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Pacific Crest Brings Bad News for Disney

By Jamal Carnette, CFA - Jan 6, 2016 at 8:31AM

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How can a movie studio get a downgrade while nearly setting a box-office record? It's because Disney is no ordinary company.

Disney's Studio Entertainment division, which includes Walt Disney Pictures, may play a bigger role in the company's operational performance going forward. Image Source: The Walt Disney Company.

For The Walt Disney Company (DIS 3.30%), it's a tale of two divisions. On one hand, the company's studio entertainment division has been in the news of late as the company's monetization of Lucasfilm has begun in earnest. And if the early results are any indication, it's another great acquisition for Disney and its CEO Bob Iger.

The company's first film in the rebooted series, Star Wars: The Force Awakens, pushed past Jurassic World and James Cameron's Titanic, good for second place in domestic gross box office, with $740.3 million in 19 days. The top domestic-grossing movie, another Cameron movie, Avatar, grossed $760 million, and took 72 days to gross $700 billion versus Star Wars: The Force Awakens, which did it in 16 days. It's safe to assume that Star Wars will set the domestic gross record. On a total box-office basis, Star Wars: The Force Awakens has grossed nearly $1.5 billion worldwide as of this writing.

You'd expect Disney investors would get a short-term bounce from this large windfall -- and you'd be mostly wrong. Shares of the company are down nearly 7% since the opening day of Star Wars: The Force Awakens versus a flat Dow Jones Industrial Index. Instead of Wall Street analysts upgrading the stock, Macquarie's Tim Nollen downgraded the stock to neutral from outperform on Jan. 5. For the reason why, look no further than Pacific Crest analysts (by way of Business Insider) Andy Hargreaves' and Evan Wingren's newest research note: These analysts believe the NFL has reached peak television ratings.

Sorry Star Wars' fans, ESPN is Rylo Ken to Lucasfilm's Han Solo* 
While the company typically is known for its eponymous movie studio and theme parks, the company's media networks (read: television) division is the beating heart as it relates to operational results. For example, for the recently ended fiscal year, 44% of the company's total revenue, $23.3 billion, was attributable to the company's media networks versus 14%, or $7.4 billion, for studio entertainment. As far as segment operating profit, those numbers are even more stark: 53% versus 13%, respectively.

Image Source: Disney/ESPN.

While the intra-division specifics aren't broken out, it's widely known that ESPN is the overachiever as it relates to the media networks' division, as it pulls in an estimated $6.04 per subscriber per month. This is more than 300% higher than the second most-expensive channel. With ESPN2 pulling in nearly $1.00 per customer per month, the company has two channels in the top 10 most-expensive channels. At one point, analyst firm Wunderlich Securities estimated ESPN alone was worth more than 30% of Disney's total market capitalization.

In the end, a sizable portion of your cable bill winds up in Disney's top line. ESPN has been able to do that because it's a powerful conduit -- nearly a gatekeeper -- for live-sports viewing. As the most-popular sporting event in the NFL, a decrease in viewership, both directly and indirectly, hurts the sporting network.

Rising costs and lower viewership is a toxic stew
Unlike script comedies and dramas, where hundreds of similar shows compete to be on the air, the NFL really has no direct substitutes. As a result, the league is able to essentially dictate terms, and sign long contracts with Disney's ESPN, NBC, and CBS (PARA 1.51%). In 2011, the league's newest contract with ESPN is more than 70% higher than the last contract, at $1.9 billion per year, nearly double CBS' $1 billion annual cost. For ESPN, a combination of higher costs and fewer games made the average viewer more expensive: According to a Bloomberg article, ESPN pays more than $8.00 per NFL viewer, where CBS pays less than $2.00. Add to that higher costs for MLB and NCAA sports, and Disney's content costs keep increasing.

Lower NFL viewership is a multifaceted problem for Disney. On one hand, more people are foregoing the channel as a result of cord-cutters and cord-nevers opting out of cable TV. In addition, many with cable TV are opting for lower-channel packages -- cord-slimmers -- as many are aware of ESPN's costs, and the channel is the most salient example of bloated pay-TV packages. Last year, ESPN cut nearly 4% of its workforce, or 300-plus positions, in a bid to cut non-content operational costs.

Personally, I disagree with Pacific Crest's impetus for lower ratings -- concussion awareness and off-field issues -- as the former may be a long-term concern as more parents elect not to allow their kids to play the game, and kids migrate to soccer; but this is probably not a short-term concern. Off-field issues have existed for years, and even with social-media's huge megaphone, most viewers are able to separate bad individual behavior from the on-the-field product of a large organization with thousands of employees.

In the end, ESPN is in a tough spot, as many subscribers are now balking at the cost of pay television. Disney appears to be picking up the pace with its studio-film releases, with a host of Marvel and Pixar movies on tap for the next three years, but a struggling ESPN will be hard to counterbalance. Disney's no ordinary company, and it will be interesting to see how CEO Iger addresses a tough media environment.

*If you do not get this reference and plan to watch the film, do not seek clarification until you do.

Jamal Carnette has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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.

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