How Much Further Can ESPN Drop? - TheStreet

The story was originally published Monday in Eric Jackson's Tech & Media newsletter.

For the last several months, I've argued that Bill Simmons' departure from ESPN's Grantland was less about his comments on National Football League Commissioner Roger Goodell or office politics and more about money.

Although I'm sure there were concerns about Simmons' rogue comments about the NFL, this should pale in comparison to ESPN's main concern throughout 2015: cord-cutting.

Disney's (DIS) - Get Report ESPN topped out with 99 million U.S. subscribers ("subs") two years ago, according to filings with the Securities and Exchange Commission. Since then, its sub count has been shrinking. It's currently at around 92 million. That drop in subs has meant a big drop in profitability for ESPN which has been at the heart of its parent company's profitability.

If you look at the Disney 10-K from 2013 to 2014, you can see the drop in subs:

  • ESPN dropped from 99 million to 95 million (-4%)
  • ESPN2 declined from 99 million to 95 million (-4%)
  • ESPNEWS went from 76 million to 73 million (-3.9%)
  • ESPNU went from 76 million to 74 million (-2.6%)
  • ESPN Classic dropped from 31 million to 26 million (-16.1%)

Fortunately for ESPN, it rolled out a new network to collect affiliate revenue in 2014 called the SEC Network for which they had 63 million subs (which has helped mask the bigger drop in affiliate revenues from their main networks).

For each of these subs, ESPN -- like every cable network -- gets affiliate revenue per sub from cable and satellite providers. Per financial information firm SNL Kagan, the revenue per sub last year were as follows:

  • ESPN $6.61
  • ESPN2 $0.83
  • SEC $0.63
  • ESPNU $0.22

It is believed that ESPN now has 92 million subs.

That difference in seven million subs from 2013 to 2015 means ESPN has about $650 million less in affiliate revenue. The drop in viewers also affects their ad revenue in a negative fashion (probably a drop of $250-300 million). Most of these revenue are sheer profits.

To compensate for this drop, all cable networks have been trying to raise their per-sub affiliate revenue fees each year with the cable and satellite providers. This gets more difficult as viewers and ratings keep dropping. ESPN has also combated these revenue declines by rolling out the SEC Network to 63 million households (which is pretty staggering to think that much of the country wants to see Southeast Conference football). The SEC Network has been a secret weapon for ESPN in the last year and it has helped bring in more than $200+ in annual affiliate revenue to Bristol, Conn., where the company is headquartered.

Before 2014, ESPN sub number kept going up. Perhaps that explains why ESPN reportedly spent $125 million in mid-2013 on revamping the SportsCenter set. In the face of recent ESPN cost-cutting, spending such a sum on a show that is now somewhat passé seems hard to fathom.

Last week on his new podcast, with guest Chuck Klosterman, Bill Simmons addressed these financial issues facing ESPN (at the 27 minute mark).

Simmons agrees that cord-cutting is a real issue having major ramifications on ESPN (and all cable networks, of course). He states that he didn't hear ESPN execs really worrying about it until later in 2014. He points to the new SportsCenter set as proof that none of the executives saw this sub drop from cord-cutting coming.

Yet, Simmons also claims that none of the departure of top talent relates to these cost demands. He states that his departure had nothing to do with money. But what if ESPN didn't want to pay him $6 million a year and that's why they stopped negotiating with him?

Simmons said commentator Colin Cowherd left because he got a better offer from Fox. But why didn't ESPN counter the offer?

Simmons said Jason Whitlock self-destructed, but ESPN can't have been oblivious to the benefits of not going through with a new Grantland-like third-party site The Undefeated (even though at present they say it's still going to happen, something I doubt).

Simmons said Keith Olbermann was cancelled because of bad ratings. But, again, there would have been a lot of cost savings from not using the expensive Times Square studio any longer.

Simmons also discusses the demise of Grantland, without connecting the dots of its closure to the cord-cutting phenomenon. They're still honoring the staff's contracts (what choice did they have?) but they will no longer support some outpost operation and bring it back into Bristol.

I don't quite understand how Simmons is so easily able to hold these two realities of financial pressures and personal vendettas so separately in his mind.

(Simmons also has a little soliloquy about how Grantland failed, in part, because it didn't have an app because it was conceived of in 2010. Someone explain Buzzfeed to him.)

My point isn't to bash Simmons here. I love his podcasts. It's to point out that his departure and the closure of Grantland was about money. Let's not pretend otherwise. Maybe they kept Grantland going for 6 months to try to stick it to Simmons that they could go on without him. But after Iger's August earnings presentation, that kind of fanciful thinking gave way to hard-nosed economics.

More importantly, it's fascinating how ESPN top brass was totally caught off-guard by cord cutting. To see your subscribers go from growth to a 7% decline in 2 years must be hugely alarming. Media Networks (the formal name of Disney's cable nets group) did $7.3 billion in operating income last year for Disney and most of that was from ESPN. Media Networks accounted for 56% of Disney's operating income last year.

ESPN is a big deal to Disney and its shareholders. To watch $1 billion of annual affiliate and ad revenue go away in a couple of years is a shock to the system. But where's it going? That's the real question any of us has yet to tackle.

We've now seen the first wave of cord-cutting lead to a 7% drop in 2 years. Have we bottomed? Unlikely.

I think it was Rich Greenfield of BTIG who said a couple of weeks ago: "The real question is do subs bottom out at 90, 70, or 50?"

That's exactly right. And those are three very different realities for Burbank -- not just Bristol.

If the answer is 50 million subs for ESPN in five years (or less -- imagine that!), Disney likely sees cable and satellite companies beating them down on per sub affiliate fees. In such a world, Disney's Media Networks might do $4 billion to $5 billion in annual revenue instead of $11 billion and $4 billion in ad revenue vs. $8 billion today.

That's a total shrinkage of possibly $10 billion in revenue in the next few years. Disney had $13 billion in operating income in 2014 across the whole company.

When is Bob Iger's retirement party so he can focus on LA NFL football? Let the next CEO take on this one.

Some will argue that Disney (and other cable networks) can simply figure out a way of charging more more money to the cord-cutters or never-signed-up-for the-cable-bundle people for their new and exciting digital products? 

After all, this is America. We need our sports. And we'll pay any price for it. Won't we? Some certainly will. But how much will they pay?

What if most of the diehards are the ones who stick with the bundle? What if the cutters or never-had-its don't need sports? And what if half of those 50 million households are gone forever to Netflix and chill, check Facebook, and watch sports highlights on Twitter Moments and Vine?

A $10 billion hole in any ship is going to take on a lot of water.

If $10 billion in Disney operating income just evaporates in the next few years out of a total of $13 billion, does a Disney investor pay 12x enterprise value to Ebitda? Or 9x? Or 7x? Those are very different realities.

This article is commentary by an independent contributor. At the time of publication, the author held no positions in the stocks mentioned.