ESPN, MSOs Face Off

ESPN CEO George Bodenheimer calls it a price break. A top cable operator calls it "Disney's usual baseball bat." Yes, ESPN has a new twist to its annual 20% spring rate hikes, but that isn't changing the ritual dance of the season.

Cable operators reflexively moan about ESPN's annual increase in its already huge license fees, now around $2 per sub monthly. ESPN executives, in turn, talk up the cost of sports rights and how their channels drive subscribers and local advertisers to cable operators.

If this were a typical year, on May 1, the Disney-run programmer would notify cable and DBS affiliates that it plans to take the full 20% rate hike beginning in August, and operators with several years left on their deals could do little more than complain.

This year, however, ESPN executives have a new and complicated proposal, offering to start dropping the rate of increase first to 16% annually and eventually to 11%. In exchange, ESPN wants wide distribution and relatively high license fees for its all its products, including ESPN Classic, startup Spanish-language service ESPN Deportes, and a new pay-per-view service. Further, ESPN wants long-term commitments and pricing schedules for more-uncertain products, such as a high-definition ESPN feed, a nascent interactive-TV product, video-on-demand packages and a high-speed Internet product.

Bodenheimer, president of both ESPN and ABC Sports, calls the proposal an "opportunity" for affiliates. He cites ESPN's high ratings (particularly during football season), its high ranking in independent consumer surveys and its high level of appeal in selling basic-cable subscriptions.

He also argues that operators substantially offset their license fees by selling local ads on ESPN. He contends that the ad revenue will come to $781 million this year, or about 92 cents per cable subscriber per month.

Operators adding up the pieces say that whatever savings they got on ESPN would be offset by the costs of the other products. For example, one senior MSO executive said his rate for ESPN2—now about 45 cents monthly—had always increased 6%-8% a year but the new deal calls for "double double-digit hikes."

"Five years later than they should have, they've realized that it's dangerous to run the rates of ESPN up," says the MSO president, who sees the proposal as a baseball bat. "So they're going to build value in other ways."

He contends that ESPN executives fear political repercussions from being the most expensive basic-cable channel and demanding a 20% hike each year. Already, ESPN and its siblings account for 20%-25% of basic-cable programming costs.

As for the ancillary products, operators are averse to 10-year pricing deals on something like broadband services or video-on-demand because they can't tell what the economics will be. "Imagine if, two years ago, you had set the pricing for interactive-TV product until 2010," said a senior executive at one cable operator. "There's no business, but you're still paying big for the product."

That's assuming operators are willing to pay anything at all. One programming executive who wants to launch ESPN HD is balking at a price that starts at 85 cents and keeps climbing. "First, this is basically a simulcast of something I'm already paying a lot of money for," the executive said. "Then they said they need to cover the cost of the hi-def technology. But those costs are going to go down, not up, and their rate card only goes up."

Jerry McKenna, vice president of strategic marketing for MSO Cable One, concurs. "If you're providing the same programming just in different delivery, we believe that is a cost of doing business ESPN should incur, not something its customers should be paying for. We're already paying for that programming once."

Sean Bratches, executive vice president of affiliate sales and marketing for ESPN, said the rates on ESPN HD might change as the technology costs fall.

ESPN is critical to Disney, which is misfiring in many other parts of its business. The spots network is such a money-maker that the network group should deliver 30% of the company's consolidated operating income this year—around $1 billion out of $2.7 billion—even though it accounts for just 10% of the company's revenues, $3.8 billion out of Disney's total $27 billion.

But, between the escalating cost of sports rights and ESPN's grab for more sports and games, the network isn't quite as lucrative as it used to be. Morgan Stanley media analyst Richard Bilotti says ESPN's sports-rights payments have surged from $525 million in 1997 to $2.2 billion this year. That has sliced operating profit margins from a huge 52% to a more modest 20%. He expects operating profit on ESPN's main channel to fall 14% this year, to $575 million, despite a 16% increase in revenues, to $2.8 billion.

Additional reporting by Allison Romano