Billion Dollar Bevo, Part I: Inside the UT/ESPN Longhorn Network Deal

The billion-dollar Longhorn Network goes live today.

That's right. Billion. The big daddy with three commas.

If you want to know where we got that number, stay tuned. This post is the first in a three part series analyzing the "License Agreement" between Texas, IMG Communications and ESPN that created the LHN. This installment offers a high altitude overview. Part II delves into economics - and most of what has been written on that subject is wrong. Part III covers the finer points of the contract and will serve as a Q&A for readers.

Care for a glimpse of the future of Texas (and collegiate) athletics?

Background

From a purely Machiavellian standpoint, the Longhorn Network deal is a thing of beauty.

For one thing, it's lean and simple. At only 40 pages, it ripped off the printer so fast that I was sure it had run out of paper mid-job. Whenever you encounter a major corporate transaction that can be stapled without a pneumatic gun, it's enough to restore some measure of faith in the legal profession. After the first read, you might be inclined to think: "Is that really it?"

From this lawyer's perspective, the Agreement has little to offer in the way of near-term impact. It's fair to describe the Agreement as a conglomeration of potential contingencies and aspirations. It was carefully crafted to avoid any headlong collisions with the existing Big 12 television contracts. This allows both UT and ESPN to say with a straight face that the LHN Agreement is in no way a blunt-force kill shot to the Big 12. Indeed, ESPN and UT can also say that they've worked within the framework of the existing Big 12 TV package to secure at least one (Rice) and possibly two (K-State) 2011 games for the LHN.

But make no mistake: the ultimate consequences of the LHN Agreement are anything but benign. This is a deal with enormous implications for all of college athletics. Last week, toward the end of his column about Texas A&M, Spencer Hall referred to the LHN as ESPN's "bomb at the heart of college football."

I agree with the gravamen of Spencer's thesis, but calling it a bomb implies that an act by one of the Agreement parties is required for detonation. That's not possible in this case. UT's only strategic limitation here is the realities of Texas politics - it can't be the one to push the plunger on the Big 12, but it can plant the idea via inception.

A copy of the Agreement was released by Texas in response to a Texas Public Information Act request. Apparently, UT redacted only one paragraph of the Agreement pursuant to the statutory exemption for confidential business information, which means that it fell into the waiting arms of the public largely unmolested by Vice President of Legal Affairs Patti Ohlendorf's Sharpie.

Since then, a majority of the reportage and analysis has been confined to pecking away at the margins, chasing red herrings, or if you're among the Friends of Bellmont, downplaying the impact of the deal. We've taken a little longer to digest it and do a little research of our own in an effort to cut through the noise and assess the real economic implications for both ESPN and UT. When you boil it down to its irreducible minima, this story is really about two interrelated considerations: (a) the economics of cable and satellite television; and (b) the expansion of what is presently a narrow beachhead of third-tier broadcast rights. Those are the two critical-path prerequisites to divining the geopolitical implications of the deal.

With that written, don't worry about who hires and fires on-air talent; ESPN's abandonment of journalistic integrity (how can you abandon something you don't have?); all the whining about a 24-hour Bevomercial; why Texas A&M was inexplicably napping for six months after the deal was inked; and most of all, forget the hue and cry about televising high school football, however amusing it may be (you'd think that Joel Osteen sold the Lakewood Church naming rights to the Spearmint Rhino).

Another common mistake to avoid: looking at the deal solely through the Bellmont keyhole. Multiple stakeholder perspectives must be accounted for, and none is more instructive than ESPN's.

Three Keys & A Question

Consider these three points, then ask yourself why ESPN would do the deal? The answer tells you the future of the Big 12.

1. This is a billion-dollar enterprise.

Last week the Associated Press referred to the LHN as the "$300 million Longhorn Network." That's wrong. If you're going to put a price tag on it, then a more accurate figure would be in the neighborhood of $1 billion, since that's roughly how much ESPN has apparently committed to the enterprise over the 20-year base term of the Agreement.

The $300 million refers to what's called the "minimum annual guaranteed royalty" payments to UT and IMG (unless otherwise necessary, we'll refer to them collectively as UT). UT gets $10.98 million in the first year, with a 3% bump each year thereafter (the aggregate of those payments is actually a little less than $300 million). Here again, this is what you see if you're only looking at it from UT's perspective. The Agreement provides an annual budget estimate of $26 million, which comprises $15 million for production and $11 million for overhead. It also provides an estimated annual escalator for those two elements at 3% and 4% respectively. Annualize that over the base term, add it to the aggregate MAGR, and voila - three commas.

2. ESPN acquired minimal TV rights under the Agreement.

There's a lot of confusion over exactly what ESPN acquired in terms of television rights for UT football games. For the near-term, the answer is not much. Although the Agreement contains non-binding language acknowledging a "mutual desire" to broadcast "no less than two" games per season on the LHN, neither party presently has the legal right to make any guarantee along these lines. That's because the Agreement had to be made subject to the existing Big 12 TV contracts, meaning that the rights secured under the existing FOX and ESPN/ABC deals are prime. Key facts: the FOX deal runs through 2023; the ESPN/ABC deal runs through 2016. Based on a strict interpretation of the LHN Agreement, ESPN arguably got nothing more than UT's promise to "use its best efforts" to secure the rights to one third-tier game per season starting in 2012.

3. Getting games onto the LHN under the status quo is arduous.

The machinations that allowed UT/ESPN to secure the rights to telecast the 2011 opener against Rice and a reported pending deal for the K-State game in November are rather instructive. Another key fact to keep handy: any deal with ESPN is tantamount to an arms-length transaction with an octopus. ESPN is leveraging its rights under the Big 12 contract to do some horse-trading with FOX to facilitate the movement of those games to the LHN. Such "work arounds," however, can be unwieldy and expensive (particularly because they can involve the payment of additional rights fees). Moreover, they're making the rest of the league understandably nervous since they disturb the egalitarian (more or less) regime under the Big 12 TV package.

Exhibit A: the Aggie Separatist Movement. (The Aggies might be pissed off for all the wrong reasons, but that doesn't mean that the right reasons don't exist.) Surely this less-than-ideal operating scheme cannot be how the LHN is supposed to co-exist with the Big 12 forevermore, can it?

So why would ESPN make what amounts to a $1 billion commitment to a dedicated UT network when the rights to its marquee programming - Texas football - are so thoroughly restricted by the existing Big 12 TV contracts for at least the next six years?

It wouldn't, unless it was betting that the broadcast rights for UT football games aren't going to be encumbered by the Big 12 for much longer. It's that simple.

Why ESPN And Texas Partnered

There are at least three reasons, and this is as good a place as any to bring UT back into the discussion:

1. For ESPN, market leverage over competitors.

For ESPN, the ultimate utility of the LHN is market leverage if/when the Big 12 is euthanized. Their part of the Big 12 TV deal ($60 million per) expires in 2016, but FOX just re-upped for 13 years at $90 million per year. ESPN counters by buying an equity stake in the Big 12's most marketable commodity and the key to the future of the league. More importantly, Texas is the biggest prize in the realignment game. This is one in a series of moves by ESPN to gain a measure of control over the next round of realignment rather than sitting back and reacting to it, as it would have had to do last summer if Texas had pulled the trigger (which would have precipitated a global realignment scenario that's been referred to by a dozen synonyms of Armageddon). It was in both UT's and ESPN's best interest to stem the tide of the 2010 realignment. For ESPN, it allowed them time to re-do their deal with the (now) Pac-12 and take the commanding heights in the future of the Big 12.

Under the LHN Agreement, wherever Texas goes, ESPN goes with it.

2. For both parties, but especially Texas, some serious whip-out.

You'll have to read Part II for the particulars, but here's a peek...

The vast majority of cable network revenue - and vast in this case means about 90% - is generated by the wholesale subscriber rates charged by the networks to the providers (like Time Warner, Cox or Comcast) who pass the cost through to their customers. When it comes to negotiating carriage agreements, suffice it to say that ESPN is blessed with more leverage than Galavision. We've looked at several models, and depending on how successful ESPN is at negotiating the carriage agreements, UT stands to earn a hell of a lot more than the minimum royalty payments. Particularly as it participates more robustly in the LHN. And given what we know about its anticipated costs, ESPN obviously anticipates doing quite well. For today, that's all you get - read Part II.

Whenever a new network is launched, carriage agreement negotiations typically go down to the wire. It usually takes one or two larger MSOs (multiple system operators) to sign up and set the market before the other targets make a deal. Verizon inked its deal for the LHN yesterday. A source tells me that ESPN is advising UT to expect that the most important deals (i.e. Time Warner) will still be in negotiation until next Friday (the day before the Rice game).

3. Unfettered TEX-ploitation.

For over a decade, DeLoss Dodds has been carefully pursuing the unfettered ability to exploit the marketplace solely for the benefit of UT's own interests. If A&M bolts for the SEC, it actually leaves Texas with more flexibility. The LHN can co-exist with the Big 12 under the status quo, but that's not its highest and best use.

The two most likely destinations for Texas are a Pac-14/16 or football independence. And the latter might be the most lucrative option. Stay tuned.

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