Disney (NYSE:DIS) today is a stock beset by contradictions. Although worries over ESPN and its 7 million lost subscribers continue to dog the stock, it has recovered substantially from a low of $86 as continued strong results in the Film division, i.e., Captain America: Civil War and Star Wars: Episode VII, buoy some traders. A growing number of Disney bulls are also challenging the skepticism of ESPN, arguing that it remains a potent asset for Disney.
I too am encouraged by the Film division results, but I am steering clear of Disney stock and may even open a short position. ESPN is simply too big a deadweight for any of the company's other divisions to overcome.
Recapping The Argument
The argument against ESPN is two-fold. First, as the channel which benefited most from the old cable bundle, it is the channel most at risk as that bundle continues to fray. ESPN is far and away the richest channel in cable-TV, taking in almost five times the per-subscriber fees of the next closest channel. And that is just the flagship channel. ESPN2 brings in more fees, as does ESPNU, ESPN Classic, and all the rest.
Second, ESPN is not nearly as capable as some other channels of adapting to a decline in its revenues. This is because of the kind of content it carries, sports, which just a few years ago was seen - and is still seen by some - as ESPN's greatest strength. In fact, it is its greatest weakness.
Traditional channels which produce TV shows have a months' long lead time for their content commitments. They order a show in March or that shows runs for 13 episodes through Christmas. If it does well, it gets a further commitment for another 9-11 episodes to take it through to next May, when the whole lineup's performance is reviewed and the whole thing starts all over again.
This means that if CBS or NBC suffered a sudden loss of income as people didn't like their shows anymore, they would only need a couple months to adapt. When they got to next May, or even just to Christmas, they could throttle back their spending on their lineup and either replace the shows with lower-budget alternatives or even just produce fewer shows.
Straight Off The Bottom Line
ESPN is different. Its content is composed almost exclusively of multi-year sports agreements that are set years in advance. Currently, it is committed to the NFL through 2022, the NBA through 2025, and MLB through 2021. On the college front, it is committed to the SEC through 2024 and to the BCS playoffs for a year longer. Those are the biggest contracts, but there are lots of others.
These commitments mean that spending at ESPN is almost completely independent of income. Although it spends billions each year on its sports rights, it spends very little on adding an additional subscriber and cannot quickly spend any less when it loses one. This is a good thing when it's adding subscribers, because almost all of the marginal revenue of an extra subscriber goes straight to the bottom line. But when subscribers are falling off, it runs the other way: every subscriber's lost revenue corresponds almost 100% to lost profit.
Almost all content creators have high fixed costs in the short-term, of course. Netflix, CBS, HBO, Hulu, Amazon, NBC. They all face the same system. And in the long-run they are also in the same boat: no one's content obligations go on forever, all costs are variable.
But in the medium-term, in between there, they are very, very different. CBS and NBC and even Netflix can ramp down spending in months. ESPN needs years, and in some cases, it needs over a decade.
Analysts spend a lot of time calculating just how big a slice of Disney's pie ESPN is every quarter. But because of the almost 100% marginal effect that I just described, we actually don't need to dig down in the report for those numbers. However, much of Disney's total profit is, whatever they lose from ESPN we simply subtract that from the current number.
What we do need to know is how much each subscriber contributes, as well as an estimate of how many more subscribers they could lose. That number multiplied by 80% - Disney's ownership stake, Hearst Corporation owns 20% of ESPN - is the hit to the profit level.
According to Disney bulls, that second number might well be zero. In fact, some bulls, including Seeking Alpha's own Nicholas Mushaike, think subscriber losses could even reverse and start growing again. As evidence of that, he cites, among other things, a widely reported statistic from Disney's last fiscal year. At a conference in March, CEO Bob Iger repeated that "95% of multi-channel television [cable/satellite TV] subscribers watch live sports, and 81% of them watched ESPN."
Obviously, I have a very different take on this from the bulls.
The Flip Side
First, please note how carefully this is phrased. If you currently have an MVPD subscription, you have a 95% chance of watching sports, and an 81% chance of watching ESPN specifically. So all the people who've already left the sports-heavy cable bundle because they don't need it are excluded right off the bat. Still, 81%. Sounds like great news, right? It's not.
To understand why, simply remember how MVPDs work. Customers pay a fixed fee for a set package of channels. They cannot pick and choose channels, and they pay nothing extra to watch whatever channels they already have as much as they want. In other words, the marginal cost of ESPN to existing MVPD customers is zero.
81% of those customers watch ESPN. So Iger's comment could just as easily be rephrased like this: "19% of the people buying cable bundles won't watch our content even when its free with their subscription."
In Dollars, Please?
So as the cable bundle continues to fray and pay-TV continues to slowly migrate towards a la carte, or at least smarter bundles a la Verizon's Custom TV, it's safe to assume that a minimum of 19% of customers will be leaving ESPN behind. How bad is that?
Commentators usually cite ESPN's subscriber fee of $6.61 a month. But its twin channel ESPN2 is always in the same bundle with it and shares the same content packages. Basically, the overflow from ESPN is on ESPN2. So the two together are $7.44 a month, or $22.32 per quarter.
19% of ESPN's remaining 92 million subscribers is about 17.5 million. 17.5 million subscribers times $22.32 last quarter is about $391 million coming straight out of ESPN's bottom line.
But the ESPN family actually consists of eight channels, including ESPNU ($0.22 per month), the SEC Network ($1.30 per month, but it's only in about two-thirds of American households), the Longhorn Network in Texas, ESPN Classic, ESPNews, and Spanish-language ESPN Deportes. Assuming the SEC Network lost subscribers proportionally to its original size, 12 million multiplied by $1.30 multiplied by 3 months knocks about another $47 million out. ESPN Classic, ESPNews, and ESPN Deportes losses would be less, but they'd still hurt. At a conservative $0.20 per channel plus ESPNU's $0.22 per month, multiplied by a proportional share costs another $29 million last quarter. Longhorn Network has a very narrow Texas focus so I've excluded it for now.
So ESPN is out almost $470 million per quarter in profit, almost $1.9 billion per year. Disney's share of that comes out to $1.5 billion.
Disney is trading at $100 right now, after plumbing a low of $86. Its last annual profit was $9.1 billion. Assuming its TTM P/E of 19 didn't change, it would have to fall to a new low of $83 to make up the loss of $1.5 billion from the apathetic subscribers. That's before any actual declines in viewership at ESPN.
ESPN will not lose all those subscribers at once, of course. The transformation of pay-TV will continue to move gradually, although fewer and fewer question that it is transforming. But the stock market is a discount mechanism, and investors should be concerned that the stock might come to price in their loss a good deal faster than that, once evidence of it begins to emerge, as I believe it already has and will continue to.
Investors should not wait for that to happen. If they bought the dip, they have already secured a good profit. But the long-term future of Disney, I believe, is very cloudy at the moment, with a chance of thunderstorms. I would avoid Disney stock.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.