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Disney’s ESPN Reality Show Doesn’t Convince
http://www.wsj.com/articles/disneys-espn-reality-show-doesnt-convince-1438802891
ESPN’s sensitivity to subscriber declines may lead Disney to rethink its plan
ESPN’s subscriber base has fallen by about 2% this year. PHOTO: DAVID KOHL/ASSOCIATED PRESS
Walt Disney’s Robert Iger doth protest too much.
The chief executive gave an impassioned defense of his ESPN sports network on the media giant’s earnings call Tuesday. Mr. Iger said Disney executives were “realists” about the pressures from new distribution models that will continue to bear down on the cable ecosystem. Still, he said, expanded cable packages would remain the norm and ESPN would remain must-have, even in new Internet-TV bundles.
Yet Disney’s actions spoke louder than those words. The company lowered its expectations for domestic cable affiliate revenue and said lower subscriber numbers, along with foreign-exchange rates, would push cable operating income growth for fiscal 2013 to 2016 down to mid-single digits from a previous forecast of high-single-digit growth. Disney shares tanked Wednesday.
Indeed, cable networks made up 50% of Disney’s overall operating income in fiscal 2014 ended September. And ESPN is the biggest factor in that. But as the cost of cable has risen, more consumers are opting out. Some have selected “skinny” bundles of channels, which typically exclude the costly ESPN. Others opt for Internet services like Netflix or individual channels such as HBO.
Mr. Iger made clear that Disney isn’t ready to take the “radical” step toward an Internet offering, saying 83% of U.S. cable households watched ESPN in the first quarter. He added the company doesn’t see “dramatic declines” in cable subscribers over the next five years.
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But unpacking assumptions underlying that view suggests Disney may feel pressure to pivot more quickly.
ESPN’s primary channel gets $6.61 per subscriber per month, according to SNL Kagan estimates. Assume that rises by 8% a year—roughly the average of the past six years—and that fees from ESPN’s secondary channels continue to climb by about 6% a year.
ESPN’s subscriber base has declined by about 2% in 2015, in line with the previous two years, Nielsen data show. Assuming that rate continues, ESPN’s affiliate revenue should still grow by about 6% a year from 2016 to 2020.
ESPN’s overall revenue is about 75% of Disney’s reported cable-networks revenue, according to estimates by Jefferies. Assuming all nonaffiliate revenue is advertising and assigning a 3% growth rate, results in annual revenue growth of 5% at ESPN for the next five years.
On the cost side, sports rights at ESPN rose by 13% in 2014 and 19% in 2015, according to MoffettNathanson. That reflects the onset of new deals with various leagues. Nonsports programming costs have grown at a somewhat slower pace. But the pace of growth in ESPN’s programming and production costs should level off to 5% a year from 2016 through 2020, MoffettNathanson estimates. Meanwhile, the research firm sees nonprogramming costs rising at less than 1% a year.
Assuming, as many analysts do, that ESPN amounts to about 25% of Disney’s operating income in 2015 and adjusting for Disney’s 80% ownership of the network, ESPN will earn about $4.5 billion in operating income on $11.9 billion of revenue in 2015. That 38% operating margin would be significantly below the roughly 45% historical margin this model implies for ESPN. But it shows ESPN margins moving back to 42% by 2020 as cost increases moderate.
If, though, ESPN subscriber declines accelerate by, say, one percentage point in 2016 and by another in 2019, the network’s 2020 operating margin falls to 39%. That would amount to $4.6 billion of operating income attributable to Disney’s 80% stake, versus $5.1 billion under the slower-decline scenario. The potential $500 million decline emphasizes the sensitivity of ESPN’s profitability to small changes in subscriber growth amid a media landscape facing what could be massive disruption.
Granted, new Internet-TV services from the likes of Apple might help ESPN avert subscriber declines if they carry the channel. Declines might also stabilize as skinny-bundle adoption slows.
Still, there are compelling reasons to believe declines will accelerate as the cost of the cable bundle rises and the availability of high-quality online alternatives increases.
Moving outside the bundle would be a painful transition for ESPN and Disney. But waiting too long to do so risks teaching some consumers to live without it.
