ESPN’s Profits Can Still Grow, But Cord-Cutting Is A Real Threat

As the crown jewel in Disney’s (NYSE:DIS) diversified entertainment business model, the ESPN network is responsible for almost 30% of Disney’s value, according to our estimates – indicating an estimated standalone value for The Worldwide Leader in Sports of about $50 billion. This would explain why the rapid decline in ESPN’s subscriber base in recent years has been the biggest source of concern for investors in Disney. After all, the network has lost nearly 10 million subscribers (or roughly 10% of its subscriber base) since the end of 2013. And this does not bode well for the segment’s long-term value, given that subscription revenues account for more than 60% of ESPN’s total revenues for any given period. The subscriber losses haven’t significantly hurt ESPN’s top line yet, though, as the network has been able to leverage its exclusive rights to live sports contents to steadily hike subscription fees.

ESPN’s growth strategy over the years has focused on ensuring exclusive access to the broadcasting rights of the most popular sporting events through long-term contracts – allowing it to charge subscription fees that are much higher than any other network. We expect this to remain ESPN’s strategy in the near future as well, as the exclusive nature of its live sports content means that the network can continue to pass on any content and operating cost increases to subscribers. Below we discuss our forecasts for ESPN’s financials over the coming years and our rationale behind them. 

View our detailed analysis of ESPN here

ESPN’s Business Model In A Nutshell

ESPN’s current business model relies heavily on the popularity of live sporting events, and on the network’s long-term contracts for exclusive broadcasting rights of a major chunk of these events – including NFL, MLB and NBA games (besides other sports and events). This allows ESPN to demand substantial premiums from pay-TV providers, who pass those costs on to subscribers. To put things in perspective, ESPN is now charging $7.21 in average subscription revenues per customer per month, while the figure for its closest rival (TNT) is just $1.76. Notably, while ESPN’s subscriber base has shrunk from a peak level of 100 million at the end of 2010 to below 90 million at the end of 2016, total subscription revenues have grown steadily thanks to consistent increases in monthly subscription fees, from $4.40 to above $7.00 over the same period.

Our Base Case Forecast: Subscriber Numbers Will Shrink Steadily

Our base case scenario for ESPN largely assumes that the aforementioned trends will continue going forward. The key trends we forecast for ESPN’s revenue and cost drivers are as follows:

• Subscriber base to shrink: We expect ESPN’s subscriber base to decline by ~2.5% annually over the foreseeable future, as a result of cord-cutting trends.
• Avg. subscription fees will increase: ESPN’s exclusive content lineup should allow the network to pass on higher operating costs to subscribers – resulting in average monthly subscription fees increasing by roughly 5% annually.
• Content costs will jump in 2017: ESPN’s costs from contracts for broadcasting rights were around $4.7 billion annually between 2013 and 2016, but will likely jump to over $5.8 billion in 2017 and will likely remain around that level going forward due to their long-term nature.
• Other operating costs to grow steadily: While content contract costs form a majority of ESPN’s operating costs, the network also incurs considerable production expenses, besides marketing and other general administrative expenses. These costs were roughly $4 billion each year over the 2013-16, and we expect them to grow at ~4% annually going forward.

Our base case scenario values ESPN at $49.4 billion. As Disney owns an 80% stake in ESPN, the effective value of the network for Disney is just shy of $40 billion. The table below highlights our forecast for key operating metrics at ESPN.

But ESPN’s Current Strategy Faces A Rapidly Growing Threat

With all of that said, ESPN’s current strategy may not remain sustainable in the future due to an evident shift in the way people consume live content. Unwilling to pay hefty monthly subscription fees to traditional cable broadcasters, many subscribers have done away with cable TV altogether – a trend referred to as cord-cutting. The growing popularity of internet-only streaming services that cost much less per month has been the primary catalyst in this trend, and it is likely to accelerate going forward.

At the same time, ESPN’s broadcasting contracts have swelled considerably over recent years, and the network’s strategy of shifting these costs to subscribers by hiking subscription fees can end up being counterproductive, as it could further accelerate the decline in its subscriber base. We will quantify the impact of such a scenario on ESPN’s revenues and profits in a subsequent research note, while also offering a potential long-term solution to this problem.

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