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Why Disney Could Cave First in Its Cable Standoff With Charter

The Disney+ streaming-service booth at the 2019 D23 Expo in Anaheim, Calif.

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“We’re committed to being the best,” a chipper voice used to say every two minutes or so while I waited on hold years ago with my local cable monopoly. You’re committed to being the only, I recall thinking. Today that company is owned by Charter Communications, America’s No. 2 cable distributor, which is striking a different tone. Cable television is “too expensive and packages don’t meet customer needs,” Charter wrote in the first line of a recent slide deck for investors.

That’s a negotiating tactic in a standoff with Walt Disney (ticker: DIS), and a powerful one, akin to the old “take my ball and go home” threat from backyard football—and, as it happens, football is at the heart of the matter. Charter’s (CHTR) stance that cable television stinks explains why Disney is likely to cave first, and neither company will come out ahead.

Disney and Charter are locked in what’s called a carriage dispute. In the clinical language that cable uses to describe the entertainment business, companies like Disney that fill channels with shows are programmers, and ones like Charter that sell bundles of channels are MVPDs, or multichannel video programming distributors.

Programmers make money by charging MVPDs carriage fees to include their channels in bundles, and by selling advertising on those channels. MVPDs charge viewers for the bundles and get a modest share of the ad slots, which is why commercial breaks are often a mix of national pitches for big brands, local ones for car dealers and furniture stores, and ones for the cable service itself.

In the early days of cable cord-cutting, programmers could offset their falling subscriber counts by negotiating for higher carriage fees per subscriber once contracts came up for renewal. If talks stalled, both sides would take their case to viewers. Programmers would tell them that MVPDs were trying to take away their favorite shows. MVPDs would accuse programmers of jacking up bills. A deal would be struck before viewers missed anything important.

Back then, no one had a stronger case than Disney, because it owns ESPN, and key sports rights. Basically, in TV, old viewers are still watching cable, middle-age ones have left for streaming, and young ones can’t be bothered to turn away from YouTube and Roblox. But sports remain a TV stronghold. Viewers watch live, audiences skew young, and traditional networks control most of the rights.

This time around, customers of Charter’s Spectrum cable service have been without Disney channels, including ESPN, since the start of September. That means they’ve missed out on tennis’ U.S. Open and some college football. Starting Sept. 11, they’ll miss the pros playing Monday Night Football. If Charter doesn’t seem particularly bothered, it might be because this is no longer the early days of cord-cutting: 25 million subscribers have canceled over the past five years.

Only about half of U.S. households now pay for traditional TV, down from more than 90% in 2010. Cancellations are accelerating, and margins are falling. Charter says it has reached “economic indifference” on keeping TV. Many customers who cancel their cable TV stick with their providers for broadband, and broadband margins are about triple those of TV.

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Meanwhile, Charter says that only a quarter of its TV viewers “regularly” watch Disney content, including ESPN, although there are likely far more occasional viewers. Charter pays Disney an estimated $12.50 per subscriber for its channels, three-quarters of which goes for ESPN, making it easily the most expensive channel in the bundle.

What Charter would like isn’t so much a freeze on fees as flexibility—the right to sell more skinny bundles that lack sports. It also wants Disney to throw its ad-supported streaming services into the cable mix. What Disney would like is to preserve what’s left of its diminished free cash flow until profitability picks up for streaming. It plans to launch a full ESPN streaming service as soon as 2025. The current ESPN+ service, sold as part of Disney’s own streaming bundle, is a complement to the cable channel, not a replacement for it.

Pricing there will matter a lot. Many sports fans aren’t used to paying their full TV tab. Remember: All of those cable subscribers who don’t watch ESPN are subsidizing those who do. Cable has already taken a tough line with regional sports networks, which have rolled out streaming services costing $25 to $30 a month. A stand-alone ESPN with a full suite of sports rights could cost more. That’s why Disney is pursuing partnerships with sports leagues to hold down costs.

The bottom line is that Disney has more to lose. Oppenheimer estimates that this dispute alone could cost the company $4 billion in yearly free cash flow, including advertising. That could derail meaningful dividends—Disney aims to reinstate payments by the end of this year. Charter will lose subscription and advertising revenue, but also a big driver of its content costs, with a more neutral overall effect on free cash flow.

What matters is how ESPN fans get their fix. Some will switch to a virtual MVPD, or traditional channel bundle online, like YouTube TV or Disney’s own Hulu+ Live TV, and continue to get their broadband through Charter. J.P. Morgan estimates that only 10% of ESPN fans will switch to a competing broadband service like Verizon Fios.

Near term, says JPM, other TV networks could see a benefit from the Disney scrap if ESPN drops out of more bundles, lowering prices and stemming subscriber losses. Long term, Charter’s willingness to ditch TV is a negative for the ecosystem. BofA Securities compares the state of TV to the music industry when CDs were replaced by downloads, and then streaming. Industry revenue peaked in 1999 and then plunged 40%, not returning to growth until 2014. On that timeline, BofA says the TV business is somewhere in the late 2000s—with years more of struggle to come.

Write to Jack Hough at jack.hough@barrons.com. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.