Disney's ESPN Problem May Finally Be Catching Up To It

Summary

• Disney's new NFL deal almost certainly marks the end of its Disney Bundle, a key part of its streaming strategy up till now.
• The new deal has full streaming access, which means cord-cutters can now cancel pay-TV and subscribe to ESPN+ for full access to Disney's NFL content.
• The current math, at ESPN+'s current price, doesn't even come close to working. Roughly speaking, a quadrupling of ESPN+'s price or more is probably necessary.
• This would double the Bundle price and essentially force non-sports subscribers to subsidize sports - the very thing that drove them out of pay-TV and to streaming in the first place.
• Even after breaking the Bundle, substantial losses on the deal are possible. Those plus the end of the Bundle may raise questions about Disney's streaming strategy and pressure the stock.

Justin Sullivan/Getty Images News

The dust still hasn't fully settled on the mid-October reports that Disney (NYSE:DIS) was seriously exploring spinning off or selling their one-time crown jewel ESPN. Disney was quick to label the reports inaccurate, and so far there's no further update, suggesting that it may well have been, at the least, premature.

I don't know which way Disney management is leaning on selling, but I do think that something is about to shift at Disney. The Disney Bundle, on which it has built its considerable streaming success to this point, is probably about to die - by which I mean fracture into its constituent pieces.

While the full implications of that will take time to manifest themselves, even the perception of it happening may act as a considerable headwind to the stock in the near-term. Disney's streaming success is what took it from $100 to $200 in the space of two years, and many associate that success - rightly or wrongly - with the Disney Bundle.

I'll start at the beginning.

A Paradigm Shift

Why do I think the Disney Bundle may no longer be able to continue, at least in anything resembling its current form of offering three services (ESPN+, Disney+ and Hulu) for $13.99?

The immediate catalyst for the shift seems to me to be the new NFL deals. This year, the NFL completed negotiations with its traditional television partners, including ViacomCBS (VIAC) (VIACA) and Comcast's (CMCSA) NBCUniversal as well as Disney and it's first ever all-digital exclusive partner, Amazon's (AMZN) Prime Video. The deals, even by the gold-plated standards of the NFL, were staggering, with the prior ($5 billion per year) deals being extended for 11 years at a total of $110 billion - doubling what was already the richest deal in American sports.

The average 100% increase obscures some variation between different buyers. NBC and CBS took the major hits, more than doubling each of their respective payments. Disney did better, at least at first glance. It's rights payments increased "only" 45%. The main, Monday Night Football deal went from $1.9 billion to $2.7 billion. The price of the corresponding Wild Card side deal wasn't disclosed, but we probably know what it is, which I'll come back to in a bit.

As part of the agreement, almost every company in the deal - Fox Corporation (FOX) (FOXA) being the one notable exception - confirmed they also obtained full streaming rights. This means that games may be simulcast on both streaming platforms and traditional linear TV channels. Disney confirmed they would be taking full advantage of this right, with MNF (Monday Night Football) continuing to broadcast on flagship station ESPN but also available to cord-cutters through the ESPN+ streaming service.

Note that these rights are far more extensive than just the "TV Everywhere" rights that have been the focus of producers and distributors the last few years. Full streaming rights means that subscribers to ESPN+ may view the game without being subscribed to any pay-TV service.

Which, I am convinced, is why Disney may now be wondering if selling ESPN would be not only beneficial, but necessary. These deals, it seems to me, almost have to mark the end of the Disney Bundle, as it is currently constituted, with ESPN+ joined with Disney's two entertainment services, Disney+ and Hulu. If ESPN+ is about to be yanked out of the bundle, Disney would have an easier time justifying that to its customers if it could say it was sold and the new owners went in a different direction. But regardless of whether it stays under the corporate umbrella or not, it can't stay in the Bundle.

The Deal's Downsides

I've certainly noticed that the initial reaction to this deal is to treat it as great news. ESPN got full streaming rights and paid a smaller increase than any other TV provider to get them. What's not to like? Well, a couple of things.

First of all, part of the reason ESPN held down increases is because its previous deal was so ridiculously overpriced. ESPN paid $1.9 billion while NBC was paying $850 million for SNF(Sunday Night Football.) Both got a primetime national exclusive window, one game a week, in fact NBC usually got the better game... and ESPN paid over twice as much.

ESPN made clear it wasn't interested in doing that again, and now it has at least narrowed the gap with the NBC rights payment, which has been pushed up to $2 billion per year. But ESPN is still paying more for the same product. Disney insists that new measures to bring the MNF quality up to par with SNF, combined with an extra three games a year for ABC and a (small) share of the Super Bowls will eliminate the rest of the disparity, but that's questionable at best, in my opinion.

Regardless, the point for our immediate purposes is just that ESPN isn't getting any sort of discount for NFL content compared to other content partners. It's simply getting overcharged less than before.

Secondly, and more importantly, the deal, when viewed in absolute terms instead of relative to the deal that came before it, isn't a very good one. And while ESPN was kind of able to shrug off the last deal's impact on the bottom line - by passing its cost through to captive pay-TV monopoly customers - this one won't be as easy to shrug off. To even try, Disney will need to break the bundle.

So why is it a bad deal, and why will breaking the Bundle be necessary to even try to correct it?

Paying The Piper

First, it's more than $2.7 billion. That deal is only for the regular-season games and the Super Bowl. To get the playoff games in between the two, Disney regularly negotiates a side deal for a Wild Card series game. Disney's ESPN, by the way, is still the only one that has to buy its playoff games separately. All the other partners get their playoff games - each far more of them than Disney gets - as part of their base package.

That game previously went for $100 million. Disney confirmed, shortly after the main deals were announced, that it had also negotiated a new side deal for the playoff game. But unlike the main deal, where Disney was eager to trumpet how its savvy negotiating had held down the rate of increase, this time it refused to disclose the price. Assuming that a playoff game was handled more like a typical NFL package, it probably doubled like everything else. I don't think it's a stretch to assume that game now costs $200 million a year.

So Disney's real total is $2.9 billion, that it has to recoup just to break even. Can it generate that much, and maybe even more, to turn an actual, you know, profit?

As long as MNF was exclusive to pay-TV, the answer to that was, just barely, yes. Millions of people have dropped their pay-TV subscriptions since Netflix (NFLX) became a household name, but enough of them - largely sports lovers - stayed and tolerated the massive price increases that MNF and other sports properties like it necessitated.

But now, people don't need to be inside the pay-TV bundle to watch MNF. They can cut the cord, and just get an EPSN+ subscription. Previously, my research had indicated that as many as 11 million pay-TV households were retaining their subscriptions primarily or even exclusively to access NFL content. With all the cord-cutting that has happened since then, both Netflix-inspired and COVID-inspired, I'm sure that number has gone down since then. But the fact remains that there will probably be an uptick in cord-cutting next year when the new deals kick in and streaming becomes truly co-equal with broadcasting and cable.

This means that Disney needs to ensure that its economic structure at ESPN+ is sufficient to generate enough revenue to at the very least, not lose money when a new wave of football-loving, cable-hating cord-cutters come its way. Can it do so as currently structured?

I just don't see how.

Doing The Math

There are a few deductions from this number in Disney's favor, right off the bat. First, not all of this money has to be defrayed through subscription costs.

Advertising Revenue

NFL games are some of the most prime real estate in advertising, and NFL advertising generates several billion dollars per year. Disney, unfortunately, gets a relatively small slice of this, since it gets a relatively small slice of games.

Standard Media Index reported that Monday Night Football was good for $228 million in 2018 and growing at 10% a year. Three years compounding at that rate would bring the total up to a little over $300 million, and then there are the Wild Card game ads, the NFL draft which gets close to MNF level viewership and the three extra ABC games.

Let's call it $500 million all together, which I think if anything is generous.

Super Bowl

Another offset we can make is for the Super Bowl. If the NFL is prime real estate, the Super Bowl is Buckingham Palace. It's just about the only time left all year long when the whole country basically sits down to watch TV, like we all used to do back in the '60s and '70s. Last Super Bowl, CBS reported that it had generated a staggering $545 million in advertising revenue from that one game. This was over and above the ad revenues they made in all the other games leading up to that.

If we divide that number by the number of years in the new contracts, and prorate the revenues evenly over the life of the contract, the Super Bowl is basically worth a prorated $50 million per year for each Super Bowl awarded under the contract. ABC got two, so that's $100 million per year we will knock off.

That leaves $2.3 billion left to be covered by the only other revenue source ESPN+ has: subscription fees. And right now, there just aren't near enough of them.

The Shortfall

One good thing about ESPN's quarterly reports is that they report ESPN+ subscription revenue standalone. ESPN+ also has Pay-Per-View revenue for wrestling matches and of course, advertising revenue as we already talked about, but this is not included in its revenue reports. So we know without doing any painful math that as of July, ESPN+ was generating $4.47 per month in subscription revenue.

It's headline price is of course considerably higher - now $6.99 a month after ESPN+'s second price hike in less than a year - but the Disney Bundle allocates its $13.99 a month revenue to its three constituent services in proportion to their share of the total headline prices of the three. This means that the $22 combined cost of the three services is essentially discounted a little over one-third each. ESPN+ also still hasn't fully worked off a group of annual subscriptions sold when it was still selling for $4.99 a month and a year was going for $50. The rate will rise slightly as these fall off.

But I'm not sure how much that's going to be worth since it's likely that the vast majority of ESPN+ subscriptions are in the Bundle. I'll raise it to $4.60 per month, to keep the numbers round, but I don't think the current estimates justify going much higher than that.

This is where Disney's problem starts to become clear. That price means that ESPN+ will need to sell 500 million "subscription-months" - a single month for a single subscriber - to recoup the remaining cost of the NFL. With the entire football season lasting only five months, that isn't even remotely feasible.

Pay-TV itself peaked around 100 million households and is currently down below 80 million. Disney probably can't count on more than a smattering of cord-cutters, people who cut the cord even when pay-TV had a monopoly on football, to come beating down their door now for a football subscription. Netflix, hands down the most popular streaming service out there, looks to be peaking at around 70 million. Figure ESPN+'s ceiling is somewhere well below that. It's probably even below Hulu's, which is having trouble getting to 50 million.

ESPN+'s subscription fees are so utterly inadequate for two reasons. The first is that it charges less a la carte than Disney's flagship ESPN channel charges as part of the bundle. Which is great for football lovers who are now about to be free of the pay-TV monopoly, but not so good for Disney or its shareholders.

But the second reason is seasonality. When Disney negotiates a contract with a pay-TV distributor, it receives a set fee for each month of the year. That means that it gets paid for its NFL content in May as much as November, and it can charge a lower per-month fee. But streaming subscriptions are monthly pay-as-you-go. A football fan who doesn't care for ESPN's baseball or golf content might very well not subscribe the other half of the year, so ESPN+ needs to charge enough to get the same amount of money in only half the time.

Even at 50 million subscribers per month, ESPN+ needs to double its price. But frankly, 50 million isn't much less ridiculous than 100 million. The average MNF game generates viewership of under 15 million, and that's with the NFL having its best ratings in years. If it falls back to 2017 levels it could be at 12 million. Even accounting for the fact that subscriptions exceed viewership of given game - some people are unavailable to watch every game in a month, but still pay to watch some - it seems highly unlikely the number is a soul over 30 million. 20 million seems more realistic to me.

If we mid-point it at 25 million, ESPN+ needs to charge four times what it is to break even on the NFL, and that's before whatever the operating costs of ESPN+ are. Not to mention other sports content it is also paying for in those months. But tacking those things onto our analysis would just be kicking ESPN while it's down. The key point is that the fee has to go way up, perhaps as early as next year when the new deals kick in.

But how can it do that inside the Disney Bundle? As currently structured, the $14 Bundle basically gives every subscriber who wants Hulu and Disney+ ($15 between them) free ESPN+ thrown in, which of course they don't mind. But quadrupling ESPN+'s current $4.60 would require doubling the Bundle as a whole, from $14 to $28.

There is no way non-sports viewers would stand for that. Of which there are apparently quite a few, since Hulu has over 40 million US subscribers and Disney+ may well have even more, compared with less than 15 million current ESPN+ subscribers - many of whom are probably only "subscribing" to ESPN+ because it comes with the bundle.

Implications Extend Beyond Disney

Before we wrap up, just one other quick thing: this analysis could be applied to a lot of the other NFL partners, too. NBC, CBS, FOX and Amazon didn't quite pay ESPN's ludicrous levels, so they're not quite as poorly positioned, but I think there is a real argument to be made that by the time the book is closed on these 11-year deals in their entirety, more than one and perhaps all of them will have lost money. AT&T (T) probably wants to think about that before extending Sunday Ticket, too, although Sunday Ticket has a fundamentally different business model so that really is probably a separate question with a separate analysis.

Still, for everyone involved, NFL deals at this price may be asking the streaming customer base too much. Remember sports fans have never had to carry expensive sports deals alone - they got to force non-sports subscribers to pony up for them too. But the whole reason people cancelled pay-TV and switched to streaming was to get away from that, so try it again and they'll just cancel again and find new streaming services that are sports-free, like Netflix and discovery+.

Investment Summary

But probably no one is as bad off in this regard as ESPN. Everyone else is generating more ad money, over more subscribers, and Amazon in particular may not even be trying to make money on the deal, just burnish its Prime service. But ESPN exists solely to sell sports, and so it needs to turn a profit on sports, not shoe sales or server capacity.

And it seems almost inevitable that if it can do that it all - and the NFL deal is so expensive that maybe it can't - it will have to do it outside the Disney Bundle. And breaking the Bundle may well push the stock down, since so many associate the Bundle so closely with Disney's streaming future.

The ironic thing is that I'm not so sure they should. Disney+ if anything will probably do better outside the bundle. But the market doesn't seem to see it that way. So rather than buy here, I am going to wait for the other shoe to drop on Monday Night Football, and maybe consider buying if it dips lower.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.