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A Semi-Definitive Guide to the Phillies Looming Television Contract, Part 2: ...Or Die Trying

So we're gonna be rich, right? We'll see, said the Zen master.

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Sports & TV sitting in a tree, K-I-S-S-I-N-G
Sports & TV sitting in a tree, K-I-S-S-I-N-G

In my first post on the Phillies standing in the sports television contract landscape I laid out many of the causal factors underlying the seemingly boundless growth of sports broadcasting rights deals. This post will present the other side of that coin, namely how the industry is in a state of flux and how potential changes in television economics might negatively impact the future value of those contracts.

As TV rights deals have escalated and cable viewership trends have changed the national commentariat have taken notice. Reporting around these deals has begun to sound the alarm on the existence of a television sports "bubble" which many editorials claim is clearly unsustainable, though frequently the reasons given for that unsustainability vary from singular data points to supposition. These articles started appearing as early as 2011 so their crystal ball is at best a bit hazy. There are, however, any number of legitimate reasons to wonder if the Phillies deal may not end up being inked in the denouement stage of the unfolding drama that is the live-sports television economy.

Potential Pitfalls:

Fewer eyeballs. As the revenue stream that fuels these deals is predicated upon extracting ever more money out of the segment of the population that pays for cable any trend which decreases the total number of cable television subscribers will negatively impact expected future revenues and, in turn, the actuarial value of owning the rights to sporting events. Unfortunately for cable providers, and in turn the Phillies, this is now happening. For various reasons (cost, demographic shifts, the rise of viable cable alternatives, etc.) people are cutting the cord on their cable service.

Young people are particularly prone to cutting the cord. And so the same thing is happening to cable business as is happening to CBS Evening News. Every month, a chunk of its audience dies off, and new consumers come of age who have no experience with the product and no intention of trying it. [...] There's a good case to be made that those lost subscribers aren't coming back. Cord-cutting, it turns out, is a real phenomenon. As Variety reported in March, the pay-television industry notched its first-ever 12 month period in which the total number of subscriber fell in its history.

Emphasis mine. The high cost of cable is one of the drivers of this cord-cutting trend so it is safe to assume that there's little blood left to extract from that stone. Increasing cable bills to pay for these RSN deals will only drive more people away from cable in a positive-feedback loop.

That said, as of today broadcasters still enjoy very healthy margins, somewhere in the 50% neighborhood. Cable providers like Comcast and Time Warner are also doing well, with gross margins in the 80% and 50% ranges, respectively. But should we expect those corporations to voluntarily lower their margins to make up for lost viewers while leaving their more flexible operating costs—in this case, the cost of signing broadcast licenses for sporting events—untouched? I find that unlikely. These corporations have a fiduciary responsibility to act in the best interests of their shareholders. That typically doesn't entail voluntarily lowering profit margins while maintaining or increasing operating costs.

Sports account for a full 50% of television programming costs. If we assume that costs will have to be pared, and recognize that single largest programming cost broadcasters have is sports content, the most obvious conclusion is that spending on sports content, specifically rights fees, will decrease.

We're currently witnessing the nascent stages of a revolt against the high price of sports content. According to Maury Brown at Forbes, CSN Houston—the regional sports network [RSN] that has agreed to pay the Astros $80MM a year in rights fees for the next twenty years—is currently operating at a loss.

At this point in time, Comcast SportsNet Houston has no major carriage agreements with anyone outside of their own partner, Comcast. With start-up fees to get the regional sports network off the ground, the fledgling RSN is running at a loss. Not only do my sources in the broadcast industry say that cash calls for CSN Houston have already taken place, other reports speak to how difficult gaining carriage is, and will likely, continue to be. SNL Kagan, which Alexander quoted for the "most profitable, ever" story has said separately, "CSN Houston ‘has been a bust."

Those ever-increasing carriage fees are the catalyst for this movement. CSN Houston is carried to Houston-area homes by local cable providers Comcast, Phonoscope and a few small cable providers in the area. The remaining local providers, including DirecTV and Dish Network refuse to pay the estimated $3.40 monthly carriage fee. This leaves nearly 60% of the Houston area without access to CSN Houston, the home of the Astros and the NBA's Rockets. It also means that Comcast SportsNet Houston isn't receiving the revenue they had planned on gaining with the creation of their RSN, thus the operating losses. A similar scenario is playing out in San Diego, where Time Warner Cable refuses to carry Fox Sports San Diego, the broadcaster carrying Padres games leaving 22% of the local cable subscribers without access to Padres games. These trends are not encouraging for teams looking to sign agreements similar to the Dodgers recent deal.

It has been suggested that perhaps these RSNs can serve as a sort of loss-leader for cable providers. Under this theory a cable provider would own the exclusive broadcast rights to a popular local team, and provided their installed customer base was large enough, perhaps having those channels exclusively would draw more customers to their cable network, thus making up the costs lost in the bidding there. This may be at work on a small scale but seems unlikely to work on a regional level. As we see in Houston, without the ability to access the entire market and recoup those lucrative carriage fees the RSN begins to hemorrhage money. This would be fine if it were incentivizing enough new subscriptions to make up for that lost money, as that's how loss-leader programs operate. I'm not sure that's feasible.

Cable markets are relatively non-robust markets, with scant competition and high barriers to entry. For historical/political reasons, and due to the costs of infrastructure build-outs, many homes are unable to subscribe to more than one cable provider. If, for example, a neighborhood or township entered into an agreement with one cable provider during construction that's the only land-based option you have until a competing cable company enters the market and lays new fiber lines across the area. This is, to put it mildly, cost prohibitive. If the sole cable provider in that neighborhood happens to be a competitor to the provider that's trying to use their sports franchise as a loss-leader that neighborhood cannot switch to the carrier of sports team. This is relatively common. Add this to the money that the cable provider would be losing out on by not collecting retransmission fees and the loss-leading idea looks to be unsustainable, at least at the current costs of team broadcast rights.

If broadcasters don't start to rein in the sports-cable-Leviathan on their own it's quite possible that it's done for them. If content producers are forced to unbundle their packages the money spigot turns off. Briefly, "bundling" is the sale of television channels to cable providers in bunches, rather than on a channel by channel basis (a la carte). Currently, because of the oligopolistic nature of the television market, content providers can force people who don't watch sporting events to pay for them anyway. Again using the ESPN model as an example, of the 100 million homes into which ESPN is broadcast there is some substantial portion that doesn't watch ESPN content and would prefer not to pay the monthly $5 fee for ESPN. They don't have this option. ESPN is owned by Disney, which also owns the ABC family of networks, and stipulates that any cable provider that wishes to carry the ABC/Disney family of networks must also carry ESPN, and typically must do so on their basic cable tier (meaning that by contractual agreement the cable provider cannot shift EPSN into a higher HBO-like tier of cable channels that costs the consumer more if they choose to subscribe). If that cable provider wants to give their customers ABC/Disney content, they must also provide ESPN content, and must pay the combined carriage fees for all of those channels. This is standard practice in the industry and is what allows ESPN (and others) to extract hundreds of millions of dollars from people who have no desire for their product. Bundling is the engine that fuels these megadeals.

This bundling is under attack on multiple fronts. Legislatively, John McCain introduced a bill in May which proposes to remove regulatory obstacles to a la carte programming and would incentivize carriers to adopt such a model. Under an a la carte pricing scheme those millions of people who don't want ESPN suddenly stop paying that $60 dollars a year. McCain's proposed legislation isn't expected to gain much traction, as the entrenched networks and entertainment industry lobby is strongly opposed to such an idea. Nobody wants their cash cow killed, and if you can buy a few politicians to prevent it from happening that's the path of least resistance, for now.

Those opposed to the bundling system have also taken to the courts to try to prohibit cable networks from charging nonsports fans the fees for channels in which they have no interest. A class action lawsuit has been filed in Los Angeles Superior Court against the LA Lakers, Dodgers, and Time Warner Cable, charging that the defendants are engaging in unfair competition, forcing customers to pay for channels they do not want. Cablevision has filed an anti-trust lawsuit against Viacom, again, trying to break up the bundles Viacom forces Cablevision and other cable providers to carry. The goal of the Cablevision suit isn't quite a la carte programming, at least for the end consumer. Cablevision just wants to end Viacom and broadcasters' ability to prohibit cable providers from selecting which channels they prefer to carry—Cablevision would likely still bundle the channels they choose when reselling their product to customers. But it's a start, and would portend a massive shift in television economics. Like the probable fate of McCain's legislation these suits are unlikely to succeed. Precedent is against them; courts have previously ruled that bundling is an acceptable business practice. Ironically, one of the defendants in one recently dismissed lawsuit was Cablevision:

The bundling practice withstood a previous antitrust lawsuit brought by consumers on both pay-TV providers and cable networks. In October 2009, the cable industry won dismissal of the suit, filed in Los Angeles federal court, which claimed that customers were harmed by tying cable channels together. Cablevision and Viacom were on the same side of that case, as defendants fighting in favor of bundles.

Ah, the tangled webs we weave when trying to extract money from consumers. It's all fun and games until the cable provider gets trapped between increasingly frugal customers and spendthrift content providers.

While it looks like unbundling is facing an uphill battle in Washington and the courthouse, perhaps the best chance it has to break the current economic paradigm might come from within the industry. This past Monday Time Warner Cable and CBS came to terms on a transmission fee agreement after an unprecedented carriage dispute. This dispute took CBS, the country's number 1 rated network, and their associated bundled channels (TMC, Showtime, etc.) off the air in eight major markets including New York, Los Angeles, and Dallas, affecting nearly 3 million Time Warner Cable customers for more than a month. Carriage disputes like this are nothing new but this was the first time one of the big 4 channels—ABC, NBC, CBS and FOX—has gone dark in multiple major markets over the issue. The rhetoric around the dispute and the length of the blackout clearly indicate the tensions over these broadcast fees have reached new heights.

Like we've seen in the Comcast SportsNet situation in Houston and the Fox Sports situation in San Diego, as cable providers are being squeezed between ever increasing retransmission fees and cord cutting customers they're trying to contain their costs. One way they're doing this is by refusing to kowtow to the demands of the broadcasters if such a refusal won't hurt their bottom line too much. As Wendy Thurm, quoting the Wall Street Journal, points out, broadcasters are creating mathematical models to try to assess just how many customers they're going to lose if they refuse to carry certain channels.

Cable and satellite companies have stepped up their efforts to pin point exactly who is watching local sports on TV, when, and for how long, according to a report by The Wall Street Journal (subscriber only).

The data have given them a better sense for how often individual customers tune into home-team games, and for how long. They have created algorithms to gauge this level of "engagement," and are now using the findings to make decisions about whether to add sports networks and pass on the fees to all subscribers.

This is essentially unbundling done by the cable providers. If they decide that it no longer makes financial sense to carry these RSNs, if they figure they'll lose more customers by increasing customers' cable bills to pay for the networks than they will by not carrying the RSN in the first place, they will voluntarily opt out. You're seeing it in Houston and San Diego. You saw threats of it in the dispute between Time Warner and CBS. If this trend accelerates—or perhaps even if it just continues apace—the sound you'll hear is that of the cable television bubble bursting. This would be bad for the prospects of the Phillies receiving any Dodgersesque megadeal. Again, these RSNs need those hefty subscription fees as they account for 70-90% of all RSN revenue.

This analytical approach by cable carriers, by the bye, is why the Phillies 60% decrease in television ratings since 2011 (Down 38.6% from 2011 to 2012, and down 36% from 2012 to 2013) is potentially damaging to their future TV contract. If it looks to them like Phillies fans are willing to forgo whatever sports network the Phillies are broadcast on carriers may choose to dump it entirely. The silver lining here is that team television ratings very quickly follow on-field success, so the ratings concerns could theoretically be remedied by fielding a competitive team in 2014 and 2015. Additionally, the large deals in Houston and San Diego were doled out to teams that had poor ratings, as was the megadeal the Dodgers just signed (though the Dodgers have a larger television market and the Houston and San Diego deals may be serving as much cautionary tales to the broadcasters as precedents upon which the Phillies can rely).

On the other hand, if this unbundling were to occur on any large scale I cannot see how most broadcasters would be able to meet their monstrous contractual obligations to the teams. In other words, if this television economy falls apart for the Phillies deal, it likely falls apart for everyone involved, regardless of whether or not they've been the recipients of a new giant television deal. I don't see how these providers can annually lose tens or hundreds of millions of dollars on unprofitable RSNs for the next two-plus decades.

Luckily, the future is unwritten. None of this is guaranteed and we're still more than two years away from the expiration of the current broadcasting contract. In that time maybe the bundled television model completely disintegrates leaving broadcasters like ESPN and various regional sports networks in financial ruin. Or maybe those lawsuits are tossed, disputes like the recent CBS and TWC spat become increasingly rare and amicably resolved, CSN Houston and Fox Sports San Diego work out their carriage fee issues and the bubble grows even bigger. As much as I hate to get cliched and hedge here by saying, "Hey, anything can happen!" there are just too many unknown variables to project what will happen 30 months from now with any sort of specificity. Times truly are interesting in the cable television industry.

In Summary:

Taking all these variables into account, here's my very generic educated guess as to this television deal ultimately plays out. At some point in the coming months executives from the Phillies will sit down with negotiators for all of the broadcasters interested in carrying Phillies games post-2015 and start to work out the details of the future agreement (this has likely already begun). The aforementioned issues will outline the parameters of those discussions; the Phillies will point to their huge ratings over the 2008-2011 period, their dedicated fan base, the 4th largest TV market in the country, their many hours of original programming, and comparable deals that have set the market. The broadcasters will stress most of the negative issues I've outlined in this piece. Those negative externalities will be considered to some extent in the deal that is ultimately signed. Though the probability of any one of those potentially damaging events occurring on a large scale may be small, it must be accounted for actuarially. It would be negligence on the part of the bidders to not consider potential future costs.

In the end, barring some unforeseen catastrophe (Carrington-type event? local magnetar quake? Methane clathrate explosion?) the Phillies will sign a new deal that provides a substantial increase in television revenues from their current $35 million a year placing them among the richest clubs in baseball, though the above concerns are real, non-trivial and will likely prevent them from surpassing—or possibly even matching—the $8.5 billion Dodgers deal. The contractual differences between the Phillies and Dodgers television deals caused by the aforementioned factors should be of degree, not kind, but sanguine as that sounds it's not to say there isn't a lot of money on the line. When discussing differences in degree of contracts in the $8 billion dollar range you're still talking about potentially hundreds of millions of dollars, which can buy a lot of dollar dogs or allow a team to shrug off a few ugly contracts.

As for the Phillies fan, any cost increase to the cable provider is going to be passed along to them. Expect cable bills for providers carrying whatever channel the Phillies end up on to increase. I also expect Phillies games on basic cable channels like PHL17 to decrease if not disappear entirely as has happened in other markets after similar deals have been signed.

We can rest assured the Phillies will be a very high revenue team. What that means for the future of the franchise with respect to personnel moves in an era of a luxury tax soft payroll cap, capped amateur draft spending, capped international spending, and teams locking up their young talent long before they ever hit free agency is a story for another day.

Please accept this classic yet topical composition as my apology for asking you to read 4700+ words on the Phillies potential TV contract over the last two posts.

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