It's been a great run for Disney (NYSE:DIS) at the box office, and with the return of the Star Wars franchise scheduled for December, investors can expect that success to continue.
But over on the small screen, things are looking a little less rosy. In fact, some have gone as far as to question, as one Fox Sports headline did in July, whether ESPN is "a giant bubble about to burst."
The problem is, in a nutshell, that as the leader in sports broadcasting, Disney and its ESPN family have inked big, long-term contracts to broadcast many sports with the expectation that it will continue generating enough revenue from cable subscriptions and advertisements that it will remain profitable. The deals looked smart at the time, but they weren't made with the expectation that American viewers would be quick to ditch their cable and satellite TV packages.
And that's what appears to be happening.
And that may spell trouble for Disney, which has reportedly already moved to start cutting costs at ESPN while it looks toward the future and the possibility of a stand-alone offering.
Far from a clear picture
To be fair, it's still very early in the game, and we can't be sure how things are going to play out in the coming years. And the impact of the cord cutters has likely been muted by the fact that Disney is such a diverse entertainment business, with money coming in from movies, TV shows, toys, cruises, and theme parks. But ESPN is a big part of Disney's business, accounting for about 25% of its annual operating profit.
Clouding the picture even more, investors are encountering seemingly conflicting numbers regarding the growth or decline of ESPN viewership. While the company was boasting last quarter of "double-digit growth" for viewership on ESPN and ESPN2 over the last year, news outlets were detailing a grim long-term picture.
The Wall Street Journal used Nielsen data to report last month that ESPN's viewership in the U.S. had fallen by 7.2% since 2011, and cited unnamed sources as saying that included a loss of more than 3 million subscribers in just over a year's time.
In its quarterly conference call last week, Disney CEO Bob Iger noted that "ESPN has experienced some modest sub losses, though those have been less than reported by one of the prominent research firms." Iger said the multichannel ecosystem was being affected by economics as well as a decline in households and the growth in so-called skinny or cable-light packages.
What we know for sure it that Disney has large obligations to meet in terms of the long-term sports contracts it inked for the coming years.
ESPN will pay $1.9 billion each year to host Monday Night Football through 2022. On top of that, a new deal with the NBA will nearly triple the cost of the network's basketball broadcast rights -- from $485 million annually to $1.47 billion annually --- starting in 2016-2017.
This is important because Disney's media networks are its single largest segment, bringing in some 44% of overall company revenue, and more than 58% of overall income. Studio entertainment, by contrast, contributed about 16% to the top line and 11% of the company's profits.
No panic yet
Iger addressed concerns over cord cutters in the earnings call Tuesday:
We are realists about the business and about the impact technology has had on how product is distributed, marketed and consumed. We are also quite mindful of potential trends among younger audiences, in particular many of whom consume television in very different ways than the generations before them.
Iger has discussed the eventual offering of ESPN as a stand-alone subscription service, but that's something that's still at least five years off, he said. It also wouldn't be easily accomplished. First, there are costs associated with the endeavor. And we need to look no further than Time Warner's rollout of HBO Now to see that those costs can weigh on a company's earnings.
Then, there's the issue of pricing. A recent Wall Street Journal article estimated that ESPN would have to charge its direct customers about $30 a month to make the same money as it does through pay-TV distribution. The exact pricing would depend on how many people sign up for the service – the more direct subscribers, the lower Disney could charge.
But it raises an important question: If cord cutters are looking to ditch expensive cable bundles to save cash, could we expect them to ante up $30 a month just for ESPN?
Not standing still
Company executives have continued to imply that cord cutting is not as large a concern for Disney as media outlets have portrayed it. Revenue from its media networks division was up 5%, year over year, in the third quarter. Perhaps more important, income from its cable networks was up 7%, outpacing the rate of revenue growth.
That said, the company has been moving to get out in front of the problem. News outlets last month reported that ESPN is looking to cut $100 million from its 2016 budget and $250 from its 2017 spending plan. Disney's media networks spent about $13.8 billion In 2014. So a $250 million 2017 cut would likely represent less than 2% of the segment's overall expenses. That's a sizable cut, but not exactly an austerity measure.
Something to watch
The numbers so far don't point to imminent danger for ESPN and the company's other cable networks. And the reported plan to start cutting costs at the network appears to be more proactive than reactive.
But with ESPN and Disney's sports networks comprising such a large piece of the entertainment giant's pie, investors will want to stay on top of the cord-cutting trend and what efforts the company is making to address the problems it's creating. It could prove to be a major drag on what has been a reliably profitable and growing division of the company.
John-Erik Koslosky has no position in any stocks mentioned. The Motley Fool recommends Walt Disney. The Motley Fool owns shares of Walt Disney. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.