This article originally appeared on Real Money on Nov. 14, 2016.
But the fact that so many people are taking those rumors seriously, perhaps, says something about how concerns have grown about the threat posed by online video to Disney's media empire. And that Disney needs to make a big move to protect its flank.
Netflix rose 4% on Oct. 3 after vague rumors emerged that Disney is looking to buy the streaming company. The chatter died down for a while, but flared up again on Monday, thanks to a TechCrunch column making the case for a deal. The column didn't cite any sources indicating Disney and Netflix are in talks, but simply argued why it's in the companies' interests to merge.
A look at Disney's fiscal fourth-quarter (from September) results shine a light on why the company could be pressured to shake things up. The company's media networks division, which produced nearly half of its profits in fiscal 2016, saw revenue fall 3% annually to $5.7 billion. That was a reversal from the 2% growth posted in fiscal Q3; never mind the 12% growth seen in the year-ago period. The division's operating income fell 8% to $1.7 billion.
While media networks' broadcasting segment, responsible for ABC, saw revenue rise 8% to $1.7 billion and operating profit rise 37% to $224 million, its cable networks segment, which oversees ESPN and the Disney Channels, among others, saw revenue drop 7% to $4 billion and operating profit drop 13% to $1.4 billion. Lower affiliate fee revenue from pay-TV providers weighed, as did lower ad revenue and higher production costs at ESPN.
Cord-cutting is obviously a big culprit here: Research firm SNL Kagan estimates ESPN gets $7.21 per month from every pay-TV subscriber receiving ESPN whether or not they watch it for a minute, and another $1.16 per month for ESPN2 and ESPNU. While Disney doesn't break out ESPN subscribers, the sports network is believed to have lost over 10 million subs since 2013, bringing its total base below 90 million.
Meanwhile, lower subscribers have contributed to lower ratings. And regardless of how many people are tuning in, ESPN and ABC are on the hook for tens of billions in licensing fees in the coming years to the NFL, the NBA, the MLB and other sports rights owners.
ESPN has tried to narrow its sub losses by making its channels available for relatively cheap online TV services, such as Dish Networks' (DISH - Get Report) Sling TV, and is prepping a streaming service that will feature content not currently appearing on ESPN channels. But Sling TV and its peers have seen limited uptake, and ESPN has no plans to make its TV channels available through an a la carte service, given the pay-TV backlash it would face if it did.
ESPN has effectively created a giant affiliate-fee business by holding pay-TV providers hostage -- pay use $8 per sub per month, or your customer will be up in arms because they're no longer getting ESPN. But ironically, this "hostage situation" also hamstrings ESPN from providing a standalone streaming service that would appeal to cord-cutters, since pay-TV firms would have little incentive to keep forking over those hefty affiliate fees if consumers had another way to get ESPN.
Thus, the arguments that buying Netflix is Disney's best bet for guaranteeing it can remain a growth company in the years to come. Reed Hastings' company is still growing rapidly -- revenue rose 32% annually in Q3, and Netflix ended the quarter with 86.7 million subscribers -- as its big bets on original content and international expansion pay off beautifully. Disney, which already licensed big-budget movies to Netflix, could add more popular content to Netflix's library, use its empire to promote Netflix's services and help the streaming provider finance a content-spending binge that led free cash flow to be at negative $1.3 billion over the last four quarters.
But Netflix, which currently has a $48.6 billion market cap -- even if one assumes the company is willing to sell, it might not do so for less than $70 billion -- and Hastings has given no indication that he's looking to cash out rather than pursue what he considers a big long-term opportunity. Moreover, with just $2.4 billion in long-term debt on its balance sheet, Netflix can afford to stay cash-flow negative for a while.
If Netflix is off the table, who might Disney target instead? It would be tough to acquire Hulu, since the streaming service is co-owned by other media players who also view it as a strategic asset. Online music leader Spotify, valued at $8 billion in a 2015 funding round, now claiming over 40 million paid subs and from the looks of things still losing money, seems plausible.
Disney could also join the burgeoning ranks of online TV service providers. Just as AT&T (T - Get Report) plans to launch a $35-per-month online TV service with the help of the affiliate fee cost savings it will get from owning TNT/TBS/CNN parent Time Warner (TWX) , Disney could launch a reasonably priced TV service by taking advantage of its ESPN/ABC/Disney Channel ownership. Pay-TV providers wouldn't be thrilled about this, but are unlikely to revolt any more than they have over Sling TV.
Unless cord-cutting somehow comes to a halt, Disney is staring at some tough choices. Offsetting a potential long-term decline in a company's largest and most profitable business can require some drastic measures.