Disney's ESPN Is Still the King of Cable

Walt Disney (DIS 0.18%) reported its fourth-quarter earnings on Thursday, beating analysts' estimates on every segment, except media networks. Media networks accounts for more than 50% of Disney's operating income and is one of its most dependable revenue generators, but in the last three months, operating income fell $129 million year over year to $1.44 billion for the quarter.

ESPN makes up the lion's share of operating income for Disney's media networks segment. The Worldwide Leader in Sports looks strong, however, even in the face of growing competition from Twenty-First Century Fox (FOXA), CBS (PARA -0.47%), and Comcast's (CMCSA -0.37%) NBCUniversal segment.

Behind the numbers
It's easy to look at the cable segment's operating income and say something's going wrong at ESPN. Content costs are rising as a result of an increased number of bidders -- that's true. Those competitors -- Fox, CBS, NBC -- are grabbing market share from ESPN -- not so true. Ratings at ESPN climbed year over year. Ad rates aren't rising fast enough -- also, not true. Ad revenue grew 9% on the back of an increase in units and higher rates.

For all intents and purposes, ESPN is humming along just fine. Adjusting the cable networks segment for deferred ESPN affiliate fees, it saw operating income rise 6%. On the conference call, CFO James Rasulo pointed out that "ESPN was significantly higher than that."

What brought down the cable segment's operating income was Disney's investment in the A&E Network, and an investment in a free-to-air channel in Germany. ESPN is still Disney's most valuable property, and there's nothing in this earnings report to suggest otherwise.

Is the lead narrowing?
Fox launched Fox Sports 1 last quarter. The company initially wanted to charge cable providers $0.80 per subscriber to carry the channel, but with no track record and an unestablished core audience, Fox had to back down from that price to just $0.23 per subscriber each month.

But this is a long-term game for Fox. ESPN didn't become the worldwide leader overnight, and Fox thinks it can mimic ESPN's success. The only way it can do that is to raise its affiliate fee.

That's something that's proven difficult for other sports networks. NBC Sports charges just $0.33 per subscriber and CBS Sports charges $0.20. At those rates, it's hard to make these channels profitable.

The rising cost of sports
Fox spends in excess of $900 million per year for the broadcast rights of major sporting leagues such as MLB, NASCAR, and UFC. Those are just the rights; there are additional production fees for sports broadcasts and there are programming fees for content to fill up the rest of the day. At its current affiliate fee rates for FS1 ($0.23) and FS2 ($0.16), the company generates about $320 million per year. The rest of the deficit needs to be made up through advertising, which is difficult to do when your prime-time ratings are close to nothing.

CBS and NBC don't run a deficit quite as sizable, but aside from the NBC Sports Stanley Cup Playoffs deal, there's not a lot of strong programming on either network. NBC is making moves, though. The network won the rights to broadcast 19 NASCAR Nationwide series races starting in 2015.

ESPN, on the other hand, generates a significant profit. That's profit Disney can use to fend off attacks, and maintain its position as the worldwide leader even as the prices for sports rights increase.

Goldman Sachs analyst Drew Borst expects ESPN's programming costs will rise $450 million in 2014 and $600 million in 2015. ESPN's position in the cable bundle means that it needs to raise its affiliate fee for its flagship station by 1.9% over the next two years, to keep pace with programming costs. That's really not asking much, even in the face of strong competition. ESPN increased its subscriber fee $0.50 in 2013 -- about 10%.

For now, Fox, NBC, and CBS will rely on other revenue streams to fund their relatively new sports channels. Of course, Disney has plenty of other revenue streams as well, and even more leverage with cable companies. As sports rights climb, I expect Disney to successfully raise carriage fees faster -- much faster than Fox, CBS, or NBC.

Disney in the driver's seat
Despite losing its rights to broadcast NASCAR races, Disney is still in the driver's seat when it comes to sports programming and cable networks. In fiscal 2013, operating income from Disney's cable networks rose 6%, and ESPN actually did better. Yes, the competition will drive up the costs for ESPN, but that's not going to affect Disney's cable networks operating income -- for a long time, if ever.