Disney's (NYSE:DIS) most valuable property isn't a tiny cartoon mouse; it's not from a galaxy far far away; it's not a place "Where Dreams Come True;" and it's not a team of superheroes led by Tony Stark. No, Disney's biggest profit center is, by far, ESPN.
Throughout its three decade history, ESPN has seen numerous competitors pop up to challenge its dominance as the Worldwide Leader in Sports. Time Warner had CNNSI in the late-1990's, but its clock ran out more than a decade ago. The NFL, MLB, and NBA have all started their own networks since then. More recently, however, Comcast's (NASDAQ:CMCSA) NBC and CBS started their own cable sports networks, and Fox (NASDAQ:FOXA) just launched Fox Sports 1.
Fox's highly promoted new entry into the 24-hour sports arena poses, perhaps, the biggest threat to ESPN. I don't believe, however, that ESPN is in any immediate danger or that Fox Sports 1 needs to take away ESPN's audience in order to succeed.
Just how important is ESPN?
Last year, ESPN brought in approximately $9 billion between advertising revenue and subscriber fees. That's set to top $10 billion this year. Its position as the most desirable cable network for subscribers allows it to charge approximately $5.15 per month to cable companies per subscriber. That's just for ESPN. ESPN 2 charges another $0.67. To put that in perspective, the new Fox could only convince cable providers to pony up $0.23 per month for FS1. NBC Sports Network receives $0.33.
Even more impressive than generating over 20% of Disney's revenue is the fact that Disney's Media Networks (which include ESPN) have the highest profit margin. Cable networks, in particular, posted a 41% operating margin last fiscal year. This led Fool Daniel Sparks to estimate that ESPN contributed about 43% of Disney's total operating income last year.
By some estimates, ESPN is worth more than all the rest of Disney's assets combined.
Fox Sports 1's challenge
So far, FS1 hasn't even made a dent in ESPN's ratings. In its first week, the new network saw 161,000 viewers tune in during primetime. Comparatively, ESPN had 2.17 million viewers. FS1's launch-week audience was good enough to place it fifth among sports networks.
Still, Fox represents the biggest threat to ESPN in its 34-year history. Fox already has a large portfolio of sports broadcasting rights that includes pro and college football, major league baseball, and NASCAR. Additionally, FS1 is launching with rights to Pac-12, Big 12 and Big East basketball, UEFA Champions League Soccer, and the UFC to round out its live sporting event broadcasts.
Some of these are areas ESPN has largely ignored (UFC) and others are events ESPN wanted but lost the bidding war on (soccer). Either way, Fox Sports 1 has an opportunity to attract niche crowds while ESPN continues to go after the mainstream audience. This is similar to how ESPN started off in the '80s.
With FS1's portfolio of broadcasting rights and star lineup of sports personalities, it could certainly reach its goal of increasing subscriber fees from $0.23 to $1 in the next four years. The company's ability to raise its fees will be crucial over the next decade, as certain sports rights contracts at ESPN and other networks expire.
Fox has always aggressively gone after sports rights, and with the launch of its new channel, I expect that to continue. NBC, too, has increased its spending on sports since launching its 24-hour sports network. It's spent record amounts for the rights to the Olympics, Barclay's Premier League soccer, and partial NASCAR rights in the last two years.
All this spending, however, has yet to show a significant boost in NBCSN's ability to charge a higher fee to cable companies. NBCSN charges $0.33 and generates less than $300 million in revenue from fees per year. It remains a niche channel for viewers to tune into for special events like the Olympics or Stanley Cup Playoffs.
With the added bidding power of Fox, NBC, and CBS in the mix, the real threat for ESPN doesn't come from these channels stealing its audience, but increasing its cost of business.
The cost of sports programming is rising
In the last two years, ESPN has agreed to huge deals for top-tier sports rights. It paid $15.2 billion for 10 years of Monday Night Football -- a 73% increase from its previous rights. It shelled out $7.3 billion for college football playoffs -- 480% higher than the cost to broadcast the BCS bowls. It's paying twice as much now to broadcast MLB games and five times as much to show US Open tennis.
In this era of DVR and Netflix, live sports programming is increasing in relative value. It's no wonder NBC, CBS, and Fox want in the game so badly. Now, increased competition is likely to bid up sports rights even more.
Lucky for ESPN, Disney's free cash flow ($5.51 billion ttm) is significantly higher than Fox's ($2.38 billion ttm). It can easily outbid Fox on most anything it wants. ESPN's virtuous cycle of buying up sports rights and increasing its subscriber fee has worked in the past, and the company has the cash flow to invest in continuing this cycle.
Going forward, though, it seems like contract prices are increasing faster than the company can increase its fees. Therefore, ESPN will have to be more selective in its process. This leaves room for Fox and others to gobble up the scraps ESPN leaves on the table and cater to their niche audiences. ESPN will continue to tackle the biggest and most popular events.
Sports business is big business
There's plenty of room for more than one 24-hour sports network. FS1 doesn't need to be as big as ESPN to be a significant profit center for Fox. Even with a $1 subscriber fee, the network could bring in more than $1 billion. ESPN ought to remain the Worldwide Leader for some time as no network can touch its absolute popularity and dominant bidding position.
As an investor, one who owns shares of Disney, I'll be keeping an eye on new contracts signed by ESPN as well as the competition and FS1's subscriber fee. But until ESPN's ability to attract top programming falters, I'll be holding onto my Disney shares.