results aren’t red-hot, especially when another major part of the business could continue cooling off (ESPN).

Risk 3: ESPN’s Future Could Take Years to Determine

ESPN will account for close to 25% of Disney’s operating profits this year, according to Nomura Securities.

The rise of cord-cutting and adoption of streaming services have made subscriber growth hard to come by in recent years.

As seen below, ESPN’s total subscribers began declining in 2011 and have fallen nearly 10% since peaking near 100 million.

Disney DIS Dividend Risk

Source: Wall Street Journal

ESPN has continued raising prices to more than offset subscriber declines in recent years. ESPN earns the highest carriage fees of any TV channel at about $6.61 a month per subscriber, according to SNL Kagan.

It’s hard to imagine that more than 90 million consumers would be happy to continue paying nearly $7 per month for ESPN if it was offered as a standalone service rather than bundled together with other channels.

However, they don’t get to make that decision under the current pay-TV structure.

ESPN’s content is still valuable enough that cable providers have little choice but to include the network in their packages and pass the cost along to consumers.

Live sports cannot be replicated, and EPSN’s exclusive rights agreements with the NFL, NBA, and college football give it access to unique, in-demand content.

Other staples of ESPN, such as SportsCenter, are beginning to look more vulnerable. SportsCenter’s ratings are down 27% since 2010, according to a former ESPN executive.

The rise of mobile devices and a number of online applications have made sports information available 24/7 at our fingertips.

In other words, a show such as SportsCenter isn’t as newsworthy as it was 10 years ago.

ESPN is experimenting with different show formats and has taken a number of actions to right-size parts of its cost structure (also driven by higher sports rights costs), including parting ways with some of its popular but pricey hosts.

Looking at the bigger picture, ESPN faces the innovator’s dilemma – Disney doesn’t want to give up the golden goose of lucrative pay-TV packages, yet it risks falling behind in the rapidly-growing world of direct-to-consumer streaming if it doesn’t somehow evolve with the times.

Disney is far from resting on its laurels and announced a deal earlier this year to acquire a stake in BAM Tech, the video-streaming unit for Major League Baseball.

The company plans to use BAM Tech to launch a direct-to-consumer ESPN-branded subscription streaming service, which will show content that Disney has licensed but doesn’t air on ESPN’s cable TV networks:

“The goal is to launch the ESPN-branded service probably by the end of the year, but we’re not saying specifically what date it will launch. It will include content that BAM Tech has already licensed for Major League Baseball and the National Hockey League, and we will add content that ESPN has licensed like college sports, football and basketball, tennis, rugby, cricket, et cetera. The goal is not to take product off ESPN’s current channels but to use sports and product that ESPN has already licensed that’s not appearing on the channels. And so we view this as a complementary service to what ESPN is already providing as part of their multichannel package. Obviously in an over-the-top, direct-to-consumer fashion.” Source: Seeking Alpha Transcripts

During Disney’s recent earnings conference call, CEO Iger said the pricing of its networks is similar on over-the-top networks compared to its pay-TV packages and helps drive higher subscriptions for carriers. He also noted that AT&T new DirecTV over-the-top service would feature ESPN and Disney’s other major networks.

“We know from what we’ve seen particularly in the last year, that the inclusion of Disney product, particularly ESPN, on these OTT services is quite meaningful. Sony certainly had that experience when it launched Sony Vue without ESPN. And then it included it later after the launch. And it saw its subs go up substantially. So clearly, we believe that by putting our product on these platforms, the platforms stand a chance of growing faster than they would have without it. Whether it will result, I guess, in a huge shift, I don’t know. I think the consumer is largely going to dictate that, but I think it’s important to point out that by us being on these platforms at prices that make sense to us, we’re really quite neutral in terms of shifting from a traditional MVPD consumer to an over-the-top consumer. Meaning, the pricing of our networks is similar on the over-the-top networks than it is on the MVPD platforms. I guess I could add that – and I guess the DirecTV, AT&T platform, DirecTV Now is a great example of this. We think Hulu will be as well.” Source: Seeking Alpha Transcripts

It’s still too early to know what consequences (intended and unintended) growth in over-the-top services will have on ESPN. Change will likely be gradual any given quarter but could have a major impact on long-term growth and profitability.

While revenue growth from Disney’s media networks business remains uncertain over the next couple of years, its cost structure will almost certainly continue to inflate. As this plays out, margins could be squeezed if cost cuts and advertising growth fail to keep up.

ESPN’s sports-rights costs have increased 50% since 2011 to hit $4.5 billion in fiscal year 2015, according to the Wall Street Journal.

Disney DIS Dividend Risk

Source: Wall Street Journal

Disney renewed its Monday Night Football deal for $15.2 billion in 2011, agreeing to pay close to $2 billion per year through 2021 when the deal expires.

That marked a 73% increase compared to Disney’s prior rate for the rights to Monday Night Football.

Disney’s annual payments for NBA sports rights have tripled in recent renewal deals as well.

Unfortunately, the competition for live sports rights is only increasing. For example, Amazon has over 60 million Prime members and is making a more aggressive push with its streaming TV service.

The company already spends billions of dollars each year to offer TV shows and movies.

According to a Bloomberg article, Amazon started exploring the creation of a live online pay-TV service in late 2015 and is interested in making a big move in sports.

For now, Disney has Monday Night Football rights locked up until 2021, and its NBA deal runs through the 2024-25 season.

However, there will no doubt be plenty of other bidders with big wallets ready to make a move for sports rights when the opportunity presents itself.

With cable companies already paying ESPN the highest monthly fees of any network and consumers fed up with the high price of cable, something has to give if sports rights costs continue soaring.

Adding in the developments of over-the-top streaming services, the emergence of new threats (e.g. Amazon), and consumers reaching their limit on pay-TV packages, Iger has his work cut for him the next two years to successfully position Disney’s media assets for the future.

Closing Thoughts on Disney

I really like Disney and believe it possesses one of the strongest portfolios of hard-to-replicate assets in the world.

Demand for content will continuing rising over the long run, which ultimately bodes well for the company’s ability to monetize its intellectual property.

However, Disney is at a crossroads and faces the innovator’s dilemma with its lucrative ESPN business.

While I believe Disney will eventually figure out ways to maximize long-term profits from its media content, it could realistically take several years for a clearer picture to emerge, and things could get worse before they get better.

When coupled with rising sports-rights costs, the Studio Entertainment segment’s potentially peaking profitability, and uncertainty over CEO Iger’s successor, I am more inclined to wait for an even lower stock price to compensate for these risks.

I am all for snapping up shares of high quality businesses when they go on sale for reasons that have nothing to do with their long-term earnings power, but some legitimate cracks have seemed to emerge for the future of ESPN’s business model.

That’s not to say that ESPN won’t be even bigger and stronger than ever before in 10 years, but the heightened uncertainty suggests it would be prudent not to rush into the stock without a healthy margin of safety.

There is obviously much more to Disney than ESPN, which accounts for 25% of operating profits. However, when combined with Studio Entertainment, a big part of Disney’s profit growth engine could sputter more than analysts’ currently expect in the next year or two.