The Thesis
Discovery, Inc. is one of the largest media providers in the world with over 2 billion total subscribers across 220+ countries. Through its three main networks (TLC, Discovery, and Animal Planet), the company reaches close to 90 Million American households and 270MM+ international subscribers. This doesn’t even include the eight other networks the company owns such as OWN and Investigation Discovery. Now, Discovery, Inc. is looking to continue its momentum from its 1Q 2018 results. The company closed on its acquisition of Scripps on March 6th and is now focused on paying down debt, reducing its leverage, increasing its range of content throughout the globe, and generating consistent cash-flows. DISCA is projecting 2018 year-end revenues to hit the $10.8B mark (nearly 60% increase), which if given a modest average growth rate of around 4% for the remaining 4 years, would give us a fair value upside of nearly 80% from its current trading levels.
If DISCA can manage to increase its revenues while reducing its leverage, it presents not only a unique chance at owning a great, durable business at a cheap price, but it also provides the investor with a “call-option” like position in case of a buyout (which we know could be on the horizon given the tremendous consolidation going on in the media space). Furthermore, the acquisition of Scripps will provide DISCA with even more distribution outreach through Scripps’ main networks such as HGTV, Food Network, and Travel Channel, giving it even more reach and more options to leverage for cash flow generation.
The market seems to be focused entirely on the leverage of the company, the recent hike in debt, and the operating income loss. If one doesn’t take a closer look under the hood, it would be easy to bypass this company, and in fact, wouldn’t be surprised if DISCA fails many “quality business” screeners due to the above characteristics. If you dig deeper, you begin to realize the potentially exciting value proposition.
The Business
Discovery has one advantage over other major networks: Original Content. The company cranks out OC like no-one else in their industry. Since Discovery owns and produces all of their own content, it gives them tremendous leverage in pricing power as well as increased cost efficiency. Moreover, Discovery isn’t in the business of scripted content like most of its peers. One of the driving reasons why Discovery is successful is because it built its brand on the idea that viewers like to see unscripted, real life scenarios and events. Shows like Deadliest Catch, Wild Tuna, (and my personal favorite) Dirty Jobs are just a few names of the type of content that captures audiences and keeps consumers coming back.
This position as the network for unscripted, real life content has created not just fans of DISCA’s content, but what CEO David Zaslav calls, “super fans”. The reason for this super-fandom is that the content DISCA puts out actually has value. This isn’t to say that binge watching Jersey Shore for 6 hours a day won’t add value to your life (hint: It will not only NOT add value, but will FOR SURE make you less intelligent), or diving into the latest season of Peaky Blinders won’t make you more “culturally aware” (I’m actually a huge fan of the show and would recommend the show to everyone), but there is something about the shows on Discovery and its associated networks that have real tangible value. Shows on Food Network and HGTV provide real utility for the consumer who wants to make that new recipe from scratch for the first time, or for the newlywed couple that bought a fixer upper and are looking for ideas on how to remodel their home. This combination of entertainment and utility is what makes DISCA unique.
A Global Reach & Wide Moat
Although the company produces over 50% of its content in the United States, it actually generates 50% of its revenues from outside the USA. This reach of over 220 countries gives DISCA ample room to grow organically as it seeks to create localized versions of American favorites. And, don’t forget, since it owns all of its own content, it can take that content wherever it wants, giving the company tremendous flexibility that other larger media companies simply can’t match.
To go along with its large global presence, DISCA accounts for 20% of ad-supported cable viewership in the United States. The company also has four of the top seven networks for women in total day viewing across all ad-supported cable. These statistics make DISCA a cash flow machine. In the company’s most recent quarterly report, Zaslav referred to his company as a cash-flow machine, saying (emphasis is mine),
“We have a steady financial and operational tailwind and a model that provides a strong visible free cash flow generation. Indeed, our free cash flow is like a moat in turbulent times. It’s a distinguishing strategic asset for Discovery. That free cash flow will, over time, provide us with a loaded gun, giving us flexibility to deploy that free cash flow like bullets wherever we see opportunity to drive shareholder value.”
With this in mind, the company’s strategy for deploying its FCF include all of the following: investing in content, IP, extending content on all bundles and services, buying back stock, or paying down debt.
The Scripps Acquisition
Discovery’s acquisition of Scripps will tremendously benefit the company. By combining companies, DISCA now has nearly 8,000 hours annually of original programming, with a library of 300,000 hours of content. These include shows such as Deadliest Catch, Shark Week, Fixer Upper, and House Hunters. The combination of the two companies creates the largest share of Viewership out of any media company. To give you an idea, DISCA + Scripps accounts for 20% of the viewership for the ages 25-54. The next closest competitors are Viacom at 15%, Comcast & Turner at 14%, and then Fox at 9%.
Discovery and Scripps is a home-run with female audiences. Combined, DISCA and Scripps now lead all of media in terms of Cable Ad Revenue for Female-Skewed networks (think HGTV, ID, Food Network, TLC, OWN, Animal Planet). This makes sense intuitively when you consider the YoY growth internationally from networks such as HGTV (+55%), Food Network (+25%), and Travel Channel (+47%). Viacom comes in second with MTV, TV Land, BET, and CMT … You’re starting to see a consistent pattern of industry leading indicators.
Finally, DISCA is looking to achieve significant cost synergies from its acquisition of Scripps. The company originally estimated an annualized rate of $350M in cost synergies, but over the last earnings report revised that number up to $600M. Scripps debt will be pari passu with the existing / new debt from DISCA, and the company is targeting leverage ratios of 3.5x within the first two years after the acquisition. With the cost savings to the side for a second, the company is expecting serious free cash flow generation from the Scripps’ line of networks, which they will use to repurchase shares after debt levels return to manageable levels.
The Numbers
Looking at the last quarter, DISCA increased revenues by 10%. The 10% increase was driven by 2% domestic growth and a whopping 26% international growth. Operating Income was down 6% due to a 30% decline in international OI. This is misleading however due to the timing of the 2018 Sochi Winter Games, which sent costs skyrocketing. If you back out the impact of the Olympic Games, adjusted Operating Income was actually positive for the quarter. The problem is, that isn’t as easy to figure out if you’re watching CNBC.
Advertising growth grew 2% in the United States and 11% internationally. Domestically, the growth was due to continued monetization of the company’s GO platform (their digital app), as well as higher volumes. Internationally, the growth was attributed to the Winter Olympics across Europe, which drove higher volumes.
Moving on to costs, the company recognized a 44% increase in total operating costs. Like I mentioned earlier, the bulk of that increase was due to sports rights and production costs for the Olympics. Once again, if you back out the added cost of doing business during the Olympics, the company recognized an increased in Total Operating Income for the quarter.
Projections For Year End
The company is estimating year-end Operating Income to be around $4.05B, which projects revenues around $10.8B. Remember, these numbers include the increased cost of the Olympics. Free cash flow is projected to be in the $2.3B range. With this cash flow, the company is committed to funneling nearly all of it towards reducing their debt burden. The company is currently operating at 4.8x Net Debt to EBITDA, and management expects to pay down that burden to get to their year end goal of being 4x leveraged.
Finding a Roughly Right Fair Value
Using a 5-Yr DCF model, DISCA represents around an 80% potential upside from current trading prices which would put the Fair Value Price in a range between $41 and $55. We start with top line revenues of $10.8B in 2018, estimated revenues for 2019 -2020 coming in at $11.4B and $12B respectively. After 2020 I’m assuming an average growth rate of 3%. From this top line revenue we can approximate EBITDA growing from $4.05B in 2018 to $4.11B in 2022, representing roughly 32.5% of Revenues.
The company historically spends on average 1.8% of revenues on CapEx. For the sake of this valuation, I am upping that number to 2% across all five years due to the acquisition costs associated with Scripps. Net working capital is on average 12% of revenues which gives us Net Working Capital of $1.32B – $1.5B over the next five years. We can now estimate FCF numbers for the next five years. Taking top line EBITDA, subtracting all Capex and NWC Investment you get a FCF growth of $3.35B – $3.816B over the next five years.
Taking these FCF ranges we can calculate Enterprise Value by taking the PV of our discrete cash flows first, which gives us a range $14.85B – $15B. Assuming a perpetuity growth rate of 2.50% – 3% we arrive at terminal FCF of $2.92B. Using a terminal discount factor of 68% we get the PV of the Terminal Value range of $31.3B – $38B. Adding our Discrete Cash Flows and Terminal Value we get a final estimated range for EV of $46.2B – $53B.
Now that we have our EV range we can find our fair value range. We add cash and investments, subtract all debt and minority interests to get to a Common Equity value range of $28B – $35B. Divide that by the total number of shares outstanding and you get a Fair Value per share price of $41.37 – $51.24. This would give an implied exit revenue multiple of around 4x and an EBITDA multiple of 12x.
Reading The Tape
If price breaks above horizontal resistance around $29/share, I would be a buyer. However, I would also be a buyer if prices were to trade lower and consolidate around the $22/share range. For now, I’m comfortable waiting for the right time to deploy the capital. I would start this position around 75bps entry and look to pyramid in, moving my stops up accordingly.
Where Is My Fallibility?
If it wasn’t obvious by now, debt levels are my biggest concern when it comes to affecting the probability of my bullish thesis playing out. Staying around 5x leveraged for more than the next two years would start to choke out the growth prospects for DISCA, as more and more of their FCF would funnel into paying down debt instead of investing back into the business / returning capital to shareholders.
Another threat to my thesis would be the continuation of advertisers retreating from television ads, and opting for more cost-effective ads online / digitally through apps. This goes hand in hand with more people switching from standard cable bundles to more “choose-your-own” packages, or even products like Slingbox where you can hand-pick what channels you want to pay for.
These are real threats, yes, but I believe DISCA is positioned well for each of these scenarios as long as they stick to their current plan. I also feel more confident that John Malone (director and 10% owner of all outstanding shares) continues to buy. Malone currently owns close to 15M shares and has made bought 1.407M shares since June.
The Market Plunger 