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Billion Dollar Bevo, Part II: The Bloody LHN Carriage Negotiations

This is no ordinary standoff over wholesale subscriber rates. In this installment of the Billion Dollar Bevo Series (Part I here), we'll tell you why the Longhorn Network has become--at least for the moment--the 38th parallel of sports television. We'll also tell you why ESPN (and UT) will likely eventually prevail. The current situation is influenced by the factors described below. We'll also tell you why ESPN didn't set up a pay stream for the Rice game.

1. Absence of a true comp.

Here's how it usually works: the network will cut deals at the margins first, as ESPN did here with a half-dozen small operators in Texas, then bite off a bigger target. That was the Verizon/FiOS deal. The Friday night deal with Grande Communications (only 140,000 subs) doesn't qualify as a major pickup. The key to achieving widespread distribution is one dam-busting deal with a major operator that sets the table for a succession of carriage agreements with the others. That's why everybody has been watching Time Warner, Comcast, the dishes, Charter and AT&T U-Verse. From their standpoint, nobody wants to be the first to cave.

Eventually, though, one of them does.

Typically, that process is aided by lessons from recent history that help the parties achieve a reasonable understanding of the network's market value. But in the LHN's case, there is no true comp. The LHN is a first-of-its kind, precedent-setting enterprise. It's not like the existing regional sports networks ("RSNs") or even the BYU network (which has a heavy CJCLDS programming component). That's making it harder for the parties to set the market, and even harder for the interested public to figure out just what the hell is going on.

2. ESPN's market strategy.

Here's what ESPN is trying to do:

- Establish a base primary market for the LHN in Texas first. The secondary market is adjacent states; tertiary market is nationwide.

-For systems in the primary market, ESPN wants the LHN on the "expanded basic" or "standard" tier. This guarantees the maximum subscriber yield since that's what most people have.

- At the same time, ESPN's ask for the wholesale subscriber rate in the primary market is quite high. Mainstream coverage has picked up on industry analyst estimates that peg ESPN's goal at somewhere between .30 and .40 cents per sub/per month. In the last 24 hours, we're hearing that ESPN's demand for the primary market is twice that, and perhaps even higher.

- We know that the Verizon/FiOS deal is consistent with this split market strategy. The LHN is included on a lower base tier for Texas customers, and an advanced tier nationwide. What we don't know is the agreed-upon wholesale rate, but we're trying to find out.

Based on our estimates and research, the premium rate being demanded by ESPN arguably isn't necessary to ensure the near-term viability of the LHN. But wow, would it make a big dent in the LHN's overall risk profile. If ESPN can command something north of .50 in the primary market (the higher the better), then the LHN can turn some serious coin on the margins just by getting into "sports tiers" nationwide. And if the primary market rate for getting onto expanded basic is something close to a buck, then you can start talking about maximum yield scenarios. Remember that under the Agreement, once ESPN recoups $295 million of AGR, then UT commands an annual bonus of 70% AGR. We'll get into this in Part III.

Some of your comments to Part I argued for a direct subscriber or fee-based service, and a couple of you made compelling cases for a cut-the-cord scenario. You're not the only ones thinking along these lines. The "License Agreement" between ESPN, UT and IMG contemplates the creation of a digital network, and would allow the distribution of the same content licensed for television. But as long as federal law allows the packaged approach to expanded basic cable (and the analogous satellite tier), the traditional route provides a larger, more stable revenue source in the near term (although interestingly, the Agreement doesn't provide for an either/or scenario -- it contemplates the development of both).

3. Code blue on the Big 12.

The LHN is a precedent-setting enterprise in its own right because it's a single-source network devoted to one institution. It faces the added challenge of having the television rights for its marquee events (football) largely encumbered by existing Big 12 TV contracts. In one sense, the apparently imminent implosion of the Big 12 makes the LHN an easier sell. Think about it. Not only will Texas be free of the Big 12 TV restrictions, but it's guaranteed to have a powerful advocate and partner wherever it goes in ESPN (most likely a PAC-14/16 or football independence).

At the same time, the cable operators are fools if they don't use the Big 12's instability as a means to better their bargaining position. Certainly the issue is being raised. Wouldn't you like to be a fly on that wall when ESPN reps are telling the cable operators where they think Texas will end up and when? The outcome may not be certain, but the roadmap is partly laid out by the LHN Agreement.

The Agreement contains terms that would provide for UT's transition to another conference (as well as a process for how UT will sell its rights as a football independent). It even provides that the TV rights granted to ESPN under the LHN deal would be subjugated to the TV contract of whatever conference UT joins. But here's the catch: UT's entry into that conference would be a negotiated transaction, and guess who's a party to every major conference's TV deal? That's right. ESPN.

Those who argue that the LHN makes Texas incompatible with the PAC-12 are very short-sighted. Everything is negotiable. You don't put together a deal like this without adequate safeguards and contingency plans. One of the other topics we're working on is how the LHN could transition to the PAC-12 either in its current format or as a reconfigured 2-school joint venture. For the moment, take our word for it. It would work.

4. ESPN's considerable leverage.

There is something to be learned from previous battles over RSNs, and to a lesser extent, national networks like those for the NFL and MLB. The big takeaway from some of these, like the Big 10 and some of the RSNs featuring pro teams, is the rather creative use of federal law and FCC regulations that prohibit anti-competitive discrimination in the negotiation of carriage agreements. The law was designed to prevent vertically-integrated operators who also had a stake in programming or distribution from boxing "competitor" networks out of their systems. Or, more importantly, relegating them to a higher "tier" than expanded basic (or "standard" as it's called), which is what most of their customers buy. The short of it is that ESPN might have a hammer that it can use to shorten the argument over carriage rates if this drags out too long.

5. Why didn't ESPN set up a pay stream for the Rice game?

Answer: ESPN wants to maximize its leverage and the Rice game was a sacrificial lamb. From a negotiating standpoint, ESPN stands to benefit by making the product scarce in the near term. It's a public leveraging opportunity. Look at it this way, DirecTV hasn't had this many calls from the Houston area since one of its satellites dropped the feed on the Hentai Channel.