Struggling with lower income from its media networks business, The Walt Disney Company (DIS) announced yesterday that it will end its relationship with Netflix Inc. (NFLX) and launch two of its own streaming services, one for ESPN and another for Disney content. The ESPN streaming service is likely to be offered starting in 2018, while new Disney movies will not be available on Netflix starting in 2019. The move was made possible by Disney's $1.5 billion acquisition of video streaming firm BAMTech. Both Disney and Netflix shares tumbled in after-hours trading.

The question is: Who will feel the pain of this divorce more?

The Key Term: Operating Income

  • The ESPN Challenge: Disney’s cable business saw its revenues drop 3% compared to Q2 2016 while operating income plunged by 23% to $1.5 billion. Despite rising viewership numbers across the wide variety of channels Disney has a stake in, operating income for the media networks business is declining. In this quarter, the company blamed ESPN as the biggest drag on these numbers.“The decrease at ESPN was due to higher programming costs, lower advertising revenue and severance and contract termination costs, partially offset by affiliate revenue growth,” the company said. As Inc. (AMZN) and Facebook Inc. (FB) step into the sports programming arena, traditional broadcasters and feeling the burn, and ESPN is no different. A separate streaming channel may be Disney’s only hope to salvage ESPN. (See also:How Amazon, Facebook May Crush the TV Networks.)
  • New Revenue Stream: The direct to customer model for original content has worked for Netflix, Time Warner’s HBO and even Amazon Video. It is hardly a surprise then that one of the world's largest media companies would consider it. Having its own streaming service could open a new subscription revenue stream for Disney, an improvement over the licensing fees it gets from sending its content to other streaming services. “Today we announced a strategic shift in the way we distribute our content. The media landscape is increasingly defined by direct relationships between content creators and consumers, and our control of BAMTech’s full array of innovative technology will give us the power to forge those connections, along with the flexibility to quickly adapt to shifts in the market,” said Disney Chairman and CEO Robert A. Iger. In addition, the company has to come up with a model that allows both strategies to co-exist. It could consider licensing some of its content out and rake in the fees while maintaining exclusivity on newer or even more coveted content for its own subscription service.
  • Hulu Ain’t Cutting it:  This is not Disney's first foray into streaming. Disney’s 2009 play of investing 30% equity in Hulu hasn’t really reaped benefits because the streaming service itself hasn’t reached a huge subscriber base. Earlier this year, Hulu announced 47 million unique viewers, less than half of Netflix's 104 million subscribers.

What Works For Netflix

  • Game of Content: Piper Jaffrey analyst Michael Olson estimates that only 3% of Netflix’s annual content costs are from Disney, according to CNBC. That in turn would mean little in terms of impact for Netflix, especially since the company is pumping billions into creating original content. That includes its first ever acquisition, that of comic book publisher Millarworld announced a few days ago.  (See also: Networks to Pour Billions into Original Content in 2017)
  • The FAANG Effect: Netflix isn’t just a part of the elite tech group but it also enjoys extreme investor confidence, one might even say a bit too much if we look at the valuations. This confidence is fueled not just by the original content that it is producing but also by geographical expansion. Netflix is currently trading at 217x P/E while Disney’s P/E ratio currently stands at close to 18x.

The Takeaway

Disney is not the first media company to be suffer from disruption from Netflix and Amazon; however, it is the only media giant that produces enough original content to mount a serious challenge to the newcomers. The uncertainty for Netflix on the other hand stems from whether Disney’s departure was a one off or the beginning of a trend among content creators. If that does become a trend, can Netflix's original content drive growth? For now, that seems like too many ifs for Netflix and a rather real challenge for Disney.