How high can ESPN's license fee go?

Tuesday, February 26, 2013 9:54 PM ET 

After growing in the double digits and high single digits for many years, license fees at ESPN moderated last year to the mid-single-digit range. But those days will soon be over for multichannel operators. 

Like other sports networks, ESPN has been hit by a huge escalation in rights fees on major contracts like its deal with the NFL.

Walt Disney Co.'s carriage agreement with Time Warner Cable Inc. was made public in a lawsuit where DISH Network Corp. is suing ESPN for violating its "most-favored nation" clause by charging DISH more than it is charging other operators. 

According to MediaPost, the most recent contract calls for Time Warner Cable's rate to go to $5.40 per sub per month at midyear, growing to around $7 per sub by 2017 and nearly $7.50 by 2018. Escalators of 6.5% per year will bring the wholesale price to $8 per sub per month by the end of the decade.

We estimate that ESPN is going to bring in more than $7.31 billion in affiliate fees in 2014. License fees are expected to grow at a compound annual growth rate of 7.5%, rising from $5.54 per sub in 2013 to $7.40 per sub by 2017. Margins are still expected to contract a bit, but we still expect cash flow to grow from $2.48 billion this year to nearly $3.33 billion by 2017 — not a bad business.

Earnings were negatively impacted by a whopping $321 million in expenses related to litigation with Celador after Disney lost its appeal in the "Who Wants to Be a Millionaire" case. This equated to a decline of 11 cents in EPS. The company reported that diluted EPS fell 4% year over year to 77 cents, but excluding certain items affecting comparability, EPS was 79 cents, compared to 80 cents in the year-ago quarter.

A jury found in 2010 that ABC and its affiliated companies failed to include ABC's profits when calculating the profit participation due to Celador. After a five-week trial, Disney was ordered to pay $270 million plus interest, and the 9th U.S. Circuit Court of Appeals upheld the decision.

The only division to report a decline in revenue was studio entertainment, down 5% to $1.55 billion. Studio entertainment also was the only division to post a decline in segment operating income, dipping 43% to $234 million. All of the other divisions posted gains, although the media networks division's bottom-line growth was tepid.

Media networks grew revenue 7% to $5.10 billion, but segment operating income was up just 2% to $1.21 billion. Pulling out broadcasting, the results for cable networks were even worse, as revenue grew 7% to $3.54 billion but segment operating income decreased 2% to $952 million.

Management attributed the decline to ESPN, which was partially offset by growth at the domestic Disney Channels,ABC Family Channel and the A&E Television Networks. Costs at ESPN were negatively impacted by contractual rate increases for college football with the Pac-12, the Big 12 and the NFL, and an increase in the number of NBA games (following the NBA lockout in the Dec. 31, 2011, quarter).

The media networks division reported a $234 million increase in programming costs primarily due to the increased sports rights at ESPN. Affiliate fees rose 9% in the quarter, 7% of which was due to contractual rate increases and 2% from reduced ESPN revenue deferrals. This compares to growth of 3.8% in the Sept. 30, 2012, quarter, and no growth in the June 30, 2012, quarter. Clearly there is a major acceleration happening.

Ad revenue was up just a hair, increasing $24 million, or 2%, at the cable networks division to $1.14 billion. As the graphic below shows, that is half of the growth rate posted in the prior quarter and well below the double-digit growth rates posted in the first and second calendar quarters of 2012. Cash ad sales were up 2% during the first fiscal quarter at ESPN, but ABC Family fared much better, up 15% in the first fiscal quarter compared to an increase of 10% in the first fiscal quarter of the prior year.

The cable networks division reported a 4% boost in advertising coming from higher units sold, a 3% uptick from higher rates at ESPN and ABC Family, partially offset by a 6% decrease in lower ratings at ESPN.

On the company's earnings call, Chairman, President and CEO Bob Iger said the company had closed seven out of 10 major affiliate agreements for its cable networks. "And with long-term sports rights now locked in, we expect ESPN to remain the must-have brand for sports fans," Iger said. He noted that ESPN serves up almost 30,000 hours of live events, news and original programming across all of its networks and services each year, and that every week more than 113 million of the estimated 230 million sports fans in America interact with ESPN for sports coverage and information.

Iger also took a pot shot at the myriad regional sports networks that are raising rates through the roof. "By contrast, emerging regional sports networks serve fans of local teams with limited programming. RSNs may compete for local market share but ESPN offers an entirely different value proposition to sports fans and multichannel operators," Iger said. "ESPN delivers almost twice the audience of all RSNs combined. And among the key sports demo of men 18 to 34, on average ESPN's audience is more than four times the size of the audience of all RSNs put together."

Disney has been including TV Everywhere in its deals, and Iger pointed out that the authenticated mobile service WatchESPN is now in 46 million homes, a number which will rise to 55 million in March when some new affiliate agreements kick in.

Commenting on rate hikes going forward for ESPN, Senior Executive Vice President and CFO Jay Rasulo told investors, "While ESPN's results in this quarter were impacted by higher costs, we expect ESPN starting the second quarter to benefit from several new affiliate deals and, therefore, deliver attractive growth for the full year. Our confidence in ESPN's full-year performance is based on our visibility into the value and timing of new affiliate agreements and ESPN's positive advertising trends. At the same time, Q1 programming costs growth will be the high water mark of the year," Rasulo said. 

ESPN ad sales were pacing at 7% as of the Feb. 5 earnings call, so 2013 should be a better year for the sports network.