Disney, DIRECTV, The Blackout, And The Next Phase Of The Pay-TV Revolution (NYSE:DIS)

I’m not surprised it got ugly. I am a little surprised at how fast it got ugly.

For those who haven’t heard, Disney (NYSE:DIS) is in a blackout dispute – again – with a major distributor on the eve of NFL Monday Night Football kickoff. This time it’s DIRECTV, whose five-year deal with the company expired at the end of August. And while blackouts are never fun, there has been what I can only categorize as an exceptionally high level of vitriol in the public statements. Not just “the other side is being greedy,” but accusations of lying, destroying the TV business, the kind of talk that two companies who know they’ll eventually have to kiss and make up don’t usually engage in.

The reason is simple: this isn’t just another carriage dispute. If the senior executives at both Disney and DIRECTV – which is still 70% owned by AT&T (T) – both sound like they think the other is trying to kill them, well, in a way they both are. This dispute represents the second step, after the Disney deal with Charter (CHTR) took the first last year, to fundamentally reshape television in America and, especially, the linear bundle which has been its hallmark since the 1960s. And nothing less than the future of these companies is at stake.

One Year Into The Revolution

A year ago, to the day, Charter was enmeshed in its own blackout showdown with Disney, and I was writing that it could be the thing that reshaped TV. As it turned out, it was rather transformational; it saw the first-ever incorporation of complimentary SVOD service access into TV cable service and a considerable culling of Disney’s linear general entertainment channels. But it didn’t do the whole job; however, it did lead us to this moment, which will take the transformation forward another step. And as the seeds of this showdown were planted by Charter, so too is DIRECTV probably planting a seed of its own.

In fact, this is the first major implication of the dispute that investors should take away: this is the new normal. Once so vital to the mountain gusher of cash flow that was American pay-TV that no one dared challenge it in a blackout for long, Disney now finds itself regularly squaring off with major pay-TV partners almost every year before the start of football season, like clockwork. And each “victory” it scores in such disputes eats away another portion of its cash flow from the linear bundle, and plants the seeds of the next battle.

Today’s Blackout Crisis

To be sure, the current situation is somewhat different from the Charter dispute. The Charter dispute was about preserving the bundle; Charter wanted Disney+ added to the linear bundle so that customers would stop defecting away from it. The channels that were dropped were basically only channels that showed reruns that were also available on the streaming services, making their loss minimal to consumers.

By contrast, DIRECTV has made clear it wants the bundle slimmed down, not just reorganized. Even worse, it wants the bundle broken up, with a series of genre-based packages replacing the linear bundle’s traditional all-or-nothing offering.

That means that this dispute is going to enter the one territory that Disney never wanted to enter, and which it managed to stay out of the whole time it was fighting with Charter. Rather than arguing about price, this dispute will almost certainly turn on minimums.

Minimum Penetration Requirements: A Primer

Specifically, it will turn on minimum penetration requirements. In my article a year ago, I already explained what these are, so I will refer you to that article here and not repeat the same points.

The nature of MPRs, as we will see, is such that they cannot meaningfully be separated from the bundling issue. Disney is far from the only company to have MPRs in its carriage deals, but the fact that Disney’s monthly affiliate fees are so much larger than other linear providers means that they count for a lot more.

Minimum Actually Means Multiple

The key point is this: minimum penetration requirements are not really minimums, they’re more like multipliers. This is because almost no channel has a minimum that it has any hope at all of exceeding in a truly optional system.

According to reports, Disney, for example, has a roughly 82% MPR for ESPN. Meanwhile, even the most optimistic estimates have demand for ESPN topping out around one-third of subscribers. (That estimate is far, far too optimistic, it would probably be more like 10%, but that is not the point of this article.)

Almost every other bundle channel, from every other provider, has a remarkably similar number. Even Regional Sports Networks, a particularly narrow and specific channel, typically have penetration requirements in the 80-90% range. Usually, about 10% of subscribers show any interest in RSNs. Kids networks are also about the same even though only one in three households has a child under 18 in it. And how many 17-year-olds watch kids networks anyway?

Pricing, Not Quantity

Because the minimums are basically unreachable if consumers were given any kind of choice, they function much more like multiples of price than they do as true minimums. No one thinks of them as hurdles to be cleared.

This is also why you will sometimes see two different prices quoted for the same channels. Right now, media reports have ESPN costing $10.79 per month per subscriber, while two years ago ESPN was already supposed to have crossed the $11 mark.

The former figure probably incorporates the penetration multiple, while the latter presumably did not. Ergo, two years ago, ESPN’s price might have been $11 per subscriber with 82% of a service’s subscribers required to take it, i.e., approximately $9.02 per subscriber in the service overall.

Today, $10.79 per subscriber, if it is being expressed as the total cost and not the cost per subscriber whose package includes ESPN, is presumably about $13.20 in cost per ESPN-subscribed DIRECTV subscriber.

Why MPRs matter

This is why this fight over minimums may be truly transformational. DIRECTV is negotiating its deal in the shadow of Disney’s attempt, along with Fox (FOX) and Warner Bros. Discovery (WBD) to launch a new skinny bundle sports package, Venu Sports. Right now, that is on hold pending a full trial after a judge entered a preliminary injunction. But the Venu Trio is appealing, and there is always a chance the injunction could be overturned, and the service launched after all.

The key point about the service is just how much cheaper it is. At a putative launch price of $43 per month, Venu would have the ability to dramatically underprice all existing linear sports providers in the market today. This is because almost all the non-sports fluff has been removed from it. Meanwhile, Disney can put almost all its scripted, non-sports fare on Disney+ and Hulu.

Under the circumstances, DIRECTV understandably feels that it may soon be facing a new competitor who can offer sports fans a skinny bundle without bloated general entertainment offerings, and it also knows that a lot of the cord cutters who are defecting from the bundle are non-sports fans who don’t want the sports channels that are Venu’s whole reason for being and can find everything they want on SVOD services.

Illustrating The Problem

This places DIRECTV, and indeed any pay-TV operator with an MPR built into its carriage deal, at a fundamental disadvantage because MPRs apply across bundles. When a subscriber joins DIRECTV or Charter Spectrum, they are added to the subscriber count for MPR purposes, regardless of whether they subscribe to a particular channel or not. Conversely, when Disney sells ESPN to Venu and then puts its scripted shows on Disney+, or even a new non-sports live streamer Disney creates, Venu does not have to pay out for its sister service’s subscribers.

Let me briefly illustrate. Assume DIRECTV has 10 million subscribers and splits them into two 5 million subscriber bundles: Sports and Non-Sports. Disney takes 10 million, multiplies it by the MPR and price of each channel, and sends DIRECTV a bill.

Now assume that Venu manages to get to 5 million subscribers, all sports subscribers, obviously. Venu takes the same price per sports channel, multiplies it by 5 million, and sends Disney that check. It doesn’t pay for non-sports channels because it doesn’t carry them. Some new non-sports live streamer, let’s call it Hulu Subset, does the same with 5 million non-sports subscribers, paying only for the non-sports channels, again at the same price for those channels that DIRECTV pays.

Add the numbers up, and Venu and Hulu Subset sent combined checks for 5 million subscribers to all of Disney’s channels, while DIRECTV sent checks for 10 million subscribers to all those same channels. DIRECTV paid twice as much, even though it and Disney’s own streamers sold the exact same service to the exact same number of subscribers. And this is true even if the 5 million subscribers to Venu and Hulu Minus are the exact same 5 million households.

DIRECTV’s Position

Under these circumstances, DIRECTV may not be bluffing when it says that it is prepared to go the distance with this carriage dispute. It may not feel it has any other choice.

While everyone talks about the dangers to DIRECTV in not carrying ESPN for Monday Night Football, and assumes DIRECTV absolutely has to have the situation resolved by then, if I were DIRECTV management I would be much more concerned if I signed a contract that obligated that I did have to carry all of Disney’s channels, no matter how they carved them up outside of my service.

Disney’s Current Offer

After the dispute started, ESPN President Jimmy Pitaro went on CNBC to berate DIRECTV for its negotiating position and, as proof of how reasonable he was being indicated that in fact he had already offered to let DIRECTV offer Disney channels in two separate bundles, a sports package and a general entertainment package. However, and frankly I’m shocked at this, the interviewer declined to follow up about minimum penetrations. Pitaro didn’t mention them, either. But the dispute is still going on, so something was clearly missing from that proposal in DIRECTV’s eyes.

I’m guessing Disney has offered DIRECTV the option to split the Disney channels into two bundles, but probably without any reductions in penetration minimums. That would mean that if the penetration requirement stayed at 82% on both, a minimum of 64% of DIRECTV subscribers would continue to have to subscribe to both packages for DIRECTV to avoid the fines. No way the number would be anywhere near that; frankly, I’d be surprised if even 20% of subscribers want both.

Even more importantly, the cost per subscriber of Disney’s channels would not decline at all; because DIRECTV has already apparently agreed to the fee increases Disney is seeking, maintaining MPRs at current levels would mean that splitting the bundle in two would accomplish nothing except to cut off subscribers access to channels they were paying for anyway.

Conclusion

Minimum penetration requirements are essentially where pricing and bundling meet. They are also where unbundling stops. If you’re paying on each subscriber, you are severely limited in how much unbundling you can actually do.

There is only one way out of this: The MPRs have to come way down, down far enough that DIRECTV can actually make its different bundle offers provide meaningful savings to consumers who elect not to take one or the other.

Disney Financials

But can Disney afford that? Like I said, DIRECTV would tell you that they are arguing over minimums, not pricing, but minimums are pricing. An MPR cut is just like a price cut as far as Disney is concerned. And this is assuming DIRECTV only wants a reduction in cross-bundle MPRs; if what it’s actually demanding is an end to the cross-bundle nature of MPRs, that’s even worse for Disney.

Assume for the moment that isn’t happening – or more likely, that Disney convinces DIRECTV it will hold out until doomsday before it signs a deal like that – and we are left to wonder just how deep an MPR reduction DIRECTV needs in a Venu-like world.

Mathematically speaking, a cut to 50% for each package ought to be the bare minimum if you’re offering two bundles. But let’s generously assume that there really are 20% of subscribers who will take both packages, and assume that MPRs are only cut to 60%, from roughly 80% now. That leaves a roughly 25% hit to Disney’s linear revenues from DIRECTV.

But it’s not just DIRECTV. As I explained last year, the largest pay-TV providers all have interlocking Most-Favored-Nation clauses that require that concessions offered to one of them be offered to all the others who are the same size or larger. You better believe that Comcast (CMCSA) Charter, and perhaps even YouTube TV are waiting in the wings – I doubt very much EchoStar’s (SATS) DISH Network is still large enough to qualify – to obtain similar terms. That means that Disney would also be looking at similar 25% cuts from at least two and possibly three other major pay-TV players.

The Calculations

Assuming that 25% is the haircut and that it applies to 60% of Disney’s pay-TV subs, Disney is looking at a 15% reduction to pay-TV revenue. In 2023, Disney reported $15.4 billion in US pay-TV affiliate fees. That means a loss of roughly $2.3 billion if it reduces its MPRs to what is probably the maximum workable level for its pay-TV partners. Net income in 2023 was $2.35 billion. If the 25% haircut gradually spread to all of its pay-TV partners it would be looking at a $3.85 billion hit.

The damage probably wouldn’t stop there, though. For one thing, even loosening MPRs in this way is unlikely to fully halt cord-cutting, so some of this would be on top of the damage that Disney is already taking. I’d also conservatively estimate that with advertising revenue at $6.6 billion domestically, a hit of at least another billion is well within reason as some subscribers who watch ESPN currently decide they’d rather save the money and drop off once the option is available.

There is some room for variation here. First, ABC is unlikely to see its fees reduced at all, but Disney doesn’t break out its broadcasting revenue from cable fees anymore, so we can’t see exactly how much that is. On the other hand, DIRECTV subscribers would probably also get the same free/discounted streaming subscriptions that Charter got, so that is another hit as utilization climbs. Assuming those two more or less cancel out, I’m reasonably comfortable with my estimates, again assuming that MPRs are actually changed once DIRECTV and ESPN strike a deal.

My Two Cents

I’m paid to analyze, not predict, but just to put my two cents in along with everyone else’s, my guess is that Disney will ultimately cave on the minimum penetrations for the entertainment channels, but will hold firm on the penetrations for the sports networks. That will be relatively meager pickings for DIRECTV, but it might be all they can get. Disney cannot really afford to offer too much out of the Sports division if it wants to keep it in the black, and has already proven in the Charter dispute that Sports is the division it will prioritize when dividing revenue.

It might be just enough. Disney hasn’t actually launched a “Hulu Subset” streaming service yet, so if it promises not to do so then DIRECTV can know it’s only caught in one-half of the pincer this article describes, and if free Disney+ and Hulu are incorporated into the general entertainment bundle then its affiliate fees, there aren’t really wasted money.

The Pay-TV Revolution

But the impact of this coming revolution in MPRs, if it happens as I think it will, wills still be significant. For one thing, a lot of pay-TV providers may soon have a dual-bundle structure, though I doubt it will help as much as DIRECTV hopes, for reasons that are beyond the scope of this article.

Comcast, Charter, and DIRECTV would probably all see a short-term subscriber bounce, or at least a slower pace of decline, as they exploited the reduced MPRs that smaller providers did not have the leverage or MFN clauses to extract before their own next renegotiations.

Sports leagues might be in for a shock. While sports are legitimately popular among many viewers, somewhere between 40% and 50% of households are still not sports fans. Sports windfall over the past two decades owed largely to the pay-TV bundles integration with sports, to the point that many now no longer distinguish between the linear bundle and the sports bubble; they are one and the same. Lowering MPRs represents another step towards probably bursting that bubble.

More than anything though, what this really highlights is that, as I said a year ago, the revolution in pay-TV really is here. It will still take a little longer to fully play out, probably another 12-24 months, but after almost two decades of waiting, streaming’s potential power to fundamentally reshape all of TV is finally within sight.

Investment Summary

I am skeptical of Disney’s ability to come through that transformation unscathed. Many call Disney a winner of the streaming revolution because of the IP and sports properties it owns, but sports may swing from an asset to liability and even the IP is subsidized by its competitors, as I’ve explained elsewhere. I rate Disney Avoid.

Charter is more interesting. As the co-king of pay-TV with Comcast, it is in pole position to take advantage of any concessions Disney and other media companies offer, and unlike Comcast it is far more of a pureplay on cable service. I am not currently an owner of Charter stock, but I am getting closer to diving in, depending on what final deal DIRECTV and Disney end up announcing.

Comcast is much the same as Charter, with perhaps the benefit of a strong NBCUniversal studio to boost it even higher. The biggest downside with Comcast is that, like Disney, it has taken on substantial sports rights exposures, which Charter has not. I rate it a Hold only, as I remain skeptical the NBA and NFL deals will deliver the promised benefits.

AT&T owns 70% of DIRECTV, but it is a relatively small part of its operations. I am not comfortable with the core wireless business, so I am rating it Avoid.