The U.S. pay-TV sector held its collective breath this month as The Walt Disney Co., owner of key domestic TV networks including ESPN and the ABC Network, faced off against the largest U.S. pay-TV provider, Charter Communications Inc. At stake was not only an important pay-TV distribution agreement between the two companies but also the long-term prospects for the U.S. pay-TV sector. Finally, after 10 tense days, the two sides reached a broad agreement that restored Disney's TV networks to Charter's pay-TV systems.

Here, we address investors' questions on the dispute, the agreement, the impact on Disney's and Charter's credit measures, and longer-term implications for the U.S. pay-TV ecosystem.

We view the agreement as a win-win for Disney and Charter, as well as for the entire pay-TV ecosystem. Both contending parties achieved important objectives: Charter can now bundle Disney's direct-to-consumer (DTC) services into its pay-TV service while Disney may have created a template that other media and pay-TV companies can use to help to slow the decline of the pay-TV bundle.

Frequently Asked Questions

What were the key terms of the agreement?

Key terms of the agreement publicly disclosed include:

• The Disney+ Basic advertising-supported offering will go to customers who purchase the Spectrum TV Select package as part of a wholesale arrangement. Charter's pay-TV subscribers won't directly pay for Disney+, but Charter will pay a wholesale per-subscriber rate to Disney (and indirectly pass that cost along to consumers through overall higher prices). Despite paying more, Charter's pay-TV subscribers will perceive increased value from their bundles. While Disney gives up a few dollars per subscriber (the difference between retail and wholesale pricing), it will have a new distribution channel that will instantly add millions of new ad-lite Disney+ subscribers. However, it can still upgrade the subs to the more expensive ad-free tier. We believe the growth in advertising revenues for many ad-lite streaming services (Disney+, Max, and Netflix) have been constrained by too few subscribers.
• Spectrum TV Select Plus subscribers will receive ESPN+. We believe Disney has struggled to expand its ESPN+ subscriber base. The service doesn't have the key sports content found on the ESPN linear TV network, so it has limited appeal to casual sports fans. This agreement with Charter will boost ESPN+ subscriber count. While Disney will not get paid subscription fees for them, a larger ESPN+ subscriber base should generate greater advertising revenues.
• The ESPN flagship DTC service will be made available to Spectrum TV Select subscribers upon launch. We believe this is the lynchpin to providing consumers a seamless path from the pay-TV bundle to a DTC-based ecosystem. Consumers will not have to pay for them separately. Disney is still researching this service and has not yet determined a launch date.
• Charter will maintain flexibility to offer an array of video packages at varying prices based upon a customer's viewing preferences. Minimum penetration levels will remain 85%, based on media speculation. (Disney has not disclosed this number.) We believe that Charter wanted this lowered because it has seen strong consumer demand for its skinny pay-TV video package that excludes all sport-focused linear networks including ESPN. We note that Charter can actually go below the minimum penetration level but must still pay Disney for the minimum subscriber level.
• Networks no longer included in Spectrum TV video packages will be Baby TV, Disney Junior, Disney XD, Freeform, FXM, FXX, Nat Geo Wild, and Nat Geo Mundo. We believe removing several second-tier cable networks from Charter's pay-TV bundle will have far reaching ramifications for the entire pay-TV ecosystem as other media companies will likely be forced to follow suit, leading to smaller bundles. Pay-TV distributors and consumers, who have long called for slimming down oversized bundles, will view this as a small but significant victory.

Could this agreement help support the pay-TV bundle?

We believe this agreement, in particular the inclusion of Disney's DTC streaming services and the removal of several second-tier networks, addresses several long-running complaints raised by cable companies and consumers. Consumers complain about the size of the bundle, its high price, and the lack of perceived value. This agreement, according to Charter chief financial officer Jessica Fischer, will allow the cable companies to moderate growth in content costs for consumers. Offering DTC services combined within the pay-TV bundle could increase consumers' value perception and may provide some near-term support to the pay-TV bundle.

Why did we get to this point?

For years, affiliate fees that pay-TV operators have paid to the media companies have increased at rates well in excess of inflation. Overwhelmingly, sports have been the cause. Leagues have extracted huge payments from media companies for the right to broadcast their games. They passed these cost demands on to the pay-TV distributors through affiliate fees and ultimately to consumers through higher pay-TV video bills. This trend continues today. The National Football League (NFL) nearly doubled its annual TV broadcast fees when it negotiated a new 10-year broadcast contract last year. We expect the National Basketball Association (NBA) to also double its annual rights fees when it awards new broadcast contracts in the next few years.

What has changed for the cable industry to take this position?

Pay-TV has become less important to cable companies, with the majority of profitability coming from high-margin broadband services. Mobility, for those that offer it, has replaced pay-TV as the second most important service and the one cable companies increasingly use to retain customers. They have said that they're indifferent to the loss of video subscribers and have passed along most, if not all, of the programming cost increases directly to consumers. Several smaller cable companies, most notably Cable One Inc., have stopped selling pay-TV to new customers. Although pay-TV remains profitable for the two major cable providers, Comcast Corp. and Charter, continuing with the status quo would leave them with two choices: pass along full cost of programming to preserve margins, likely accelerating cord-cutting and customer frustration, or subsidize programming costs to alleviate upward pressure on customer's bills, which would continue to erode margins and eventually make the service unprofitable. Neither option is a good one, which left Charter with less to lose in the negotiations.

Could Charter or Comcast take similar tactics with other media companies in the future?

It's possible given that the bargaining power is shifting toward distributors. However, although cable operators now have less to lose, going dark with popular content still involves risks, and we do not view them as completely financially indifferent. Therefore, we believe preserving the video ecosystem and avoiding blackouts is in the best interest of all parties.

To illustrate the potential financial impact to scaled cable operators from dropping popular content, we performed a sensitivity analysis below. We estimate that Charter could have lost 1%-6% of its EBITDA if the blackout with Disney were permanent. We believe this would also apply to Comcast. Major risks are:

• Lost video customers, which we estimate generate 15%-20% EBITDA margins.
• Broadband customer defections from unhappy video customers, particularly given the more widespread availability and convenience of fixed-wireless access coupled with a high-speed fiber alternative available in roughly half the country.
• Lost advertising revenue from associated video customer losses.

Table 1

As media companies focus their attention on streaming, how has their negotiating position changed?

Over the last few years, they have prioritized expanding their in-house video streaming businesses and diverted new original content that would have gone onto their TV networks to these streaming services. In addition, both Paramount Global and Comcast's NBCUniversal offer key sports programming, such as the NFL, on both their linear TV networks and streaming services. Neither Fox Corp. nor Disney currently do. In particular, Disney's ESPN+ streaming service features sports content not generally on its ESPN linear network. We believe this has weakened the media industry's position in its negotiations with pay-TV distributors. As a result, the media industry has taken a more constructive (and less aggressive) position in negotiating new distribution contracts. They have made concessions on pricing, slowing programming price growth, and lowered minimum penetration requirements for networks in the basic bundle.

What could this mean for future programming cost growth?

We believe this arrangement could set the stage for a moderation in content costs as the negotiating leverage shifts in favor of distribution. Given that distributors have less to lose because video profit margins have eroded, they can more easily afford to forgo linear video and instead refer customers to streaming offerings that could provide essentially the same content over a profitable cable broadband service. Therefore, we believe we could see smaller linear bundles with increased subscription video on demand functionality similar to the deal Disney struck with Charter. We note that while both Paramount Global and Warner Bros. Discovery Inc. have given their Showtime and HBO linear TV subscribers free access to their streaming services (Paramount+ and Max, respectively), it's different than what Disney is doing since those linear networks are premium add-ons.

We believe this agreement, especially the inclusion of Disney's DTC streaming services, gives the cable companies another arrow in their quivers to sustain the pay-TV ecosystem. However, we also recognize that cable operators still derive value from video, which may force them to continue to absorb price increases.

Could this agreement affect future sports rights negotiations?

We believe sports leagues have a vested interest in maintaining the pay-TV ecosystem. Their goal is to have their marquee events reach the broadest audiences. Hence, they generally prioritize them (playoffs, finals, all-star games, the Super Bowl) to be on television, especially broadcast television. ESPN, while not a broadcast network, falls under that same strategy because of its national reach and its amount of key sports programming, including the NCAA college football playoffs. In addition, the leagues have an ulterior motive for Disney and Charter to settle quickly. A number of key sports broadcast rights contracts are up for renewal in the next few years, including the NBA and NCAA college football playoffs. Had Disney's networks remained blacked out on Charter's systems, with the potential loss of $2.2 billion in annual programming payments from Charter (based on Charter's disclosures), Disney may be less aggressive on bidding for those contracts or willing to forgo more expensive packages.

What is the potential impact of the settlement to Disney's financial performance?

We believe the agreement could modestly increase revenues and EBITDA for Disney. Disney hasn't disclosed updated guidance on the exact financial implications of this agreement. We estimate Disney's linear TV revenues (Table 2) will be modestly lower (due to the elimination of the eight networks from the Charter pay-TV bundle) and DTC revenues higher (more Disney+ ad-lite subscribers). We believe the greater financial benefit to Disney will come from the broader long-term positive implications for the pay-TV ecosystem.

In assessing the immediate impact from the Charter agreement, we assume:

• Charter paid Disney about $2 per subscriber per month, based on Kagan affiliate fee data, for the eight niche networks dropped from the bundle.
• Based on media reports, affiliate fees for ESPN, ABC stations and all other networks will increase about $1.50 per pay-TV subscriber per month.
• On the DTC side, Disney could add 6 million net new Disney+ subscribers (Charter Select subs less churn from existing subs). We assume Disney generates $13 in total monthly average revenue per user (a $5 wholesale monthly rate and $8 per sub in advertising).
• Disney adds 3 million ESPN+ subscribers. Even though Disney would not receive subscription fees from those subs, we assume the company would generate $5 per subscriber in advertising revenues.
• Based on these assumptions, we believe Disney could realize roughly $1 billion in incremental revenue from the Charter agreement.

Table 2

And what do we estimate are the financial implications for Charter?

We do not expect a meaningful near-term impact from the 10-day blackout because management has indicated that video losses were less than anticipated and broadband defections were minimal. Longer term, we expect Charter will largely preserve its video gross margin of roughly 33% based on our assumptions on dollars per sub per month:

• Charter will save about $2 with the elimination of the eight niche networks.
• Based on media reports, affiliate fees for ESPN, ABC stations and all other networks will increase about $1.50.
• Charter pays a wholesale rate of $5 (a 40% discount to the retail price) for the Disney+ ad-supported service.
• Charter raises monthly pay-TV consumer prices $4.50-$5 to offset increased programming costs and the inclusion of Disney+.

The monthly price hike could increase pay-TV subscriber churn, though we believe the addition of Disney+ may convince some customers to remain. Therefore, we believe the biggest impact will be a potential moderation in the pace of cord-cutting and the preservation of video profits.

What are the broader implications for the U.S. media sector?

We believe this landmark agreement has broad ramifications. Pay-TV is still the largest cash flow stream for media companies, and preserving it even as they build out their streaming services has been key. By bundling DTC services into the pay-TV bundle, this agreement may add life to the bundle for two reasons: Consumers may now feel there's value in continuing to subscribe, and the deal may also smooth the transition from pay-TV to streaming since the streaming services will get greater subscriber scale. This will help media companies better migrate advertisers from linear TV to ad-lite streaming and accelerate profitability.

What's the impact of the settlement to local TV broadcasters?

We believe it could be positive to local TV broadcasters because it could slow the migration of traditional pay-TV subscribers to virtual pay-TV alternatives or over-the-air viewing. We believe the subscriber economics for local broadcasters are better from traditional pay-TV providers than from virtual providers. At the same time, we believe the amount and stability of cash flow from retransmission revenue are materially better than the advertising revenue generated from over-the-air viewing. While we believe there still could be blackouts from time to time between pay-TV distributors and local TV broadcasters, we believe both the recent Charter/Disney agreement and the Nexstar Media Inc./DirecTV agreement support our view that broadcast television, which includes news and sports, continues to be must-have programming.

How does the new Disney deal affect cable companies?

If the terms of bundling the TV networks and DTC services were extended to the rest of the pay-TV ecosystem, we believe it could slow the pace of cord-cutting by providing a higher-quality video bundle for consumers. Disney will likely offer Comcast similar terms due to most-favored-nation clauses in Comcast's existing distribution agreement with Disney. We believe cable companies value the addition of Disney's popular streaming services to the pay-TV bundle because they add high value content to the pay-TV ecosystem. This is important because:

• Pay-TV remains a defensive tool for cable companies since they compete against fiber-to-the-home players. Charter and Comcast can typically offer a more affordable pay-TV bundle because they get scale discounts on programming. Despite perception to the contrary, roughly 50% of households still desire a full linear TV experience.
• Despite comments of indifference, pay-TV is still profitable for both Charter and Comcast. We estimate it has a 15%-20% EBITDA margin.

We believe the small and midsize cable operators may realize limited benefits. Most smaller operators have been deemphasizing pay-TV for years. As a result, pay-TV penetration is low and the service is only marginally profitable given the higher per-subscriber programming costs. We estimate margins are less than 10%.

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