The launch of Disney's (NYSE:DIS) new streaming service, Disney+, ushers in a new age at the media and entertainment giant. Streaming took center stage during the company's fourth-quarter earnings call, and that speaks to the potential impact its direct-to-consumer segment will have on its overall business going forward. Not only will the company start to see meaningful revenue growth in the segment from the launch of Disney+, but it'll also have a noticeable impact on another important operating segment: its media networks division.
Media networks, which includes its cable channels and ABC broadcast networks, accounted for half of Disney's operating income in fiscal 2019. The launch of Disney+, as well as increased investment in Hulu and ESPN+, will show itself in the media networks segment through its impact on cable subscribers, Disney's ability to continue increasing affiliate fees, and licensing revenue from selling content to the streaming services.
Getting ahead of cord-cutting
Cord-cutting has eaten into Disney's media networks revenue and profits for several years now. ESPN, its most valuable cable network, has posted declining operating income as its contractual commitments for sports rights continue climbing every year, but total subscribers decline. The subscriber losses are currently offset by contractual affiliate rate increases with distributors.
Investing more in streaming is a way for Disney to get ahead of cord-cutting. With a growing number of streaming options in the market from both media companies and tech companies, consumers have more and more reasons to cut the cord. Disney can't afford not to be one of them.
That means it's going to cannibalize its media networks business to a certain degree. Disney+ will very likely contribute to a continued acceleration in the trend of ditching cable, but it should offset the impact on the media networks business through streaming subscription and advertising revenue.
It's not a bad trade. Disney will be able to exercise much greater control over its revenue from streaming than it could from media networks, where it's subject to the impact from distributors.
Who needs the Disney Channel when there's Disney+?
On top of accelerating cord-cutting, though, Disney's streaming services are very likely to have a negative impact on the company's ability to keep raising affiliate fee rates. The Disney Channel gets a lot of value from having no true replacement. While there are other kids' networks, The Disney Channel's strong brand makes it a must-have for any distributor looking to sell a bundle of channels to families. That's no longer the case if a family can get all their kids' favorites through Disney+.
Likewise, Disney announced plans for Hulu to distribute FX's entire catalog starting in March. Hulu subscribers will be able to access FX original series just hours after they're broadcast on the cable network. That will negatively impact the value of FX as part of the cable bundle.
ESPN -- with its exclusive access to live sports -- may see less impact, however. ESPN+ is much more of a supplement to the cable network than a replacement. For sports fans, which represent a key demographic for pay-TV distributors, ESPN will remain valuable. As such, Disney may be able to keep raising its affiliate fees at its most important network. That's extremely important because ESPN faces big content contract expirations in 2021 with the NFL and MLB that could lead to significantly higher expenses.
The impact on licensing revenue
Media networks currently generate additional revenue from licensing content to streaming services. As Disney pulls back on licensing content to third parties and instead focuses on licensing it internally, it's had a noticeable impact on the business. Foregone licensing revenue had a negative impact of about $150 million on Disney's operating income in 2019.
Importantly, Disney will account for its internally licensed content as an expense for its direct-to-consumer segment and a revenue for media networks and studio businesses. Disney+ content licensing expense will total less than $1.5 billion this year and grow to the mid-$2 billion range by 2024. Likewise, Hulu's licensing expense will likely increase over the next year as it expands its partnership with FX and becomes increasingly reliant on Disney content over the next five years.
Unfortunately, Disney doesn't say how it expects licensing revenue from its own streaming services to compare with what it generated from existing deals. That said, Disney's paying itself market value for its content, so it's a mostly neutral impact. But there's a strong likelihood Disney is licensing content to itself it wouldn't otherwise license to third parties, producing more high-margin revenue for the segment.
Overall, Disney's push into streaming will likely have some negative impact on its media networks business through increased cord-cutting and decreased ability to raise affiliate fees. A potential rise in licensing revenue should help offset that. The most important thing is the direct-to-consumer business provides a revenue stream that offsets the declining fortunes of media networks while giving Disney greater control over its customer relationships.