Warner Brothers Discovery’s Biggest Warning Light Still Flashing Bright Red (NASDAQ:WBD)

By now, the news is well-travelled that the three leading pay-TV content companies are banding together to form a new sports streaming service. While this is important news for all three, potentially, Fox (FOX) and Disney (DIS) are in a somewhat different position than Warner Brothers Discovery (NASDAQ:WBD) who will be the focus of this article. Put simply, the news is not as momentous as it appears and may be relatively small potatoes for Disney. For Warner, however, the news is potentially more alarming, rather than comforting, ironically not because of the service itself, but because of what Warner has to do to make itself a part of it and what that could cost it.

A Strange Announcement

Who Goes There?

One of the many things that is a little strange about this new service is that it was announced with no name. I need something to call it for this article. Apparently the internal code name of the service is ‘Raptor’ and I thought that sounded cool, but since I believe this product was launched more out of desperation than confidence, it almost sounds too cool.

Hats off to Julie Alexander of Puck, who was the first person I saw to compress the ‘sports Hulu’ that everyone has been talking about to ‘Spulu.’ (It was there the whole time; I’m just no good at this, clearly.) Like any good spoof name, it’s both ridiculous sounding and entirely too close to true, so I’ll go with that.

Now, on with the main event. What does this new service mean for investors, and Warner investors in particular?

Know What You Don’t Know

When ‘Spulu’ was first announced, the three owners made it sound as if they were preparing to do something at least with the potential to be considerably disruptive to the existing ecosystem. The more information has emerged, however, the more it sounds like Spulu is little more than a copycat product, albeit with a slight twist that may allow it to carve out its own little niche.

Here is what we now know: first, we don’t know anything yet. It wasn’t just a name that was missing when ’Spulu’ was announced. The new service also has no price, no official launch date – late 2024 is as close as we’ve gotten – no management team, no brand or logo, and no marketing campaign.

In fact, it doesn’t even have itself, technically; Fox, Disney and Warner haven’t actually agreed to launch this thing yet. There is no signed agreement, just an “understanding on principal terms,” to quote the press release from Disney.

Current Information

Assuming, however, that our current information is now more or less complete and accurate, the service will be a full-simulcast non-comprehensive service, i.e., it will carry exactly the same feeds of the channels it carries as a regular cable service shows, but unlike a regular cable service it will not carry every channel these three providers offer. As the initial release made clear, we already know the channels that will be included, and a considerable number of the channels these three companies broadcast will be missing. Fox CEO Lachlan Murdoch also confirmed during his earnings call that they are not looking to add any more partners, so this appears to be the final list of channels it will serve. Pricing is unknown, but generally estimates at somewhere between $40 and $50 per month. We’ll ballpark it at $45.

Almost all of the channels, as was reported, are sports channels. Either all-day or at least central to the sports rights those providers offer. The Fox and ABC broadcast nets are included, as are the top three Turner nets and a whole plethora of Disney’s sports family including, of course, ESPN. News, family/kids and movies are all excluded.

Very little has been said, contrary to what some of the original reports indicated, of anything being done to make this ‘cable-plus’ or to add special features that would make it more appealing than regular cable. In fact, the very next day after announcing it Disney CEO Bob Iger said in his earnings call that ESPN would still proceed with launching its own DTC service, which we’ll call ESPN Flagship since that service also doesn’t have an official name yet. This service, Iger made clear, would be special, offering various perks and services that cable-ESPN doesn’t, including ESPN Bet, the new joint venture Disney partnered with PENN Entertainment (PENN) on.

The Target Demographic

This has led some to wonder what the purpose of this service is, if it’s just a cheap imitation of cable with less features than the companies plan on offering on other digital services. In fact, the service does have appeal to a specific customer demographic, but that demographic is admittedly rather small, and the execution may be problematic. For Fox and Disney, that just threatens to turn it into a nothingburger. For Warner, it may threaten worse than that.

Ex-NFL

Despite the skepticism, I believe the service will have appeal to a certain kind of customer. The service’s greatest appeal, I believe, is to not only sports fans – no surprise there – but specifically to non-NFL fans.

For NFL fans, the service’s appeal is frankly minimal. With no Paramount (PARA) or Comcast (CMCSA) involvement, both NBC and CBS are missing, between them home to close to half of the games played every year. At the expected price of $45, adding NBC and CBS for $12 each would all but eliminate all the savings a customer would reap from stepping down from YouTube TV’s $73 per month. $4 per month extra for all the extra non-sports channels YTTV offers – to say nothing of the convenience of having all of them in one place – hardly seems like a great motivator.

You could, I suppose, get the ad-supported versions of Peacock and Paramount+ for half price to increase your savings, but ignoring the fact that a lot of customers simply won’t tolerate ads to begin with, those versions also come without DVR capability, which is important to sports fans who want to rewatch certain plays. Even for scripted shows, YouTube TV’s DVR means that those shows can be recorded and watched ad-free, so taking credit for cash savings compared to a full DVR service (another way of saying ad-free) is apples to oranges.

Comprehensive Coverage

Take the NFL out of the picture, however, and the rest of the sports ecosystem suddenly seems considerably better served. Between them, Fox, Turner Sports and ESPN control all of the national MLB, NHL and NBA rights, as well as the vast majority of the Football Bowl Subdivision, including the entire SEC, ACC and Big 12. Only CBS and NBC’s share of the Big Ten is missing, perhaps half of the B1G games not including playoffs. March Madness is more seriously impaired, with half of the games missing including, in half the years, the Final Four, which are housed at CBS.

That last qualifier notwithstanding, a sports fan might find that in the seven months of the year that the NFL is not playing, they suddenly need only pay $45 for content that was previously costing them $73. Those savings are far more substantial, and might well attract a considerable number of customers.

The Hidden Danger

Before investors celebrate too much, however, I think there is one other danger sign here that needs to be explored.

In order for this thesis to be correct at all, Warner simply must, must, must extend its deal with the NBA. Alone of the JV 3, Warner has neither NFL nor a single FBS contract. MLB and NHL are well and good, but they do not offer the same market potential as football or even the NBA, widely seen as the second most important sports property after the NFL due to its younger viewership and international appeal. That contract, as I’ve explained before, is due to expire at the end of next season, and the next one is supposed to be finalized soon. In fact, Warner and Disney have an exclusive window to negotiate until April of this year, so it’s do-or-die time for a pre-open-market deal and an announcement could come pretty much any time, as late as October and as early as next week.

To be sure, many felt that Warner was already extending regardless, and the market may well have already priced such a deal in. In fact, Warner has already extended the contracts of its NBA analysts roster for the industry-leading show Inside the NBA, some of them at considerable price tags in the eight-figures.

I have a hard time seeing that NBA deal being fully priced in, however, for one simple reason; such a deal would be such a negative for Warner that if it were fully priced in the stock should be trading for well into the single digits. I recognize that calling the NBA, the second most powerful professional sports league, a massive money loser is a provocative statement. This article is getting long already, but I will just briefly show my math.

Doing The Math On The NBA

The NBA Finals reported 11.64 million viewers in 2023, down slightly from 12 million in 2022. That was a return to healthy viewership after a somewhat COVID-supressed NBA Finals in 2021, which averaged a viewership of 9.91 million; but it is still barely half the viewership of a regular-season NFL game and about 10% of Super Bowl viewership.

A simple exercise would be to line that number up next to the money the NFL makes every year, $15 billion all in, and say that the NBA is worth $1.5 billion. That isn’t quite exact, however, so we can briefly make a slightly more reasonable estimate.

The NBA is worth to a broadcaster essentially the subscription and advertising revenue it brings in. Claims of “brand prestige” are rather more abstract and don’t pay the bills, especially in a declining industry like pay-TV.

Advertising

The NBA season is much longer than the NFL season, 5x longer in fact. That means both more games in which to sell ads, and also more months in which to charge subscription fees. For now, I will take the $1.3 billion the NBA booked in national ad revenue in 2022 and assume it has grown by 20% in each of the last two years, as some of the most bullish estimates have it. Such growth is unsustainable, however, as the linear sports bundle continues to shrink, so I will assume from here it will average 2% growth even as TV advertising as a whole shrinks, and I will round the weighted-average $1.98 billion result up to $2 billion even.

Subscription

Subscription revenue is harder, but the key point is this: it would be nothing short of absurd to assume that the 12 million or so viewers who tune in to the Finals are going to pay a subscription fee every month of the season. Outside the Finals, NBA national game broadcasts average 1.6 million viewers in the regular season and about 5 million during the playoffs. Even assuming that the higher number of available games means customers are more comfortable missing individual games, 12 million simply is outside the reasonable band of estimates.

If we assume that all 5 million playoff viewers have a subscription throughout the regular season – suggesting in turn that they only watch about 1 in 3 of the national game broadcasts each, which seems unlikely, but we’ll go with it – then the NBA should generate 40 million subscriber-months, or subscription fees paid each year, to the new Spulu.

What shall we price those at? Well, it all depends on what the new rights fee costs, doesn’t it? Initial reports were that the NBA was seeking nothing less than a tripling of its current rate, to $7.8 billion. It was said to be firm on that price, and the craziest part of all was that most industry analysts seemed to actually expect them to get it or something close to it.

There’s no point in even doing that math; if that’s the price Warner is losing the NBA, and if they’re actually foolish enough to sign it they’ll lose the NBA anyway when they can’t cover the fee in a year or two. So let’s assume that the fee only doubles.

The sad part is, there’s almost no point in doing that math, either. Subtracting the $2 billion in ad revenue leaves $3.2 billion to be covered by the subscription fees. At the 40 million subscription-months level, that would require $80 per month!

Spulu is only charging $45, and Disney and Warner have to share that with Fox, don’t forget. Even worse, we are not applying the “overweight” factor which makes all streaming deals more costly than they appear. That is why Comcast’s NFL deal isn’t as profitable as it looks, either. You can read more about that issue here if you’re curious.

One could argue that the NBA will spread its contract over more players, reducing the share of the cost that Warner will have to bear. I suppose that’s possible, but such a move would also compromise the appeal of ‘Spulu’ as a place where all national NBA games can be found. So, like I said, my assumption is that Warner only got itself invited to this party because it promised to bring the snacks.

Final Numbers

Assuming that Warner and Disney allocate all of their two-thirds of the Spulu revenues to NBA for all the subscribers who watch NBA for all the months the NBA is on – and remember if they’re doing that, Warner is allocating nothing for March Madness for those customers and Disney is allocating nothing for the NFL or FBS – then a doubling of NBA fees would mean losing $50 per month per subscriber for eight months. At 5 million subs, that would be about $2 billion in losses. Splitting that evenly, Warner would take a $1 billion hit.

And unlike Disney, it would not have other sports properties to defray the losses. It’s not like Warner has a broadcast network with scripted content that the NBA can serve as some sort of loss leader for – though I question the wisdom of loss leading like that in streaming anyway. This is just straight up a bad investment, with almost no chance of generating enough revenue to cover costs, let alone turn a profit.

Old Tricks No Longer Best Tricks

In the past, the typical ploy when confronted with a massively overpriced sports package was to pay it and take the extra money out of non-sports viewers who were bundled into the same pay-TV service. But this is our new ‘Sports Hulu’ and everyone in it is already a sports subscriber. What’s more, that trick doesn’t even work with regular pay-TV anymore. Behavior like that is exactly why non-sports viewers are deserting the bundle in droves.

It’s important to emphasize that the issue here isn’t whether Turner can demand higher monthly affiliate fees per subscriber if it re-ups with the NBA; it almost certainly can. But demanding higher fees is practically rote in January at this point; Turner and all other content providers already demand higher fees every year. The issue is that every higher fee drives further cord-cutting, making the revenue increase much smaller than the fee increase. And the fact that Turner’s distribution revenue has stopped growing altogether since mid-2022 may suggest that it simply is no longer possible to grow revenues, if subscriber defection is now large enough to completely wipe out further fee hikes.

That means Turner will eat the losses on any new NBA deal itself, not stick its subscribers with them. Unless the NBA’s asking price has absolutely collapsed, and there’s been no word of that, it just seems impossible to make it work.

The thing is, I can see some circumstances where Disney actually manages to turn a profit on the NBA deal. It has ESPN Bet and other monetization avenues beyond just pay-TV. Its ESPN Flagship encompasses football as well, so even if it does have to eat something on the NBA, it can still potentially be better off for the subscribers having the league on board brings.

But for Warner, it seems more questionable. Renewal of its NBA deal seems almost a sine qua non for making it past the ‘Spulu’ front door, and unless the NBA has completely folded its hand, there is just no way to get the rights fee low enough. What’s more, unlike Disney and Fox, Warner doesn’t have a broadcast network to defray some of its sports losses with profits elsewhere.

Investment Summary

This news does not make me more confident of Warner’s prospects, it adds to my worries even further. I am tempted to slap a Sell rating on it, even with it trading below $10. However, the market as a whole is – unwisely to my mind – more inclined to view sports deal renewals as positives rather than negatives, which means that Warner may spike upwards on the NBA renewal news before declining subsequently as the economics of that deal play out. So for now, I’m going to keep a ‘Hold’ rating – which really means ‘Avoid’ in this instance – and assess potential short possibilities at the appropriate time.