Walt Disney Will Survive, The ESPN Problem is Overblown
- Walt Disney stock has underperformed the consumer discretionary sector and the broader market.
- This is due to fears that ESPN subscriber growth is in tailspin mode and might not recover.
- ESPN subscriber decline is, however, moderating and Disney's Media Networks segment could return to growth in 2017.
Walt Disney (NYSE:DIS) stock has been one of the more notable laggards this year, trailing the Consumer Discret Sel Sect SPDR ETF (NYSEMKT:XLY) and the broader market by a wide margin of more than 10-percentage points. DIS stock has a YTD return of -4.87% compared to a gain of 5.33% by XLY and 7.87% by the S&P 500, respectively. Disney's troubles can be chalked up to its prized gem, ESPN, which has continued losing subscribers at an alarming rate. Let's take a closer look to figure out what the future outlook of DIS stock could be.
Walt Disney vs. Consumer Discretionary Select Sector ETF YTD Returns
Source: CNN Money
Walt Disney does not routinely disclose subscriber trends for its cable channels. Investors though can still glean some useful highlights from third-party players, such as AC Nielsen. Nielsen recently released an ESPN report for the month of October. According to the report, ESPN lost a whopping 621,000 subscribers during the month compared to average churn of 300,000 subscribers per month recorded over the past years. That qualified October as the worst month in channel history. But that's just the tip of the iceberg. Walt Disney's smaller channels are also bleeding subscribers: ESPN2 lost 607,000 subscribers while ESPNU lost another 647,000.
That revelation was quite shocking, and did not go down well with both Walt Disney and the investing world. This prompted Nielsen to issue a recall of the initial data. However, the firm later stood by its earlier report saying:
“The month over month decline in coverage that most cable networks saw was driven primarily by an overall decline of approximately half a percentage point (0.55) in the Cable Plus universe, meaning fewer households are subscribing to pay TV via traditional cable MSOs, telcos or satellite providers.”
The reverberations of the damning report were compounded after Disney posted a double whammy, missing on both top and bottom line expectations in its Q4 earnings. The company reported consolidated revenue of $12.97B, a 2.7% Y/Y decline, and $220 million below Wall Street consensus. That marked the first revenue contraction by the company in 15 quarters. The company's pivotal Media Networks segment, of which ESPN is the biggest revenue contributor bringing in ~75% of segment revenue, fell 3% to $5.66B while the segment's operating income dropped 13% to $1.45B. ESPN ad revenue fell 13%.
Looking At The Bigger Picture
Walt Disney and other cable players have been losing subscribers to cord-cutting and skinny bundles that carry only a few channels. Studies have shown that the average subscriber watches only 17 channels compared to hundreds of channels available on an average cable service. Cord cutting has been going on for years, and the end of the last fiscal year marked the third straight annual decline for ESPN and the cable industry as a whole.
But focusing solely on the latest ESPN snapshot by Nielsen can be misleading because it misses the bigger picture. Looking at Walt Disney's latest SEC filing gives a better overall picture of the health of the channel. According to the SEC filing, ESPN lost ~2M subscribers in FY 2016, bringing subscriber tally to 90M. That works out to a 2.2% Y/Y decline, which is actually an improvement compared to the 3.2% decline recorded the previous year and 4% decline in 2014. Moreover, that marked the lowest annual churn recorded since 2005.
ESPN could actually be close to turning the corner. Disney CEO Bob Iger recently provided upbeat 2017 guidance where he predicted modest revenue growth for ESPN during the year. Further, a new ESPN MVPD contract renewal cycle could kick-in in late 2017, which could provide multi-year revenue growth for years. That, coupled with moderating churn, might help ESPN return to revenue growth during the second half of the year.
Walt Disney Not Likely To Sell ESPN
There have been widespread calls by investors for Disney to sell or spin off ESPN so as to eliminate the investment overhang that has been clouding the company. For instance RBC's Steven Cahall recently put out estimates that selling an 80% stake on ESPN could fetch Walt Disney ~$22B, and considerably more if sold to a strategic buyer such as a rival cable company.
From a purely investment point of view, selling ESPN probably makes sense since it would unlock considerable shareholder value. But given the strategic importance of ESPN to Walt Disney, it seems highly unlikely that the company would even consider going down that road any time soon. ESPN contributes about 30% of Disney's revenue and more than half of operating income.
While spinning off the business might be off the table right now, Disney has in the past indicated a willingness to deliver ESPN direct-to-consumer. This would allow ESPN to move out of the bloated pay-TV bundle and maybe charge something cheaper like $30 per month for a subscription. This would probably encourage some of the subscribers who are contemplating cutting the cord to stick around.
Such a move though would be fraught with risks. First off, ESPN would no longer be carried in a basic default tier and cable companies could choose to move it to an add-on tier as they choose. This would likely lead to lower viewership, which in turn would severely curtail the ability of ESPN to command premium pricing from advertisers. ESPN currently commands close to $7 per subscriber per month in affiliate fees, by far the highest in the industry.
Indeed, Bob Iger reiterated to investors in 2015 that Disney will not consider distributing ESPN on a direct-to-consumer model for at least five years, saying such a move is currently unnecessary.
The Outlook For DIS Stock
For all its cable woes, Disney's Studio Entertainment segment has been doing exceptionally well, and is set to finish the year with the second-highest box office gross ever in history. Although the segment is only about a third (revenue) the size of Media Networks, a strong showing like that can offset some of the Media decline and help allay fears by investors.
Wall Street still remains bullish about DIS stock. I, however, expect the stock to remain a tough battleground over the next 12 months as investors watch and see whether ESPN will be able to bounce back. DIS stock though still looks like an attractive long-term investment 2-3 years out especially if the company will be able to successfully deal with the ESPN overhang.