At last month’s Communacopia conference held by Goldman Sachs, Disney CEO Bob Chapek was asked about the importance of ESPN and sports broadcasting to his company’s streaming strategy. His answer sounded like a throw-away line.

“The number one most-viewed thing every year tends to be sports, something like nine out of 10 of the top viewership events in television are sporting events,” Chapek said in a virtual session on Sept. 21. “Who knows what the future will bring, but it’s certainly an important part of our consumer offerings at the Walt Disney company.”

Chapek’s generic response about the future for one of Disney’s most valuable assets inspired no follow-up questions or headlines. But Chapek was addressing an existential threat facing the media industry, and an issue that may one day rock the foundation of his media empire, which includes some of the most valuable studios and film franchises in the world alongside the dominant network for live sports.

Disney’s big dilemma for ESPN is whether and when to fully embrace a future without cable.

Broadcast and cable networks still make billions of dollars per year from the traditional TV model. ESPN is a huge beneficiary, because media companies earn monthly subscriber fees from pay-TV providers regardless of how many people watch their programming. Niche channels make just a few cents a month per subscriber, while sports networks charge several dollars.

Disney makes more money from cable subscribers than any other company, and that’s solely because of ESPN. ESPN and sister network ESPN2 charge nearly $10 per month combined, according to research firm Kagan, a unit of S&P Global Market Intelligence. That’s at least four times more than almost every other national broadcast or cable network, according to Kagan.

Disney requires pay-TV providers to include ESPN as part of their most popular cable packages. It’s a no-brainer for TV providers, who wouldn’t dare drop ESPN.

Meanwhile, the non-sports world is cutting the cord. More than 6 million people ditched pay TV in 2020, according to research firm eMarketer — the highest annual total ever. About 25 million Americans have dropped linear TV bundles in the past decade.

That creates a struggle within Disney that’s poised to escalate. Disney wants people to sign up for its streaming entertainment products, Disney+ and Hulu. Wall Street wants this too. Streaming video is a growth business. Traditional pay TV is a declining one.

It’s also a wise financial swap for Chapek. While Disney makes more than $10 a month per subscriber for sports, it makes far less for entertainment networks such as Disney Channel and FX, which draw lower audiences and don’t command high advertising rates.

If Disney can get a cord cutter to pay $8 per month for Disney+ and $6 for Hulu, it’s a huge win for the company.

The reverse is true for ESPN. Swapping an ESPN subscriber for an ESPN+ customer, who contributes average revenue of less than $5 per month, is a significant loss for Disney. ESPN+ is a streaming service with limited content.

Disney Chairman Bob Iger, who was CEO until last year, told investors when he launched Disney+ that Disney was “all in” on streaming video.

But ESPN isn’t. ESPN’s strategy is to cling to the cable bundle for as long as possible, knowing it can draw potentially billions of dollars from U.S. households that are each paying $120 for the network even if they never watch it.

Some analysts have even questioned whether Disney should spin off ESPN, allowing Chapek to focus more clearly on streaming. An ex-Disney executive, who recently left the company and asked not to be named, said there’s “strategic misalignment” between the parent company and ESPN, and the businesses no longer belong together because Wall Street doesn’t look kindly on declining assets. The executive said having ties to the legacy bundle will weigh down a company’s stock multiple.

Whether or not the fit still make sense, Disney has a huge financial incentive, at least in the short term, to keep the marriage going.

At $10 per month, or $120 per year, multiplied by about 75 million U.S. homes, Disney earns roughly $9 billion annually in domestic carriage fees from ESPN and its associated networks. Advertising that comes with broadcasting sports brings in billions of additional dollars.

That cash allows ESPN to spend big on sports rights, continuing a virtuous cycle. Disney agreed to spend $2.7 billion for “Monday Night Football” in a deal that runs all the way until 2033. ESPN pays $1.4 billion annually for NBA games and will likely pay more when those rights will need to be renewed after the 2024-25 season. The network owns media rights to every major U.S. sport in some capacity.

It also allows Disney to pay up for original streaming content, bolstering the quality of Disney+ and Hulu as the company competes with Netflix and Amazon.

“We’re successfully navigating the evolution of consumer choice,” said Jimmy Pitaro, chairman of ESPN, which is majority-owned and controlled by Disney, in an interview with CNBC in April. “We believe we can be multiple things at the same time. As consumers continue to gravitate toward direct to consumer, we have the optionality that we need.”

ESPN’s role as cash machine works nicely for the time being. But if 25 million U.S. households ditch cable in the next four or five years, as some predict, the math will no longer add up, said LightShed media analyst Rich Greenfield.

“If we’re going to 40 to 50 million, the question is, ‘Is there any economic model that justifies the level of spending that we’re currently at?'” said Greenfield.

ESPN has to figure out how to make up $3 billion in annual lost pay-TV subscription revenue that’s coming in the next few years as cord-cutting continues, a decline that Disney executives are anticipating, according to people familiar with the matter.

Disney’s plan is to incrementally raise the price of ESPN+ as it adds more valuable content while maintaining contractual obligations for exclusive programming to pay-TV distributors, the people said. An early example is Eli and Peyton Manning’s alternative broadcast of “Monday Night Football,” which will air 10 times this season on ESPN+ and ESPN2.

Should the number of pay-TV bundle subscribers drop to a level well under 50 million U.S. households, Disney would likely take ESPN to consumers in a more complete streaming package, said two people with knowledge of the company’s plans. At that point, the economics would flip, as most of the people paying for linear TV would be sports fans. Disney could likely make more from a full-service sports streaming service than it would make in a wholesale pay-TV distribution model.

In the near term, selling ESPN separate from the linear bundle isn’t feasible. Disney has negotiated digital rights flexibility in almost every major rights renewal in the past few years. But the company is currently restricted by its linear pay-TV obligations, which require certain premium programming to stay exclusive to the cable bundle, according to people familiar with the matter.

David Levy, the former president of WarnerMedia’s Turner Broadcasting, said that Disney will have plenty of leverage with consumers when the time comes to bypass the bundle.

Levy, who’s now chairman of data firm Genius Sports, said he thinks Disney can get 30 million customers to pay $30 a month for streaming ESPN, or more than double the cost for a standard Netflix subscription. That would bring in $10.8 billion annually — more than Disney makes today from pay-TV affiliate revenue.

“With sports, there’s a guaranteed built-in audience,” Levy said. “It’s much different than entertainment. With entertainment, every show is hit or miss, and you always have to market content. You never know what will succeed and what won’t. That’s why sports is the best content to invest in, and it will be no matter what the distribution model is.”

But Levy’s estimate may be optimistic. A top executive at one of the largest U.S. pay-TV operators told CNBC that about 15% of video subscribers are heavy sports viewers. That would equal just over 11 million U.S. households. Even if ESPN could double that number for a streaming app at $30, the service would make less than the $9 billion ESPN takes in today.

The uncertainty of how many subscribers will pay for sports in an à la carte streaming world isn’t lost on the leagues. The NFL built in early out-clauses to its most recent 11-year deals with the networks, according to people familiar with the matter, allowing the league to bail if the business model stops working. The NFL can end its agreement after seven years with CBS, NBC and Fox and after eight years with ESPN, said the people, who asked not to be named because the negotiations were private.

That’s why Disney and other networks with live sports want to keep the linear bundle around until they have to let it go. It’s difficult to make up the lost revenue in a reliable way.

“We believe strongly that the traditional pay TV bundle will remain intact for a long time,” said
Sean McManus, chairman of ViacomCBS’s CBS Sports. “I don’t think it ever whittles away to zero. And while it’s certainly possible the amount of subscribers will continue to decline, I don’t think the decline ever reaches a point in the coming years that it won’t support the current rights deals that we have, both for NFL football and our other sports.”

A streaming-only world would also subject ESPN to a challenge that it’s never had to worry about: Churn.

People who cancel ESPN unsubscribe from the whole linear bundle. In the direct-to-consumer market, it would be easy for football fanatics to only subscribe during the few months when games are played.

ESPN executives have been playing with ways to incentivize annual membership on the existing ESPN+ service to reduce month-to-month volatility. Several times this year, ESPN has sold a pay-per-view UFC fight for $69.99 on ESPN+, and at the same time offered a full-year membership, that would include the match, for $89.99, a 35% discount.

Packaging ESPN+ with Hulu and Disney+ is another churn buster, as the combined offering is 33% cheaper than buying all three individually.

However, a more complete ESPN offering combined with another streaming service would have to cost more, a proposition that would likely scare away the non-sports fans, who are used to paying much less. Disney already packages sports in some of its foreign streaming services, such as India’s Disney+ Hotstar and Latin America’s Star+. But the economics internationally aren’t the same as in the U.S.

“If you put sports into Hulu or Disney+, instead of charging $5 or $7, now you’re charging $30?” Greenfield said. “And then you’re trying to compete against Netflix at $15. There is no model I see that works. There’s no easy answer.”

Then there are the technology risks.

ESPN executives are hesitant about moving their prized programming to directly to consumers because of rampant password sharing among young users, according to people familiar with the matter.

“Watching a pirated stream or sharing a streaming service password seems like a victimless crime,” said John Kosner, who led digital media at ESPN from 2003 to 2017 and is now president of media consulting firm Kosner Media. “But it really impacts the business model of sports on streaming services.”

Whether younger audiences even want live sports is another issue for Disney. Other entertainment options, such as social media, mobile games and on-demand entertainment services may be eroding the cultural grip of televised sports. Americans age 13 to 23 are half as likely as millennials to watch live sports regularly and twice as likely to never watch, according to a 2020 Morning Consult survey.

“The overall relevance of sports is an open question for the younger generation,” said Kosner.

One potential model that could save Disney a lot of future heartburn is a new streaming bundle that effectively replicates pay TV but with more options. If that becomes the winning form of distribution, media companies may be in a familiar position, making money from their most-popular services even if not everyone is watching them.

Dexter Goei, CEO of cable TV provider Altice USA, said in May that such a product offering could work well for the sustainability of the media industry.

It “would allow us to focus primarily on our broadband product” and “be a partner for content on a direct-to-consumer basis as opposed to a partner on a linear basis,” Goei said at JPMorgan’s Technology, Media & Communications conference. It “will dramatically improve the economic trends of our business from a cash-flow standpoint,” he said.

The growing popularity of sports betting could also help. Betting by mobile app, which is slowly being legalized around the country, boosts viewership, because “if you place a bet on a game, you’re much more likely to watch that game,” Levy said.

Kosner added that augmented reality devices that create new viewing experiences and innovative products like non-fungible tokens (NFTs), which are digital collectibles, also have the potential to lure younger fans to watch games.

Add it all up, and media executives can find plenty of reasons to be optimistic despite the uncertainty that lies ahead for live sports.

“The value of sports continues to be more and more important every single year,” CBS’s McManus said. “Advertisers are going to continue to want to reach the largest possible audiences. The way to do that is with sports. I don’t see a cliff coming. Our roadways are clear.”

(Disclosure: Comcast’s NBCUniversal is the parent company of CNBC.)

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