By Kwan-Chen Ma and Michael E. Goldman
All eyes are still on ESPN for Disney (NYSE: DIS). Should they be?
It is not a secret that ESPN subscriber loss has been a sore spot for Disney for the past few quarters. As part of the universal "cord-cutting" movement toward streaming services, ESPN has lost more than 9 million, or 10%, of its subscribers in the last 3 years.
(Sources: Company 10Qs and Bloomberg)
Considering the average $80 per year subscription fee, the loss in revenue is near $3 billion (see below). The more alarming fact, though, is that the loss has spread across all sports channels, including ESPN2, ESPNU, FS1, NBC Sports Network, and NFL Network.
(Source: Company 10Qs and Bloomberg)
Here we are, on the eve of Q4 2016's earnings announcement. Despite Disney CEO Bob Iger's attempts to rally shareholders' hope and stock prices, with promises that ESPN "has reached its nadir," Nielson estimated that ESPN has accelerated its loss to another 640,000 subscribers in January. However, Nielsen has been criticized for not counting online streaming and multichannel video programming distributors (MVPD) in subscriber data. After including Sling TV last month, ESPN still saw a 219,000 subscriber decline versus a 29,000 decline in January last year.
Regardless, even for the most die-hard fans of ESPN who insist that "sports are too popular" to defect from have to concede that ESPN is no more the golden growth boy for Disney.
Quietly, Disney has been planning for the inevitable. The subscription unit rate has been rising from $4.02 to $7.04 a month, or 75%, since 2005 (see first Figure above). To further react to the changing preferences of users, Disney has explored new platform providers, MVPD, and streaming options with Hulu and AT&T (NYSE:T). Disney and Comcast have put millions into Virtual Reality as the only way to rival Netflix (NASDAQ:NFLX), and there was a point where Disney was rumored to buy Netflix.
That said, the Q3 2016 result seems encouraging that the loss in subscribers may have been partially offset by the growth in the skinny bundle. The sports channel is currently a member channel of Dish Network' s Sling TV, Verizon Communications' Custom TV and Sony' s PlayStation Vue bundles. While the bundle cost has dropped to $25, a significant savings, there is no evidence to indicate that these tactical moves have worked yet. By the end of 2016, ESPN has dropped to less than 89 million subscribers. Although that is still $7 billion in subscriber revenue per year, with an annual rights fee of around $6 billion and rising, what would happen if cord-cutting eventually drove that number down to its breakeven level, say, 75 million subscribers?
ESPN Subscriber Losses Overplayed
Look like the trajectory of ESPN's future outlook may have become more of a news-worthy talking point. This is why we should compute the actual dollars and cents for its impact on Disney's revenue, earnings and stock price:
For the last decade, ESPN has contributed between 26% and 29% to Disney's annual revenue. If we agree that ESPN needs 75 million subscribers to breakeven, it may be inferred that ESPN has been on average responsible for approximately 10% to Disney's earnings, or 15 cents of the $1.50 estimated EPS for Q4 2016. With that in mind, let's assume a "less likely" scenario that ESPN loses, say 2.5 million (219,000 per month) subscribers in 2017. Mind you it is a conservative (over)estimate since Disney's many new maneuvers to mitigate the user losses are currently in place, the resulting ESPN revenue loss should be around 2%, being partially offset by a rising subscription price. It will in turn translate into just a bit more than 0.5% loss in Disney total revenue.
(Source: Company 10Qs and Bloomberg)
As for the earnings front, the Media Network which includes ESPN and ABC has an average profit margin of around 32%, which is higher than the 16.5% of Parks and Resort and 16% of the Studio Entertainment (see Figure above). If the higher 32% profit margin is used to estimate the earnings loss from 0.5% revenue loss, it amounts to a 0.16% earnings loss.
Neither the 0.5% revenue loss nor the 0.16% earning loss that originated from ESPN's subscriber losses should be screaming sell signals. You would have to assume the highly anticipated Lucas and Marvel big box office releases and the soon-to-be-profit from Mickey "Mao" of Shanghai Disney do not materialize.
Since we brought Disney's shareholders into the picture, maybe the ultimate test is to see if ESPN's growth had any impact on the stock price. In the Figures below, we show the relationship, or lack thereof, between DIS monthly stock returns with ESPN's subscriber growth and ESPN revenue growth since 2015. Consistent with what the graphs show, the statistical tests also confirm that there is virtually no statistically significant relationship between DIS stock returns and ESPN revenue and subscriber growths with correlations around 5%. The street estimates that Disney's fair value is $108-$121. The mild 6% undervaluation seems sensible for not overreacting to the news of ESPN subscriber loss.
(Sources: Company 10Qs)
The long side of the story is not to react to a most likely worse than estimated ESPN subscriber losses on the forthcoming Q4 2016 earnings announcement.
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. I have no business relationship with any company whose stock is mentioned in this article.