Why Disney Is Going Over-the-Top With Sports Streaming

Disney (NYSE: DIS) ruffled a few feathers earlier this month when the magical media empire announced it would be splitting ties with Netflix (NASDAQ: NFLX) for content distribution. Disney revealed that it plans to make its movies and TV shows publicly available through a new "over-the-top" (OTT) digital-streaming solution. OTT is basically any sort of streamed media that doesn't require a cable company to distribute it -- essentially every internet streaming service is an OTT. It intends to discontinue its distribution agreement with Netflix and launch its new site beginning in 2019.

On top of that, Disney also announced that it plans to open up its ESPN sports content to the public next year. Sports fans will no longer need to have a pricey cable subscription to watch their favorite games.

Why is Disney doing this? The reason is because the company's golden goose has stopped laying golden eggs. It's now relying on innovation to keep its lucrative profit stream in place. While this has a fair share of uncertainty, it could potentially turn out to be a good long-term move.

Let's take a closer look at why Disney is launching this new sports streaming solution and what it could mean for investors.

Cord-cutting vs pricing power

Disney's relationship with the cable networks has been a win-win scenario for years. The company gave cable networks, like AT&T and Comcast, its ESPN content to include in their cable packages in exchange for charging them affiliate fees for the rights to do so. Disney won by raising the affiliate fees each year, and the networks won as more people signed up for their cable plans.

Unfortunately, fewer people are holding on to those cable plans these days. "Cord-cutting" has become a household word, as ad-supported digital sites like Alphabet's YouTube or Twitter are causing millions of subscribers to walk away from their expensive monthly cable bills.

The good news for Disney is that live sporting content remains in high demand. There's still something special about having your buddies over to watch the big game that you can't get from watching a replay online.

Because of this, Disney has wielded incredible pricing power. Even though the cable networks were losing subscribers every year, Disney kept raising the affiliate fees anyway. As depicted in this graphic from Variety, many of Disney's ESPN channels have lost nearly 20% of their subscribers in the past two years -- but they've offset this by charging 15%-20% higher affiliate fees during the same time period.

Unfortunately, the company can only raise prices so high. The cable networks needed to pass at least some of those price increases along in higher cable-plan bills. But consumers are already refusing to pay any more for cable, and attempts to offer cheaper, "skinny" bundles with fewer channels are only putting a bandage on the problem. Soon, these, too, won't be able to handle the rising affiliate fees, and will price themselves out of what consumers will pay.

It finally came time to make a change.

Disney's over-the-top solution

Disney is well aware that its cash cow is dying. The easy-money profit stream from the cable networks is evaporating, so it's changing its distribution strategy. By launching its new streaming site, Disney is looking to replace the revenues and profits it has pulled from the cable-network affiliate fees with new ones it would obtain by selling directly to consumers.

While the strategy makes sense, those affiliate fees have added up to quite a bit of revenue in recent years:

The two questions then become, "How many subscribers will sign up for Disney's over-the-top solution?" and "How much will they be willing to pay for it?"

To be clear, Disney's relationship with the cable networks will still continue. It will still receive affiliate fees for providing content even after it launches its new direct-to-consumer service.

But just for illustrative purposes, here's a look at how many subscribers Disney would need, and the associated costs that it would have to charge, in order to entirely replace its current $9.3 billion of annual ESPN affiliate fees it pulls in from 87 million cable subscribers:

  • Scenario 1: All 87 million ESPN subscribers agree to sign up for the new OTT service. Monthly pricing per subscriber would need to be around $9 per month.
  • Scenario 2: 43.5 million ESPN subscribers (50%) sign up for the OTT offering. Monthly pricing would be around $18/month.
  • Scenario 3: 8.7 million ESPN subscribers (10%) sign up for the OTT offering. Monthly pricing would be around $90/month.

In the longer term, Disney will need to make some tough decisions about how it will price its new offering and how many subscribers it will realistically be able to attract.

The Foolish bottom line

The price per month that sports nuts will be willing to pay for Disney's new offering is still up for debate. But there's more uncertainty now surrounding the future of the company's Media Networks division, which has caused many investors to shy away. Disney's stock price has remained bound between $100 and $110 for most of the past two years.

There's certainly potential for Disney's new endeavor to be very profitable. The company will benefit from a new direct relationship with consumers, giving it a better understanding of what shows they're watching and how often they're watching them. But Disney must also attract a critical mass of users, which will require years of marketing and associated expenses.

There's a lot riding on the future of Disney's ESPN content. We expect the OTT transition to be out of necessity, and look forward to seeing how the story unfolds.

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Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Simon Erickson owns shares of Netflix and Walt Disney. The Motley Fool owns shares of and recommends Alphabet (A shares), Netflix, Twitter, and Walt Disney. The Motley Fool has a disclosure policy.