Walt Disney Co Slumps With Subscriber Losses at ESPN -- What You Need to Know

On this consumer goods edition of Industry Focus, Fool analysts Sean O'Reilly and Vincent Shen look at 2015 Black Friday and Cyber Monday sales results to round out their discussion of the holiday shopping season.

And continuing with the story of the week, Disney's (DIS -0.31%)cash cow is in danger as subscriber losses at ESPN accelerate, presenting a major headwind for the company's largest business. Will Disney succeed without the crown jewel of its Media Networks segment? Will its other businesses be able to fill the void?

A full transcript follows the video.

Sean O'Reilly: We're talking Walt Disney subscriber troubles on this consumer goods edition of Industry Focus. Greetings, Fools. I am Sean O'Reilly joining you here from Fool headquarters in Alexandria, Virginia. It is Tuesday, Dec. 1, 2015, and joining me to talk all things consumer goods is the man whose picture is next to awesome in the dictionary, Vincent Shen.

What's going on, man?

Vincent Shen: How are you, Sean?

O'Reilly: Awesome.

Shen: How was your holiday?

O'Reilly: So, get this: I made the turkey.

Shen: You mentioned this in last week's show and now...

O'Reilly: It turned out ...

Shen: You did not burn your apartment down.

O'Reilly: ... really well.

Shen: OK.

O'Reilly: It was a little drier than I would have liked. But for a first attempt, could not be happier.

Shen: How big was it?

O'Reilly: So, it was just my wife and our son and I, so I think I only got like, I got the breast. I didn't get the whole bird and I did not remove organs or things.

Shen: That's very helpful because the bigger the bird gets, the more time it takes for potential for something to go wrong.

O'Reilly: Somebody at Fool headquarters, I forget who, they're like, "Yeah I cooked an 18-pound bird." I'm like, "That's not a bird, that's a monster."

So, Vince, we've got a situation brewing on over at Disney that we'd be remiss if we did not discuss. However, before we do that, we just had that most holy of holidays, Black Friday. We got some preliminary results as I understand it. How did things go?

Shen: Yeah, so last week we talked about the run-up, history behind it, what some of the expectations are, and honestly ...

O'Reilly: How it's going to start a Fourth of July in 10 years.

Shen: Honestly, things kind of came in the way a lot of people expected them to with the emergence of the importance of the online sales, how that's becoming bigger and bigger component during this big weekend. But overall sales from Thanksgiving and Black Friday actually fell 11% from last year...

O'Reilly: That's kind...

Shen: ... to $12.1 billion.

O'Reilly: That's kind of big.

Shen: This is according to data from ShopperTrak, so foot traffic was generally down across the board, and it was noted, I think by the National Retail Federation that this was the first year that online shoppers actually outnumbered those who ventured out.

O'Reilly: It's cold out.

Shen: To the masses.

O'Reilly: This is not surprising.

Shen: To the lines in stores. An interesting thing is, taking that one step further, it's not just that online traffic -- the importance is growing. But you know, we mentioned how mobile had a really surprising turnout. Well, a lot of people again this year were even more surprised despite high expectations with 40%, with some 40% of that online shopping taking place on smartphones. And I think another like 10 to 15% happening on tablets. So that's just I think partially from smartphones are bigger, the screens are bigger, it's easier to navigate and shop with them now. So their prominence and use among shoppers is growing. And the thing is I think to keep in mind is that Thanksgiving, Black Friday, Cyber Monday, we used to consider this stuff the beginning of the holiday shopping season. It's more like half-time now.

Because you know ...

O'Reilly: Rush in the third quarter, folks.

Shen: ... a lot of retailers begin their deals as early as the very beginning of November. And as a result of that, we've seen a decreased importance in the specific days themselves. Black Friday, like I said, Thanksgiving, Black Friday down. Cyber Monday though did see some positive results. The sales were at $3 billion, up from last year continuing that growth in terms of the online piece of the pie overall. And it's just nice that we can recap on last week's show.

O'Reilly: Yeah, no for sure. I can't believe more people didn't think that you know, just the advent of online shopping might not actually be the death knell of Black Friday. Because the purpose of Black Friday is get people to come out, give them some deals, make a name for yourself as a retailer for the holiday season. And I mean my wife, she not only went to the mall just the Saturday before Thanksgiving and bought me some jeans, but they had already started the pricing on the jeans for Black Friday. Not only that, but they didn't have my size in the store so they had it mailed to our house. Need I say more?

Shen: Well yeah, and even a lot of the retailers, their online deals which a lot of people think, "Oh Cyber Monday is that day to do your online." You know, they started those at midnight on Thanksgiving. So everything's moving up, honestly all of that consumer spend is basically being spread out more and more between November and December overall. And the one last thing I wanted to note too is some of the hottest items from Cyber Monday included 4K TVs, iPads, the Xbox and PlayStation 4. So again this kind of highlights the fact ...

O'Reilly: How'd you get my Christmas list?

Shen: This again highlights the trend for shoppers for their must-have items for the season to be electronics -- like the newest electronic stuff. And I don't see that going away anytime soon.

O'Reilly: Nope, neither do I. Cool. Well before we move on to chatting about the latest from Disney, I wanted to point our listeners to the newly redesigned Focus.Fool.com. There, you'll discover a special offer to join the Motley Fool Stock Advisor newsletter for all Industry Focus listeners. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription. Just go to Focus.Fool.com to take advantage of this offer. Once again, that is Focus.Fool.com.

So, Vince, you've got Star Wars hitting theaters in, I don't know, a week? Sooner?

Shen: Two, about less than three weeks.

O'Reilly: Yeah, OK, so three weeks. Captain America: Civil War coming out next spring.

Shen: The trailer just hit ...

O'Reilly: The trailer. What'd they get, like 51 million views?

Shen: Crazy number of views over a very short amount of time.

O'Reilly: Yeah. You would think that Disney stock, which happens to own both these massive franchise properties, would be doing super well these days. But that's not the case, so what's going on?

Shen: The thing is the stock is still doing pretty well for this year. Year to date, it's still up over 20%, but in the past week or so, it's taken a bit of a dive from about $120 per share on Nov. 20 to about $113 as of trading earlier today. And a lot of that hit has come from the filing of its 10K. And because in that filing it revealed what a lot of investors have been worried about and which really dinged the Disney shares in August I think it was, when Bob Iger basically made the comment. CEO Bob Iger made the comment that, you know, we're going to be losing some subscribers from our media networks division. And that trend really continued.

O'Reilly: How bad was it?

Shen: Basically, usually when people Disney they think about the movies, the parks, but its biggest business is the media network segment, which made up 44% of revenue, 53% of operating profit, and this for fiscal 2015.

O'Reilly: Not only that, and you know I love the movies and they're obviously going to make boatloads of cash off of Star Wars and Marvel, and Captain America, and all that stuff. But those are one-time things. The consistent cash cow is ABC, their networks. And it's... this is not good.

Shen: ESPN is like the crown jewel of all their offerings. It is able to command just the importance of live sports to viewers. It's probably one of the main things holding out.

O'Reilly: It's the one reason to have a cable subscription.

Shen: Stalling... It's like the one thing that's really stalling I think the cord-cutting trend and ESPN is able to command tons of money. But the problem is over the past two years, the subscribers just at ESPN had fallen from 99 million to 92 million, and 3 million of that loss took place the past year.

So people kind of knew, "All right, well, this trend's taking hold. We expected losses but this is at a much faster clip than what the market was expecting."

O'Reilly: Were they expecting $1 million a year? Like what did they actually think would happen?

Shen: So and the thing is, down from 99 million 92 million at a faster clip than everybody was expecting. And over that same period, you know, some of the other networks ABC Family shed 5 million subscribers, Disney and Disney XD their domestic channels each lost 4 million. And the thing is Disney also has a 50% stake in channels like A&E, Lifetime, History and they're all down 5 to 6 million consumers over the past few years as well or subscribers, excuse me.

So it's not looking good at all and, the thing is, the effect of these declines is becoming more pronounced. Again, over that same two-year period, media networks their overall revenue was up 14.3%, which is pretty good, but it lagged the overall top line, which saw growth of about 16.5%. And operating income growth is really where you see it. And this has to do with like rising costs for that segment.

Operating income growth was up 14.3% from media networks, but overall it was 36.9% for the company. So a lot of the other segments are making up for that stall. And, here, I look at it now, it's OK so now we're actually presented with a serious long-term challenge for this company. A lot of times people will bring up things that ding the stock, but this is actually something that could really hurt the company if it keeps going down from 99 to 92.

O'Reilly: You would almost prefer to be the cable provider like a Comcast or something. Because at least they get you for your Internet, which you still need these days.

Shen: I think there are some projects that Disney has in the pipeline and options that they have that will stem the losses. But at the same time investors really do need to ask themselves, "OK, I understand that ESPN is very valuable. Live sports in general are very valuable for these content providers."

O'Reilly: What's ESPN been valued on, on its own? It's like $50 billion or something crazy?

Shen: Serious like crazy numbers and the thing is as true as that is, the company has had to pay more to keep ESPN outfitted with content. So for example, rights NFL games increased from $1.1 billion to $1.9 billion annually as of the deal they signed last year. And for the NBA for the season, the 2016-2017 season, again ESPN is paying 200% more than their previous contract.

O'Reilly: Why?

Shen: Because, honestly, every other network recognizes the fact, hey, live sports, you can't replace that with a streaming service. We need that to bolster our numbers so they're bidding up more for it, and as a result ESPN's paying the price too.

O'Reilly: Wow. But they have to. Like that's game over.

Shen: Yeah, exactly. As a result, the company has tasked ESPN with trimming $100 million from its budget next year, an additional $250 million for 2017, and so for me, I'm just thinking investors need to ask themselves some questions like, "What is the bottom for these subscriber losses?" Now I don't think that it's just going to keep going down and down until zero. That's crazy because people do want live sports. It has proven itself to be a bit of a holdout for anybody else who's been considering cord cutting. But where is that bottom and once we have a better grasp of what that number is, how big of impact does it have for a segment that makes up over half of operating income?

And something else to keep in mind is to the high potential of upcoming projects like you mentioned with theme parks, upcoming movies, are those enough to make up for that hole that's left there?

O'Reilly: Yeah, and actually on that note, you got these headwinds or tailwinds for the company going around their second largest segment, parks and resorts. So what's going on there?

Shen: OK, so this is one area where the company overall sees a lot of potential and the more I read about this more I think like this is an amazing opportunity but it's not without its risks. So parks and resorts like you mentioned -- second largest segment. They make up about 31% of total revenue and 20% of operating income. And the thing is the big ...

O'Reilly: It's expensive to run an amusement park.

Shen: The big project that's coming down the pipeline is Shanghai Disney. And so this is a huge, huge deal. The park covers 1,000 acres.

O'Reilly: Do you know what Orlando is?

Shen: It's very, very large. But there's more to that that I think is really interesting. So it's the first Disney park in mainland China. Of course there's one in Hong Kong and there's multiple faces to this production process. So there'll be like multiple parks, hotels, entertainment complex, shopping, everything, the works. And they broke ground on this in 2011. It's costing them about $5.5 billion. A huge investment. I think it's the biggest single foreign investment in China ever and Disney will actually only own a 43% stake. Because there's going to be the remainder of that's owned by three state-owned enterprises.

O'Reilly: I hope they didn't put up all the money for 43%.

Shen: I think the state-owned enterprises also put up over $2 billion. And the thing is, one of the big numbers that I've seen thrown about is the idea that there are 330 million people who have enough disposable income to visit this park that live less than three hours away.

O'Reilly: Oh my gosh. That's the U.S. population.

Shen: So huge. And next to Shanghai which is their wealthiest financial center city, tons of opportunity there. And the big thing that I think kind of takes us to another step is they have reserved the land reserve that they need to expand with a few more parks for Disney itself. But this thousand acres that they have is only one fifth of this huge 5000 acre zone that Shanghai is setting aside. They're calling it the International Tourism and Resorts Zone.

O'Reilly: Oh, wow.

Shen: They want this to become like a playground, a huge focus for tourism, for them to draw out people. So Disney will just be one part of that. But I think it's a very strong bid in the company's favor that the country and the government is very committed to this area overall because they have big plans. We're talking about a decades-long plan to develop this area into like a tourism attraction.

O'Reilly: Wow.

Shen: So you have all that in mind, huge numbers. 330 million potential visitors all within a very short travel distance, this is going to be the biggest park, has the tallest castle, the Magic Kingdom castle. Everybody is looking forward to this and I'm sure it'll be a big growth driver for the segment. But something else to keep in mind is that only 30% of theme parks in China either breakeven or profit. The rest lose money.

So this is not just a guaranteed slam-dunk. So even though there are nice projects in the pipeline like this one for the parks and resorts segment, nothing's guaranteed. I think that Disney is really, has a nice wide moat around it based on the value of IP.

O'Reilly: They've got some really good IP, yeah.

Shen: So but overall it's just something that people should definitely keep in mind for this one piece of the puzzle.

O'Reilly: OK, so the last business that Disney, of course, has their hand in, is movie studios, all that. What's going on there? Will that save them?

Shen: Yeah. So we've kind of gone in order. We talked about how their media networks, it's still growing but people have those concerns about the subscriber losses. Second-biggest segment doing very well, they have this huge park down the pipeline. Now here is where I see the most potential. But the problem is so when we're talking about studio entertainment, which includes their movies but also the consumer products segment, which has a lot of the products, that is like an offshoot ...

O'Reilly: Just say Star Wars toys.

Shen: Yeah, exactly. An offshoot of all that IP, you have to keep in mind that these two segments together, they only make up about 14% or studio entertainment made up about 14% of the top line, consumer products made up about 9%, so a much smaller piece of the pie. But the growth opportunities are huge.

For example consumer products saw the most robust operating income growth in 2015 at 29%. So easily dwarfing I think it was like the 6 or 7% that the media network segment saw. And going to the title specifically, so we talked previously about The Force Awakens, about the toys and the hype that's built up around this. So show times, less than three weeks away and some box office predictions are kind of coming in anywhere between $150 and $210 million, which would make it one of the biggest ...

O'Reilly: I think it will beat that. I really do.

Shen: ... of all time. We'll see.

O'Reilly: You saw the presale ticket numbers -- that was the highest of all time.

Shen: Yes, but before we get to that though, the thing is for December there's only been a handful of films that've even broken $70 million in their opening weekend. So it's generally not a month where you see those massive numbers like the summer blockbusters. But the thing is these films have legs. They end up running very well over the following weeks after the holidays. And bringing up those presale numbers shattered records.

So Star Wars: The Force Awakens has already sold $50 million in tickets a month in advance of the actual release date. And this doubles the previous record of the Dark Knight Rises which sold $25 billion. OK, another thing that you... that kind of points in the direction of this being a huge, huge moneymaker is the fact that Star Wars: Battlefront, the game came out earlier in November.

O'Reilly: Did you see the commercial they had with Anna Kendrick and stuff?

Shen: It looks amazing and it set digital launch records for Electronic Arts over the past week. So again another record-setting number for you to kind of think about there. And I think it will be very important how this movie does because there's sequels lined up, there's one off, there's kind of like spin-off films that are planned.

But that's not the only thing that kind of hit the news recently for their, at least for their studio entertainment. Because like you mentioned the Civil War trailer for Captain America, all these views and this is where I think things really round out for this segment. Between now and 2019, there will be about 15 Marvel titles released in theaters.

O'Reilly: Oh my gosh.

Shen: Including huge sequels and new character launches, OK? So keeping in mind the fact that the Marvel Cinematic Universe for their movies, they've generated over $9 billion and they average about $750 million in worldwide ticket sales per movie. So the thing is for Hollywood with something that you generally see is very uncertain with each movie release, sometimes you just get really unlucky and your movie does not do well. This, I don't think it takes all the uncertainty away, but you have a built in fan base.

O'Reilly: Well, even because... yeah. Well not only that but Ant Man should make you a believer about these secondary character launches. Because like who the heck is Ant Man?

Shen: Lesser-known characters still managed to draw over $500 million in box office receipts, which is huge. And overall these Marvel films, since the earlier part of this deck, it's like the early 2010 just a few years ago, every movie has seemed to trend upward in terms of box office receipts for Disney and Marvel. Naturally, all this popularity around these characters in these movies spins into the consumer products with toys and things along those lines. For Black Friday, two of the five most popular toys were from the Star Wars universe.

O'Reilly: This is not surprising. All my cousins love Star Wars.

Shen: Exactly. So though this might be smaller pieces of the pie for the company overall, I think their importance will definitely be growing as they make their investments in the space. They have all these titles lined up, things are looking very strong for these segments, and I think that between this, parks and resorts, it'll help fill in some of that, the losses. Or the gap that's left by any concern investors might have with media networks. And it'll be really interesting to see how the company pivots as they need to in the future.

O'Reilly: For sure. Well, thanks for your thoughts, Vince.

Shen: Thank you.

O'Reilly: Have a good one!

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