Disney (DIS) reported a rare miss on sales and earnings in the fiscal second quarter of 2016. The disappointing results were driven by weakness in the consumer products and media networks segments. The studio segment continued to produce excellent results, driven by Zootopia in the quarter. Parks and resorts also performed well in the quarter, but missed slightly on revenue. While it is concerning to see DIS miss overall expectations during an extended stretch of massive success at the box office, we believe the recent headwinds are short-term in nature. Over the long-term, we expect DIS to continue to successfully monetize its valuable intellectual property – including Star Wars, Marvel, and Pixar – across each of its operating segments.

Consumer products faced headwinds from difficult year-over-year comparisons to Frozen merchandise. On the call, DIS noted that there was also an impact from a timing issue on minimum payments that it receives from vendors who license their intellectual property for products. Additionally, DIS wrote off inventory and decided to shut down the low-margin Infinity division, which was producing interactive toys and video games. Infinity was an experiment for DIS, and they cited inventory management issues as a factor in realizing that in-house video game production was not part of their core competency. DIS will now exclusively license its content to video game producers going forward.

Media networks experienced some ad weakness at ESPN due to obligations to advertisers to make up for lower than expected ratings on the New Year’s Eve college football semifinals. This was not completely unexpected, but was still disappointing. Investors remain concerned with the future of ESPN, which is being squeezed on the cost side by increasing sports programming costs, and the revenue side by slowing affiliate fee and advertising growth due to subscriber declines driven by ongoing changes to consumer viewing habits – cord cutting and cord shaving. Despite these concerns, DIS reaffirmed its outlook on cable networks affiliate fees and operating income for the balance of 2016. Interestingly, DIS commented that they are negotiating distribution agreements with several over-the-top TV partners, including Dish Network’s Sling TV’s newest multi-stream option and Hulu’s upcoming skinny bundle.

Looking ahead, DIS is planning to open its new theme park in Shanghai next month. This should help drive substantial growth once the initial opening costs have been recouped. The upcoming film release slate looks as strong as ever over the next couple years, with good visibility into planned key franchise titles. However, the recent box office success will also lead to more difficult comparisons, which could lead to slower than expected growth. Overall, we believe DIS is an attractive long-term investment, but expect the stock to linger in the low-$100’s until there is more certainty on the future of ESPN’s business model.

DIS is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts.  Steve is sole proprietor of Northlake, a registered investment advisor.  Northlake’s regulatory filings can be found at www.sec.gov.