Key Questions for Walt Disney Co as Subscriber Losses at ESPN Accelerate

Though Disney(DIS 0.16%)may be best known for its princesses, theme parks, and upcoming Star Wars films, the company actually generates the bulk of its top and bottom lines from the Media Networks segment, which happens to include ESPN, arguably the crown jewel of the entire company.

But over the past two years, millions of ESPN subscribers have been dropping the network, a trend that shows no signs of reversal. Disney shares tumbled over 20% after fears of a subscriber exodus surfaced in August, and the stock is trending downward again now that the official losses are on file.

The Motley Fool's Vincent Shen and Sean O'Reilly discuss these challenges and the questions every Disney investor should be able to answer.

A full transcript follows the video.

This podcast was recorded on Dec. 1, 2015.

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

Vincent 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, 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: So how bad was it?

Shen: So, basically, you know, usually when people think Disney, they think about the movies, the parks, but its biggest business is the media networks 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 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: So 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 to 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 like, 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: So the thing, so 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 to 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 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?