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Disney Valuation, Part 4: Live Media and ESPN+

This is the fourth article in my series about The Walt Disney Company (DIS).

In the first article, I looked at the Parks, Experiences and Products business, as well as the Studio Entertainment business. In the second article, I provided an overview on the Media Networks segment, as well as recent results in Direct to Consumer (DTC) and International segment. In the third article, I went into detail about Disney+. In this article, we will focus on Disney's non-entertainment programming, which consists of live news and live sports aired on the company's linear pay-TV channels and ESPN+.


Television channels

Let's start with the legacy business, which consists of Disney's television channels, as well as the channel's 21st Century Fox acquisition. This includes the domestic cable networks (such as ESPN channels, Disney Channel, FX, etc.) as well as the broadcast network (such as ABC).

As I discussed in the second article in this series, the majority of this segment's revenues are attributable to affiliate fees, which have continued to grow in recent years despite cord cutting due to outsized rate increases. However, after accounting for the rising cost of sports rights, which has exceeded revenue growth, Media Networks operating margins have started to trend lower - and if we see a further acceleration in cord cutting without a commensurate change in the pace of growth in the cost of sports rights or the pace of per sub affiliate fees growth, that margin profile worsen over time.

So, that's the back story. How should we think about the future for this business?

Media Networks generated $7.5 billion in operating income in 2019, or nearly $6 billion after-tax profits (assumes a 21% tax rate), before accounting for minority interests. As I think about the coming years, here are the assumptions I am making based on my own research and opinions:

First, I think Disney will be able to continue to push through outsized per-subscriber affiliate fee rate increases. Their content is the most valuable part of the pay-TV bundle, and distributors like Comcast (CMCSA) and AT&T (T) recognize that reality. The value in the bundle will shift even further towards live sports and news in the coming years, which is a relative benefit for Disney.

Second, the number of pay-TV subscribers in the U.S. will continue to decline at an accelerated rate from two to three years ago. As it relates to entertainment programming, offerings like Netflix (NFLX), Disney+ and HBO Max are a much better solution than linear TV, particularly in terms of the user experience (i.e. no ads, watch anywhere and anytime). For that reason, consumption of entertainment programming on linear TV, which has already fallen precipitously, will continue to decline.

Third, we could see some slowdown in the rising cost of sports rights. While that may be impacted over the long run by the incursions of tech companies like Amazon (AMZN), Alphabet (GOOG, GOOGL) or Facebook (FB), their efforts have produced uneventful results so far. In addition, the leagues remain focused on reach, which favors the cable companies and the broadcast networks. As it relates to the most prominent bidders - ViacomCBS (VIAC), Fox (FOX), NBCUniversal, Disney, etc. - they each face a set of unique circumstances. What is broadly true for the group is that another round of outsized cost hikes for sports programming would be an unwelcome occurrence - and potentially worse than that for a company like ViacomCBS. This may prove to be wishful thinking, but I'd like to think that setup encourages each of these companies to stay in their lane (basically stick to the marquee sports rights they've held previously), resulting in manageable cost increases in terms of the headline costs for sports rights in terms of the total outlaysnot on a per sub basis).

If those assumptions prove accurate, I believe the Media Networks business at Disney can generate profits in the coming years that are roughly comparable to what it generated in 2019.

ESPN+

As I noted in a GuruFocus article two years ago, I believe that the company's investments in its over-the-top (OTT) offering, ESPN+, could have meaningful long-term implications for the business. Specifically, I wrote:


"With this product, I think Disney sees a significant opportunity over the long term to address these legacy issues (it probably doesn't hurt that they've learned a lot from being disrupted by Netflix in entertainment programming). They can offer broader and deeper access to sports rights and analysis than was feasible in the traditional linear TV world.

The key piece of the puzzle is sports rights. While the premier sports rights are locked up for the next couple of years, I don't think that's a huge problem for ESPN+. In fact, I'm not sure that's where they should be focusing their attention -- at least not at first. As opposed to fighting for a handful of marquee events, I think ESPN should acquire as many niche sports rights as they can... From my perspective, any sporting event being (professionally) recorded around the world should be considered... There isn't much competition to air these events, which puts ESPN+ in a position to acquire these niche rights (at least in the eyes of your typical U.S. sports fan) at a reasonable price. That takes a market that has been nearly inaccessible for U.S. consumers and gives them the option to watch any game they want. Importantly, the cost to do this should be relatively low: The games are already televised outside the U.S. (so there is a video feed for ESPN to use), and the business is largely incremental for the leagues. It's a win for all parties involved. That's what ESPN+ should focus on: acquiring a significant amount of sports rights at reasonable prices, then using the data from the OTT service to make intelligent business decisions over time. As it relates to rights acquisition, the structure of the UFC deal (with content going to ESPN+ and traditional ESPN) could serve as a model for the future...

There's an opportunity for ESPN to become the Netflix of sports (at least in the U.S.). Importantly, building a large audience would influence discussions with the leagues. Starting with a large installed base for the ESPN app helps in this regard. As an example, could a service with millions of subscribers help expand the audience for the MLB or NHL? It may take time for the top leagues, but you could see some bold moves from others in the near future (a recent deal with the MLS moved its entire out of market package, which cost $80 per year, onto ESPN+).

Capitalizing on this opportunity will take years to come to fruition. It will require ESPN to spend aggressively on sports rights and to continue improving its consumer-facing technology (another area where Netflix has changed the game)... Disney must be willing to accept the short-term hit to the P&L (measured in years) that will come with a major investment in ESPN+. Time will tell if ESPN is willing to commit the resources necessary to turn this vision into reality."



I think those comments are still accurate, and even more relevant considering widening acceptance of sports betting in the United States. At the end of the second quarter of fiscal 2020, ESPN+ had 7.9 million subscribers - just shy of the long-term target that management set at the April 2019 Investor Day event, which called for eight million to 12 million subscribers by fiscal 2024. Recent subscriber growth for ESPN+ largely reflects the benefit from inclusion in the "Disney bundle" (Disney+, ESPN+ and Hulu).

It's still the early days for ESPN+, and the focus for now continues to be subscriber growth and engagement. I have no idea on the timing, but I still think the company is in a position to capitalize on the long-term opportunity that I laid out two years ago. In terms of the financials, management expects losses for ESPN+ in 2019 and 2020 of roughly $650 million per year, with profitability by 2023.

Competition

While I believe that over-the-top (OTT) services may become more important over time, that perspective is also balanced against the reality that, as they exist today, services like DAZN and ESPN+ for live sports are not nearly as revolutionary as Netflix was for entertainment programming. Why? Because regardless of whether you're watching a football game on ESPN (the TV channel) or ESPN+, there are still periodic breaks (time outs, half time, etc). There's a natural fit for advertising. Those ads help fund the cost of the content and keep the price to consumers down. In addition, games start at a specific time. So, while there's huge value in being able binge watch a new season when and where you want, as opposed to being dictated by a network that you must watch at 8pm on Tuesday night, that consideration does not apply to sports.

For that reason, it's still unclear to me what a company like Amazon provides to customers that a linear TV channel cannot. The experience is at best indistinguishable, and more likely to be worse if you have issues with video quality, buffering, delays, etc. Considering that ESPN and ABC currently provide leagues with access to more than 80 million pay-TV subscribers, there may be downsides with going over-the-top as well. The leagues recognize that reality and have said as such. As Brian Rolapp, the NFL's chief media and business officer, once told Barron's, "I'm convinced that one of the reasons the NFL is so popular is that we reach the broadest audience we can. Even when pay TV came about, we kept a commitment to free, over-the-air TV."

Viewership data from Thursday Night Football (TNF) in recent years supports that conclusion. When given the choice between linear TV and Amazon or Twitter, the overwhelming majority of fans watch on linear TV. This reflects the importance of accessibility (easily find and watch the game on your 65" flatscreen), video quality (none of the buffering or delays that is common when streaming live events), audience demographics, and the reality that OTT offered no incremental value to the consumer who decided to watch the game on Amazon or Twitter. I think this largely explains why the tech giants, despite endless speculation over the years, still play a very limited role in the broadcasting of U.S. sports.

For these reasons, I think legacy media maintains its dominance in the next round of NFL rights. If I'm right, that means we're likely to see the pay-TV bundle continue to evolve away from entertainment programming and towards live news and live sports (both in terms of audience viewership and where the dollars flow). Importantly, that ecosystem would still meet a need for tens of millions of American families. It's a continued decline in the number of pay-TV subscribers, but not freefall. In my prediction, that's likely where the world is heading over the next five to 10 years.

Conclusion

As I think about Disney's live content, particularly sports rights, I believe they're doing a good job playing the hand they've been dealt. In terms of the legacy business, which is tied to the fortunes of the pay-TV bundle, Disney has effectively demanded significant rate increases over time. They recognize the relative value of their content and price it accordingly. They are now using that leadership position to help them skate to where the puck is going. In the future, ESPN+ will offer more programming options and better accessibility than was available on linear TV. For sports fans, this could eventually become a product they "need" - just like ESPN is today.

As it relates to the valuation of these assets, I personally think it's reasonable to put it all in one bucket. Between the legacy Media Networks ($7.5 billion in operating profit) and ESPN+ ($650 million in operating losses), we're left with roughly $6.9 billion in operating income, or $5.5 billion after tax. Giving ourselves a bit of leeway in case Media Networks underperforms these expectations and / or ESPN+ investments surprise to the upside, let's call it a range of $5.0 billion to $5.5 billion in after-tax profits. Assuming a range of 8 to 14 for the price-earnings ratio, the businesses are collectively worth $40 billion to $75 billion.

Disclosure: Long DIS

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This article first appeared on GuruFocus.