The Final Phase Of The Pay-TV Revolution Is Finally Here: AT&T’s DIRECTV And Charter Are The Biggest Movers

Summary:

• The recent settlement between Charter and Disney over carriage terms for Disney’s linear TV channels marks a significant blow to DIRECTV’s already shrinking free cash flow.
• Pay-TV deals are complex and typically involve price, penetration requirements, and Most-Favored-Nation clauses.
• Charter and Comcast benefit from the deal with Disney, while DIRECTV is at a competitive disadvantage and may need to cut prices to match its rivals.

A lot has already been written about the recent settlement of the acrimonious dispute between Charter (NASDAQ:CHTR) and Disney (DIS) over carriage terms for Disney’s linear TV channels. I hope, time permitting, to write a whole series of articles about the carriage dispute that wasn’t just another carriage dispute, and might well and truly mark the beginning of the final collapse of pay TV. But I wanted to start by exploring the impact on the three biggest pay-TV companies: Charter, Comcast (CMCSA) and DIRECTV, which AT&T (NYSE:T) still owns 70% of and receives a significant portion of its free cash flow from.

In my opinion, while Charter and Disney probably both regard the deal with mixed feelings, especially Disney, the other two regard it with unqualified emotion: for Comcast, it’s a dream come true, while for DIRECTV, its potentially a significant blow to already shriveling free cash flow.

And it all comes down to all the intricacies of pay-TV that don’t make the headlines when these disputes are happening.

The Intricacies Of Pay-TV Contracts

Let me say at the outset that pay-TV deals are incredibly complicated things. There really isn’t any standard template, and I have no doubt that there are subtleties and exceptions woven into Charter’s Disney deal, Comcast’s Disney deal, Charter’s Paramount (PARA) deal, DIRECTV’s Fox (FOX) deal and just about every deal out there.

Even so, it does us no good to speculate about contract language the companies will never let us retail investors see. And we can make some general observations. There are typically three key components to a pay-TV deal between a distributor and a producer.

The first is, as one would expect, the price itself. Each deal specifies the monthly subscription fee – called an “affiliate fee” for cable networks and a “retransmission fee” for broadcast networks – that is owed for every channel covered under the agreement. This number is multiplied by the number of subscribers each channel has each month to determine what is owed that month. And this goes on every month for the life of the agreement.

Some new arrivals to this particular industry think the key terms stop there, but it’s more complicated than that. Every channel also has a “penetration requirement” or “minimum carriage requirement” which mandates that a given channel be sold to at least a specified number of subscribers. This number again can vary for different channels, even ones covered under the same agreement. If a distributor fails to hit the minimum, it still owes for the difference, up to the promised level.

Penetration requirements are almost always expressed as a percentage, not an absolute number, so the final requirement can vary up and down as a service gains or, as has been universally the case for traditional pay-TV the last decade, loses subscribers.

Thirdly, and lastly, most pay-TV deals also have some sort of Most-Favored-Nation clause. For those unfamiliar, this is essentially a provision which requires that even if the parties agree on a particular set of rates and penetration minimums in the contract, the producer must offer to match to the distributor any rates or minimums it gives other producers in the future which are better than the ones in the deal it just signed.

Most Favored Nation

This third one is also the most intricate and complicated. Not all deals even have such a clause, and smaller distributors in particular are usually out of luck in this regard. Meanwhile, a lot of the ones that do are usually not straight-up MFNs. Usually, only the very biggest distributors, like Comcast, get straight MFNs which say that no one can have better terms than the ones they get, or else they can write down their own deal to match.

So small gets no MFN, and largest gets true, clean MFN, which is almost simple enough. The complicated part comes with all the distributors in the middle. Typically, they will get “modified MFNs,” “subordinate MFNs,” “conditional MFNs,” I’ve heard them referred to by just about every adjective under the sun. I’m not sure there is a standard industry term for them.

The terminology doesn’t change what they are, anyway. Basically, they’re provisions which say that a mid-size distributor has the right to match any new concessions offered to other distributors smaller than them, but can’t automatically have rights to concessions offered to carriers bigger than them.

Pay-TV’s New Deal

All right. On to the second point. Keep in mind what I just said about pay-TV contracts and their structure, while we briefly review the new deal Charter and Disney reached after an eleven-day blackout.

Charter And Disney

Charter will stop carrying eight (mostly secondary) channels completely. Secondary means basically channels which are built on major brands but which are not the flagships of those brands: FXX, Disney XD, Nat Geo Mundo are all examples. The one exception is Freeform, the former ABC Family which is built as a sort of teen/tween channel and actually has (somewhat) its own brand identity. That’s been dropped as well.

Charter’s TV bundle now includes Disney+ at a wholesale rate, which will be made available to all Charter linear TV bundle subscribers. ESPN+ will only be available to Charter’s new Signature Plus bundle subs, basically the top tier of its bundle, but – and this is a real kicker – it appears that Charter got that service at no cost.

Charter also obtained a guarantee that the new ESPN Flagship streaming service will be included in its bundle at no additional cost when it launches.

Charter will make the Disney Bundle and each of its component services available to its non-linear broadband customers at retail rates. This is a modest plus for Disney, providing it a new distribution platform for streaming, but frankly Disney+ wasn’t hard to access even before this so the impact will be small too minimal.

Finally, Disney will receive significant fee increases for its ESPN networks, all of which have retained carriage under this new agreement. It is also possible, but this has not been confirmed, that Charter actually agreed to increase its penetration requirement on ESPN in this new deal.

All of these deal terms phase in over the next few months, except for the restoration of Disney’s channels carriage on Charter, which is immediate.

Comcast

The implications of this deal for Charter and Disney are mixed, which we can certainly talk more about in the future. If you’re Comcast, on the other hand, well, you’re absolutely loving this.

Comcast and Disney renewed their carriage agreement in 2021. At that time, Comcast still mustered almost 20 million pay-TV subscribers and was far and away the largest pay-TV provider in the United States. You better believe that if anyone was getting straight, clean MFN provisions in 2021, it was Comcast.

This means that Comcast was in the perfect have-cake-and-eat-it-too position.

Charter was carrying the water of fighting it out with Disney for better terms, which Disney is contractually obligated to match on your service once it grants them. Meanwhile, Charter is taking all the heat. Your customers aren’t defecting any more now than they were last month; you haven’t dropped ESPN and ABC for even a single day.

MFN Carve Outs

Comcast is easy, because its MFN is clean. But for just about everyone else, it’s more complicated. While MFN clauses are written differently in different deals, they aren’t always expressed numerically or relatively, ie., they don’t necessarily say “you have to give me the terms you give a service smaller than me.” That is the spirit of what they’re trying to do, but it’s not always the way the contract is written. (One last time, please note my use of qualifiers here; some MFN clauses are written precisely like that.) Other times, however, an MFN, particularly with an almost top-tier service that doesn’t have but one or a few competitors above it, will simply call out a specified contract by name and say it isn’t covered under the MFN provision.

So, Charter, for example, and again we’re speculating, might have had an MFN clause that promises full reciprocity for any concessions offered to other services, and then have a clause right after it that says something like “notwithstanding the foregoing, the Parties agree that Charter shall not be entitled to receive the terms of the contract number xxxx between Party Disney and third-party Comcast dated xxx, xx, xxxx, for the life of said contract. But instead shall pay to Disney the rates as set forth in this agreement.”

Note that I used the past tense. One of the first talking points that Disney deployed against Charter when the blackout started was that it had offered Charter “most favored” terms on its new deal, ie., Charter is now given a clean guarantee that it would get the best terms Disney gave to any distributor, both upfront and for the life of the deal. No exceptions.

That’s not so surprising considering that Charter has been so consistently outperforming the industry at large in video net losses for the past few years. With Comcast losing 10% of subscribers per annum and DIRECTV seeing even worse numbers, Charter was on course to become the largest video provider in Q3 or Q4 at the latest. Indeed, we can’t rule out the possibility that it dropped ESPN and became the largest video provider on or about the very same day.

DIRECTV Decline Undermines MFN Status

DIRECTV is not quite so lucky as Comcast. But its precise position in the MFN pecking order is a little more difficult to lock down. All the way back in 2019, right before COVID really hit in earnest, then-new CEO John Stankey reported that DIRECTV had just completed a major round of renegotiations with most of its content partners, and that as a result of DIRECTV’s reduced size – it had at one point lost 1.4 million subscribers in a single quarter – DIRECTV’s leverage was reduced and “we’re not going to pay at the best part of the rate card,” as he put it in the Q4 2019 AT&T earnings call.

This was a reference to price, not MFN. It’s still indicative, though. Typically, a company which is not “paying at the best part of the rate card” also has carve-outs in its MFN clause to cover the companies that do occupy that coveted position. So apparently, DIRECTV is not going to be receiving the Charter concessions.

Charter-Comcast Combined Cable Competition

To understand why I’m so concerned about the impact on DIRECTV, we need to (finally, I know) combine everything we’ve covered up to this point. Comcast and Charter combined muster a customer footprint of 55-60 million households, depending on how exactly you count, and they pass roughly another 50 million or so. All told, seven out of nine households in the United States are capable of receiving Charter/Comcast service. And both are about to receive Disney’s new concessions in full.

Broadly speaking, DIRECTV and Charter will probably continue spending about the same amounts on Disney content as now – or at least DIRECTV’s disadvantage in this area, if it already exists, is not going to get any worse – but the real blow is going to come in how that money is being spent.

Charter is going to be spending money to acquire access to Disney+ that DIRECTV spends to get access to Nat Geo Mundo, Disney Baby and Freeform. Setting aside whatever teen/tween audience the last of these might truly tempt – and remember that almost everyone in that crowd was already streaming the same content on Hulu – almost every customer in the Charter service area is probably going to prefer Charter’s way of spending their money.

The same goes for those in Comcast’s service area, who will soon undoubtedly be getting the same offer. And between the two of them, these services cover most of the households in the US.

This means that, if DIRECTV really isn’t going to get the reciprocity of Most Favored Nation that its two main cable TV rivals are getting, it is about to be put at a considerable competitive disadvantage. It’s satellite service is truly nationwide, unlike local cable monopolies; but between the two of them Charter and Comcast go well beyond the local or regional and are almost approaching the national themselves. And it can’t get the free access to Disney+ that they can. And it’s still paying for pointless secondary channels they’ve been allowed to drop to save costs.

DIRECTV Response And Risk

What, then, is DIRECTV to do in response? It could just let its customer losses accelerate, but that doesn’t seem very likely. Not only because after losing Sunday Ticket the bleeding has probably accelerated already, but also since unlike streaming it can’t count on customers’ attachment to traditional TV service to protect it or at least slow the decline. Anyone who prefers a traditional setup (cable box, remote, channel guide etc.) will find them all waiting for them at the cable companies as well. This isn’t really a threat DIRECTV can just ignore.

There are two other options. DIRECTV could approach Disney and try to get its own Disney+ wholesale deal, and now that the precedent has been established, Disney is probably amenable to the idea. However, unlike Charter, DIRECTV does not have an expiring content deal to hold over it as leverage. That means it couldn’t get it thrown in with the content it is already paying for; any wholesale deal would have to see DIRECTV paying additional money on top of what it already sends Disney under its current deal, all of whose terms would remain intact.

The other most likely outcome here is that DIRECTV is going to have to cut prices to match the implied streaming-free equivalent price of its top competitors. What I mean by that is, if Disney+ and Hulu with ads cost $10 per month and Charter includes them in its service, DIRECTV needs to charge $10 less than Charter at each of its tiers of service. Or perhaps just the proportionate equivalent of those subscribers who would be interested in such a service (ie., a 50% interest level means charging $5 less.)

Ultimately, whichever of the two options DIRECTV chose would probably amount to much the same thing. Disney’s price for a wholesale deal is presumably not too different from the value the average Charter subscriber attaches to it, if Disney’s accountants are doing their job right.

Financial Calculations

Low Cost Estimate

The exact financials of what the various costs and benefits are a little harder to pin down.

For DIRECTV, I am going to assume that roughly one in three customers are looking for Disney+ access, since Disney+ is currently in around 46 million households and the US pencils out somewhere around 130-140 million.

DIRECTV no longer reports its subscriber totals, but various third party estimates have it declining somewhere between 9% and 17% per year – the latter would make it the worst performer in pay-TV, and this was before it lost Sunday Ticket – which based on last reported figures would put it somewhere between 12.3 million and 10.9 million on the low end. I will midpoint it at 11.6 million.

A Disney+ ad membership is $8 per month, which now comes with just a $2 add-on fee for Hulu as well, which will soon be folded into the service entirely. If 1/3 of the 11.6 million subscribers who are now getting Disney+ for free would have paid retail rate for it, DIRECTV can expect to shell out around $470 million per year in lost free cash flow.

Higher Estimate

I consider this estimate low, however, for two reasons.

First, it is in the nature of wholesale deals that they provide benefits from which non-paying customers derive at least some benefit, which they factor into their choice of provider. To carry on our prior calculations, the 2/3 of households not subscribing to Disney+ apparently don’t value it at $8 plus annoying ads per month, but they attach some value to it. And once they know some providers offer it free, they factor that value into their decision making.

Second, DIRECTV simply doesn’t have the leverage that Charter does to get such a low wholesale rate as Charter presumably got. I’m not even referring here to subscriber numbers. I’m talking about the fact that Charter is a broadband provider who derives only minimal benefit from video, while DIRECTV doesn’t have an internet business to fall back on and sees video as its whole reason for being. Disney knows that too, and presumably would extract more value from DIRECTV and possibly DISH (DISH) as well.

It’s hard for me to say exactly how much these two factors move the needle, but $470 million should be considered an absolute floor. I would say $700-$800 million is more likely.

Investment Summary

The net effect of this new Charter deal, whose terms must also be applied to Comcast, but which also saw Charter be granted a clean MFN just like Comcast has, is to effectively anoint the two as the new co-kings of pay-TV. Going forward, each of them gets whatever the other one gets.

Comcast starts with a bit of a head start in its race to keep the crown because it was the largest pay-TV provider for a long time and Charter probably took somewhat of a subscriber loss having this fight with Disney. But Charter’s much lower ongoing rate of subscriber loss may give it the advantage in the long run.

Meanwhile, for DIRECTV the deal is nothing but trouble. Comcast already had it outclassed, but where before it had one cable arch-nemesis it now has two. And it no longer has the subscriber heft to force Disney to match the concessions it gives either of them.

None of these companies are only their video business of course; Comcast and Charter have broadband, Comcast also has NBCUniversal, and AT&T has its core wireless operations domestic and international. But the impact of video can still be significant, so I hope investors will find this analysis useful.

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Analyst’s Disclosure: I/we have a beneficial long position in the shares of PARA either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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