Recently, Disney's (DIS 0.16%) ESPN and Time Warner's (TWX) Turner Sports signed a massive nine-year extension to keep the NBA on TNT, ABC, and ESPN. And while the terms of the deal were not publicly stated, The New York Times reported the contract totaled $24 billion -- $2.67 billion per year.
Analysts and observers were taken aback by the inflated price tag from the current deal (which runs through the 2014-2015 season) that costs the companies just $930 million per year. The new deal is nearly three times as expensive as the current contract. Even if you are a NBA junkie, you have to ask whether ESPN and Turner are paying too much for programming. And one thing is for sure: If you pay for cable eventually you could be stuck with the bill.
How cable channels make money: a primer
While we all know that media networks like ESPN and TNT make a lot of money, very few know the specifics of their business model. Take ESPN, for example: The company either generates internal content (think SportsCenter) or buys the rights from other entities to host their programming (think the NBA deal). The company's content costs either come from the expenses associated with creating original content or partnership agreements.
Now for the revenue side: ESPN and TNT have agreements with cable providers to broadcast that content. In a rudimentary way, think of cable providers as toll road operators delivering channels directly to your living room. You pay your cable company and they pay each channel a portion of those funds, something that is called affiliate fees.
That and advertising revenues are how cable channels make money. In the last fiscal year, in Disney's media networks division and Time Warner's Turner division, the percentage of revenue that came from those affiliate fees was 49.2% and 49%, respectively. As a quick note, ESPN and TNT are the most expensive channels on cable, respectively costing cable customers $6.04 and $1.44 per month, according to research firm SNL Kagan.
What's this going to cost me?
A recent report from TDG Research estimates this deal alone could raise the average pay-TV subscriber's bill by "a couple of dollars per month." I personally wanted to confirm this, so I ran some figures to determine how much this would cost cable subscribers if last year's percentages held:
| Channel | ESPN/ABC | TNT/Turner Sports |
|---|---|---|
| Increased Cost | 904.8 | 835.2 |
| Affiliate Revenue Percentage | 49.2% | 49% |
| Total Affiliate Cost Ex-Profit | 445.2 | 409.2 |
| Segment Gross Profit Margin | 44.7% | 56.1% |
| Total Affiliate Cost Including Profit | 644.2 | 538.8 |
| Percentage Increase Over Prior Year | 7.1% | 9.6% |
| Current Monthly Cost Per Subscriber | $6.04 | $1.44 |
| Increase Per Subscriber | $0.43 | $0.14 |
Source: Disney and Time Warner 10-Ks. All figures not denoted by a dollar sign or a percentage sign are in millions. Segment gross profit margin used because it best represents the effect of the NBA programming costs on each company's income statement.
Using the current breakdown of 52% of the current deal paid for by Disney and 48% by TNT in order to estimate potential price increases, an interesting result becomes apparent. I concluded that in order to keep segment gross margin profits intact, Disney would have to increase its affiliate fees by 7.1% and TNT would have to increase them by a whopping 9.6%.
On a dollar basis, this leads to a respective increase of $0.43 and $0.14 per month -- or $0.57 per month total. And although this is less than the $2 per month increase cited by TDG Research, this is still an increase in cost to consumer that are already forking over alot of money every month for their cable.
Who pays for this?
Historically, cable channels have passed those costs to the cable provider. The cable provider, naturally in order to maintain its profit margin, passes along a rate increase to you, the consumer. This occurs whether you watch the programming or not.
More recently, cable providers are finding this harder to do. The new trend in pay TV is to not pay for TV. Cord cutting, or abandoning pay TV for streaming-based services such as Netflix and Hulu, has increased from only 4.5% of U.S. households in 2010 to 6.5% today -- a nearly 50% increase.
As consumers continue to push back against expensive packages, pay-TV providers and cable channels might not be able to pass on those costs and could instead experience margin compression.
Foolish thoughts
Pay TV is struggling; last year it reported its first ever subscriber drop. Unfortunately, if the industry continues to think it can afford to force price increases on consumers without giving them the option to opt out of un-watched channels it will continue to under-perform. The NBA deal is yet another example of how the pay-TV business model is broken and unsustainable. Only time will tell how this situation is rectified.
