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ESPN's Huge Sports Contracts Are Killing Its Profits

By Adam Levy – May 14, 2017 at 10:00AM

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Disney's Media Networks business saw a decline in operating income in the first six months of the year.

Walt Disney (DIS 3.49%) recently reported its second-quarter earnings, and ESPN came under a lot of scrutiny. The cable sports network generates a huge portion of the revenue and profits of Disney's Media Networks division, which itself accounts for the largest portion of Disney's business. It's no secret the worldwide leader is losing subscribers, but it's managed to continue increasing revenue through contractual rate increases with television distributors.

Unfortunately, ESPN's affiliate fees haven't increased at a rate that keeps pace with its massive content spending. ESPN has the biggest content budget of any network, having spent an estimated $7.3 billion on sports rights and production last year. In the first six months of fiscal 2017, Disney's cable networks operating income slipped 6% year over year. Making matters worse is the fact that ESPN signed long-term contracts with sports leagues, with their biggest deals lasting through at least 2021.

Lebron James wearing Cleveland Cavaliers No. 23 jersey.

ESPN's new deal with the NBA went into effect this season. Image source: Walt Disney Company.

The worst may be over for ESPN

The rights to sports have steadily increased in value over the last few years as big sporting events remain one of the few pieces of programming massive numbers of viewers will tune into live and watch commercials. ESPN has paid handsome sums to every major sports league, and most recently, it started paying the NBA a lot more because of a contract it signed back in 2014. The new contract (a joint deal with Turner Broadcasting) went into effect this season and upped the price per year about 180%, to $2.6 billion.

ESPN saw similar price increases for the rights to Monday Night Football and the MLB, among other leagues. But investors may be in for some reprieve, as the NBA was the last major price increase for awhile. Everything else is locked in long term through at least 2021.

On the other hand, that means ESPN is on the hook for billions of dollars in broadcasting rights over the next five years. If it continues to bleed subscribers at a faster rate than it can raise affiliate fees, investors could see a continued decline in operating income. At least its programming expenses will remain relatively stable, though.

Going digital

At the end of fiscal 2016, Disney reported numbers from Nielsen showing ESPN had just 90 million subscribers. That's down from 99 million at the end of 2013.

Importantly, those numbers don't include subscribers to the new virtual distributors like DirecTV Now, Sling TV, PlayStation Vue, Hulu Live, and YouTube TV. Disney CEO Bob Iger was keen to highlight these services on the company's earnings call, noting:

The substantial growth we're already seeing makes us bullish on the future of these nascent offerings. Right now, they're a small part of the pay TV universe, but we believe they'll be a much bigger part of the business going forward.

Sling TV has over 1 million subscribers. DirecTV Now and PlayStation Vue each have around 400,000 subscribers. Nearly all of them subscribe to ESPN, as the company has negotiated getting its channels into the lowest-priced tiers on these over-the-top services. As these services grow as a percentage of the pay-TV market, ESPN could start to see its subscriber numbers level out, or at least slow to the pace of cord-cutting.

On top of partnering with digital video services, ESPN is planning to launch its own later this year. It will be the company's first direct-to-consumer product, and it will take advantage of the huge swath of rights it has procured but doesn't have airtime on its linear television networks to show. Disney bought a one-third stake in BAMtech (the technology behind its TV Everywhere apps) to help support its upcoming streaming service.

With an end to the ramp-ups in content costs and a light at the end of the subscriber loss tunnel, ESPN and Disney's Media Networks segment should start to right the ship in the next year or so. Until then, higher content rights combined with subscriber losses will continue to cut into profits.

Adam Levy has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Walt Disney. The Motley Fool has a disclosure policy.

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