A cross-section of Wall Street analysts have raised the alarm regarding Walt Disney's leading cable channel ESPN and its subscriber loss problem. ESPN represents 75% of Disney's cable revenues and a weak ESPN channel can be disastrous for the entire company. How will Disney cope with this unfortunate trend?

Walt Disney (NYSE:DIS) has been one best-performing stocks in the Dow Jones over the past couple of years. This year has not been any different with Disney stock up 26% YTD. But this type of performance might now be in danger, with Disney's cash cow ESPN continually losing subscribers and revenue. Cable networks are Walt Disney’s most important revenue and income segment, contributing about 44% of revenue and 58% of the company’s operating income. ESPN is the most important member of the cable network, representing 75% of Disney’s cable revenues. A crumbling ESPN therefore has real potential to take a severe hit on Disney’s top and bottom lines.

Although Disney CEO Bob Iger has largely been downplaying ESPN subscriber loss, some analysts believe the problem could get far worse in the coming years. Fund manager Eric Jackson is one of the analysts that think ESPN subscriber and income loss will not moderate as many believe but will instead get worse as the quarters roll on. Jackson pointed to Disney’s past SEC filings that suggest ESPN subscribers peaked at 99 million in 2013, and have now fallen to 92 million as per Nielsen’s current estimates. Jackson estimates that ESPN is receiving $650 million less in affiliate fees and $250 billion less in advertising revenue than it did just two years ago. Affiliate fees refers to the fee that cable providers such as Comcast pay ESPN for rights to broadcast the channel.

Is The Problem That Bad Really?

There is no question that Disney is feeling some heat from cord-cutting as consumers prefer other distribution channels such as Netflix, which is increasingly competitive, while other subscribers select ‘‘skinny’’ bundles of channels that exclude costly ESPN. ESPN is also being plagued by another problem that Jackson did not talk about rising programming costs which are squeezing margins. ESPN programming costs have risen about 50% in four years to $4.50 per subscriber in 2015.

Source: Wall Street Journal

But that’s just one side of the narrative. The other side is that ESPN’s affiliate fees per subscriber have actually been growing and helping Disney to offset loss of revenue from lost subscribers. Disney’ Media Network recorded a healthy 27% Y/Y increase in operating income to $1.82 billion, which the company chalked up to higher affiliate fees and better ad rates.

Disney talked about this during its fourth quarter and full-year earnings call:

At Media Networks, growth in operating income in the fourth quarter was driven by an increase in cable, while Broadcasting results were in line with the prior-year quarter. Growth in cable operating income was driven by ESPN and, to a lesser extent, worldwide Disney channels and higher-equity income from A&E. The increase at ESPN was driven by the benefit of the 53rd week and higher affiliate and advertising revenue. Programming costs were relatively flat in the quarter, as higher costs for a full quarter of the SEC Network, additional U.S. Open tennis rights, and contractual increases for Major League Baseball and the NFL were offset by the absence of rights costs for NASCAR.

Domestic cable affiliate revenue was up 17% in the quarter and up 8% excluding the benefit of the 53rd week. Ad revenue at ESPN was up 5% in the quarter. Two factors affected the comparability of ESPN's ad growth in the quarter, the 53rd week and the absence of the Men's World Cup. We estimate that ESPN's ad revenue was up 9% when you exclude the net impact of these two factors.

So ironically, affiliate fees and ad revenue, the two ESPN revenue components that Jackson talked about, are actually doing quite well. ESPN’s affiliate fees remain the highest for any channel by a wide margin--ESPN affiliate fees clocked in at $6.55 per subscriber per month during Disney’s fiscal 2015, and is expected to cross the $7 mark in 2016.

Source: Forbes

Where Else Can Disney Get Growth?

The good news is that while Disney’s cable segment is likely to remain under some pressure in the coming quarters due to cord-cutting, Disney’s other revenue segments such as Studio, Parks and Entertainment, and Consumer Products remain in the pink of health. Disney has enjoyed a blockbuster year with box office hits such as Inside Out, Avengers: Age of Ultron, Cinderella, Inside Out, among others having set box office records. Disney has predicted that Star Wars: The Force Awakens, which is to be released in December this year will realize movie product sales of $5 billion, thereby smashing the current record of $2.8 billion set by Cars 2 in 2011. Disney has turned the screw on its licensing partners and will now take a 20% royalty on movie product sales, about double the normal rate.

After growing its EPS by 16% in 2015, Disney expects EPS to increase 10% in 2016. Meanwhile the consensus is for the company to grow earnings by 14.1% CAGR over the next five years. Walt Disney therefore remains a prime long-term holding.