ESPN's shrinking operating income margin should worry cable subscribers. Source: Disney/ESPN.
On Tuesday, February 3, The Walt Disney Company (DIS 0.64%) reported phenomenal first-quarter earnings. By growing revenue 8.8% year over year, from $12.3 billion to $13.4 billion, the company blew past analyst estimates of $12.9 billion by nearly 4%. On a diluted earnings-per-share basis the results were even better, as the company handily topped both last year's figure of $1.04 and analyst expectations of $1.07 by reporting a figure of $1.27. In all, a great report for the House of Mouse.
If there was one slight negative, it had to be the performance of its Cable Networks division. Although the division reported an 11% revenue increase, going from $3.76 billion to $4.17 billion, operating income in Cable Networks dropped 2% on a year-over-year basis as the company pointed toward higher NFL costs as the culprit. Fortunately for investors, the decrease was offset by an increase in its Broadcasting division; The New York Times credits syndication of Criminal Minds and Scandal for the increase there.
Still, for those who carefully follow the company, any decrease in the Cable Networks division should be closely followed. For the uninitiated, that's where the crown jewel of Disney resides: ESPN. For perspective, even after this quarter's poor results, Cable Networks still commands 35.4% of Disney's total operating income, down from 42.3% in last year's prior quarter. Simply put, Disney needs its Cable Networks revenue to outpace its costs of content to continue to reward shareholders, and it needs cable subscribers to (mostly) pay for it.
College Football Playoffs is just one example
For those not following the exploding costs of sporting-related content, the recently played College Football Championship was a great example. In 2012, ESPN paid in the area of $7.3 billion for the rights to broadcast seven games per year for the next 12 years. And while the first playoff year just passed, that didn't stop major publications from stating that the deal was a success based on -- apparently -- the success of one title game.
And while it's important to note that the advertising success of that game is not included in this quarter, as the game occurred after the quarter ended and Disney books television ad revenue when commercials are aired, it's prudent to mention that Cable Network advertising revenue decreased this quarter from the year-ago period.
That's important to note, because if Disney can't recoup its costs of content through increased commercial fees, it will need affiliate fees from cable providers such as Comcast and Time Warner Cable to make up the difference. And guess where those affiliate fees are coming from? You, a.k.a. Joe Q. Cable Subscriber.
Affiliate fees are doing well for Disney
When it comes to Disney's Media Networks segment (Media Networks is the term for the segment that includes both the Cable Networks and Broadcasting divisions), the star performer is affiliate fees. In fact, that figure increased 20% on a year-over-year basis, although only 8% is credited from higher contractual rates. Still, that's an 8% increase that cable providers will eventually have to pass on to subscribers to pay Disney for its content.
So on one hand, Disney is able to push price increases of 8%, but it still doesn't appear to be increasing at the same rate as operating expenses that increased 13%, or $453 million, during that same period. Of that increase, 68%, or $308 million, was due to an NFL content-cost increase. At some point, cable subscribers are going to decide pay-TV just isn't worth it and cut the cord. Although Disney investors should be very happy about this report, the sustainability of its most important division should be considered going forward.
