DISCA/DISCK - Discovery Communications

[no_free_lunch]

We assign Discovery a wide moat rating. Our guiding premise in media is that the value of video content continues to increase even as the distribution markets mutate. Discovery is a vertically integrated content company that owns domestic and international channels and produces most of content that airs on its channels. Even as the media landscape continues to shift, we believe Discovery’s exposure to international markets and content ownership provide a strong base to weather any disruptions. Despite the changes in consumption patterns, pay TV penetration remains well above 80% of households in the U.S. Even without a pay TV subscription, most cord-cutters still consume video content. While over-the-top offerings such as Netflix and Amazon Prime have begun to create their own content, both services require deep libraries to gain and retain subscribers. Given the ongoing demand for content, we believe content creation for cable networks is not a zero-sum game as quality content will always find an outlet.

...

Discovery's content has demonstrated universal appeal that translates across borders and languages. The company capitalizes on this appeal by editing and updating its content to provide localized versions that can be distributed to its subscribers in more than 200 countries in 45 languages. Over 50% of the programming on the international networks are originally produced for the U.S. networks, providing a significant source of margin leverage.

...

Our fair value estimate is $37 per share, approximately 22 times our 2015 earnings per share estimate. We expect overall annual revenue growth to average 4% during the next five years. The main downside risks to our forecast would be if television advertising weakens materially at any time over our forecast period and if the company continues to experience foreign currency headwinds. We think potential investors should consider the Class C shares (DISCK), which have historically traded at a discount to the A shares (DISCA) despite having the same economic interest and not suffering from much lower trading volume. We forecast average annual international sales growth of 4.1% over the next five years.

 

http://analysisreport.morningstar.com/stock/research?t=DISCA&region=usa&culture=en-US&productcode=MLE

 

I am on the fence on this one.  Not sure exactly what FCF is but morningstar has them at around 18x earnings which is not that cheap.  However I estimate FCF is a bit higher and so possible a 15x fcf mutiple?

 

I do question morningstar on the strength of the moat, no doubt some moat exists but it seems that consumer tastes can change fairly quickly.  I just think about the various new successful series on hbo and netflix over the past couple of years.  Is it realy that difficult to take on discovery's content as well?

[ItsAValueTrap]

The moat:

 

It takes about 3-4 years for an upstart cable channel to hit a critical mass and become profitable.  At least, that's been Discovery's experience.

 

Discovery also had a lot of channels that didn't work out, e.g. the channel that preceded OWN. 

 

2- I'm very worried about Netflix, Youtube, illegal streaming sites, and other forms of piracy.  Discovery has not been positioning itself well against those competitors.

 

For example, Discovery owns the rights to Myth Busters.  Fans started making bootleg edits of the show to cut out all of the filler BS that Discovery sticks in to suck up to advertisers.  Discovery is not doing a very good job of packaging great content in the form that customers want (though Myth Busters was briefly available on Netflix).  Netflix is doing a great job at giving consumers what they want and are holding their own against piracy; many people who pirate content will also have a Netflix subscription.

[ni-co]

Almost didn't realize that DISCA got relatively cheap. Think about the content they own. I very much like their assets because it's great timeless content. It's much more than meets the eye re current cash flows.

[shhughes1116]

Almost didn't realize that DISCA got relatively cheap. Think about the content they own. I very much like their assets because it's great timeless content. It's much more than meets the eye re current cash flows.

 

I am a buyer after the recent decline.  The US business is nothing to write home about, and is probably a declining business.  However, their European business and expanding Asian business seem to make this an interesting stock.  For those of you who are European residents on this board, I would be curious about your opinion on Discovery's European presence via Eurosport.  I am inclined to think that Eurosport is the European version of ESPN.

 

The buyback over the last few years is pretty nice also.

[thefatbaboon]

Almost didn't realize that DISCA got relatively cheap. Think about the content they own. I very much like their assets because it's great timeless content. It's much more than meets the eye re current cash flows.

 

I am a buyer after the recent decline.  The US business is nothing to write home about, and is probably a declining business.  However, their European business and expanding Asian business seem to make this an interesting stock.  For those of you who are European residents on this board, I would be curious about your opinion on Discovery's European presence via Eurosport.  I am inclined to think that Eurosport is the European version of ESPN.

 

The buyback over the last few years is pretty nice also.

 

Eurosport the european version of ESPN?  You couldn't be more wrong. 

 

[thefatbaboon]

Can't they keep building the portfolio of sports content and end up with something equivalent to ESPN in Europe? I mean, once upon a time ESPN didn't have basketball and NFL right?

 

Certainly not impossible, and Zaslav has implied as much in some conf calls, but at the moment, and on the visible horizon,  it has absolutely nothing in common with ESPN.  Sky Sports (part of BSkyB) is the closest Europe has to ESPN.  I wouldn't even know what to compare Eurosport to to help an American understand.  Eurosport is the traditional home of niche sports like handball or weightlifting or skiing.  It is also well placed, because of it's impressive distribution across europe,  as the secondary buyer of premium sports.  For example, BT Sport or Sky pay a fortune for football (soccer) rights in Uk or Germany and can then sell some games to Eurosport. 

 

Discovery's Olympics buy will be interesting - to see what they make of it; and this is something Zaslav has experience of when he was at NBC.  But all these ideas and possibilities are very nascent, at the moment eurosport is a mediocre, barely profitable property and i see a real risk that the pan Europe Olympics deal actual ends up being the thing that kickstarts Sky Sports into trying for pan european soccer deals.

 

We live in fascinating times for content companies and I'm excited to see how Discovery fares.  On the one hand it has some of the best and most ambitious people working there as managers and on the other hand the bosses, Newhouse/Malone, are not wild gamblers.  So it's going to be very interesting to see what happens over the next 5 years.

 

 

[merkhet]

I've been going over the 2015 Investor Day slides since Malone's comments on Discovery in his interview with David Faber. He specifically stated that he favored it over his stake in Charter.

 

Interview: http://video.cnbc.com/gallery/?video=3000452809&play=1

 

Investor Day slides attached. They're also an incredibly good overview of the international market.

2015-09-29_DISCK_2015_Investor_Day_Presentation.pdf

[Picasso]

Where in the video did he make those comments merkhet? 

[prevalou]

At the begining and at the end

[merkhet]

Where in the video did he make those comments merkhet?

 

I want to say two-thirds into the video is when Faber asks about what Malone is willing to give up to make the Charter deal happen. This gave me two pieces of good info. (1) It made me feel more likely the deal will go through since Malone is willing to play ball, and (2) it made me look into Discovery. The slides on the difference between market share and advertising/fee share are very, very interesting.

 

EDIT: The comment of existing Charter and keeping Discovery starts at 22:55.

[Picasso]

Ah thanks.  I listened to the interview very early in the morning so I missed some of the implications behind his comments. 

 

He does (when doesn't he though?) make a lot of great points about Charter/Comcast/Discovery.  I was eyeing Discovery after the Disney pummeling and ended up buying FOXA instead.  But it does seem like Malone is now more interested in DISCA/LGF.... Hmm....

[marazul]

I think he is more interested in Charter than in the content companies. He made his fortune building a cable business. He knows cable like few in the world, given that he created the industry as we know it. He is also an engineer that probably doesn't have a highly creative/artistic mind. Cable is a subscription business, that generates stable cash flows in which you can apply a lot of financial engineering. A studio basically makes huge bets on content development. So the reason why I think he talked a lot about the content companies was this: they experienced a huge decline in market value and Malone thinks the decline wasn't deserved. So he is probably thinking that this is a good moment to buyback stock or invest. In addition, he mentioned he would dispose his CHTR stake before DISCA most likely because he has a larger deferred tax in DISCA (due to his huge ROI). That is my opinion and I might be wrong, but I think the man would love to become a cable cowboy in US once again.

[jay21]

I am not reading into this as much as others. I didn't feel like he was saying he'd rather own DISCA than CHTR even though that's what it sounded like.

 

But to be fair, I can't remember seeing him that excited before.

[loganc]

I am not reading into this as much as others. I didn't feel like he was saying he'd rather own DISCA than CHTR even though that's what it sounded like.

 

But to be fair, I can't remember seeing him that excited before.

 

I agree with this.  I think what Malone meant was that he would give up some voting control at CHTR to facilitate closing the deal.  I am not sure that he meant to say that he would exit his investment entirely. 

 

Regardless, the statements about DISC are obviously very bullish and correspond with the recent $2B increase to buyback authorization and moving the gross leverage target to 3.25x to 3.4x.

[Jurgis]

Swapped DISCA to DISCK, over 5% spread.

[LongTermView]

...

For those of you who are European residents on this board, I would be curious about your opinion on Discovery's European presence via Eurosport.  I am inclined to think that Eurosport is the European version of ESPN.

...

 

Eurosport the european version of ESPN?  You couldn't be more wrong.

I'm not a European resident but thefatbaboon is correct that Eurosport is not the ESPN of Europe.  It's my understanding that Sky Sports and BT Sport dominate sports coverage in England.

 

On another note, A Curious Discovery by John Hendricks is a good read.  There is a lesson about established businesses not taking advantage of new opportunities:

To this day, it amazes me that the three major broadcasting networks (ABC, CBS, and NBC), even after seeing the success of HBO, didn't rush to capitalize on this obvious next step in television consumption.  Unlike us, they had the money and the content.

With a brand like ABC's Wide World of Sports, it would have been simple for ABC to launch an ABC Sports Channel in 1976 - and keep ESPN from ever existing.  And how easy would it have been for CBS to devote its considerable news infrastructure to the task of delivering a 24/7 CBS News Channel?  Goodbye, CNN.  ABC would, of course, eventually acquire ESPN, but at an enormous sum - the price of being late to the game.

There is a big lesson here for established businesses.  So many businesses fail to exploit significant opportunities incubating in their own industries simply because they have failed to correctly define themselves.

[pages 221 to 222]

[muscleman]

Please allow me to ask some dumb questions.

Content amortization seems to be the biggest cost of revenue and real capex. This seems to be a fixed cost, so with the strong revenue growth in the past few years, the profit margin should widen. Why was it narrowing instead? Is that merely because of forex fluctuations?

[dwy000]

Please allow me to ask some dumb questions.

Content amortization seems to be the biggest cost of revenue and real capex. This seems to be a fixed cost, so with the strong revenue growth in the past few years, the profit margin should widen. Why was it narrowing instead? Is that merely because of forex fluctuations?

 

Content amortization should grow as the production costs that are capitalized continue to grow.  Depending on the content it is generally amortized over a fairly short time window too.  But to your point, one of the benefits of Discovery is their huge global platform and that their content (largely reality) should be easily repackaged across their global distribution, so there should definitely be some scale benefits.

[muscleman]

Sorry for a dumb question. Discovery's P/E is about 15 and the projected EPS growth is about 15% as well. Why do you think this is undervalued?  :P

[Picasso]

PE and EPS growth probably doesn't say a lot with this kind of business.  You should be looking at OIBDA.

[dorsiacapital]

I think it's interesting question about depreciation for Discovery.  On the one hand, reality shows are probably(?) more marketable across the world than sitcoms/dramas.  On the other hand, I think reality shows age very, very quickly. (They're still re-running Seinfeld, Simpsons etc., but haven't seen any Bachelor Season 1s) so a shorter depreciation schedule for them may be more appropriate/realistic than for those that produce scripted.  As you can see, content producers have generally shifted over to scripted in the last few years with the rise of on-demand services and on-demand services (Netflix, Amazon) have generally shown almost no interest in producing reality television.

 

 

 

[dwy000]

Sorry for a dumb question. Discovery's P/E is about 15 and the projected EPS growth is about 15% as well. Why do you think this is undervalued?  :P

 

It's not necessarily undervalued in the "buying dollars for 60 cents" perspective.  But it fits the "great company at a fair price" description perfectly.  Phenomenal brand(s), global distribution, excellent leadership, shareholder friendly management, etc.  15x earnings isn't necessarily cheap, but for a company growing revenues and earnings so consistently, with great capital allocators at the helm I put it in the bargain category.  It historically has normally traded in the 20x range for these reasons, even in higher interest rate environments.

[muscleman]

PE and EPS growth probably doesn't say a lot with this kind of business.  You should be looking at OIBDA.

 

Well, my take for the ratios is that cable companies should use OIBDA because D&A is not real expenses. You spend money to build the physical assets and you keep using it for the next 50 years. However, for content companies, the D&A is quite real. You spend money to produce a movie. You release the movie and most of the revenue is collected in the first 2 months. Therefore I think it is appropriate to use  net income plus tax plus interest expense but not plus DA.  :)

 

[muscleman]

Sorry for a dumb question. Discovery's P/E is about 15 and the projected EPS growth is about 15% as well. Why do you think this is undervalued?  :P

 

It's not necessarily undervalued in the "buying dollars for 60 cents" perspective.  But it fits the "great company at a fair price" description perfectly.  Phenomenal brand(s), global distribution, excellent leadership, shareholder friendly management, etc.  15x earnings isn't necessarily cheap, but for a company growing revenues and earnings so consistently, with great capital allocators at the helm I put it in the bargain category.  It historically has normally traded in the 20x range for these reasons, even in higher interest rate environments.

 

 

Good point. A couple of questions regarding this.

1. Malone said he expected US revenue growth to accelerate. I didn't quite understand that. Could you help me gain some insight?

2. How should I analyze content companies in general? What are the most important metrics that I should track?

3. The other member said in this thread that he did research on DISCK but bought Fox instead. How would you compare DISCK with Fox or Lions Gate?

 

 

Thank you!

[Picasso]

Then just give OIBDA a lower multiple on what you feel this kind of content business should be worth.  Otherwise you will ignore real near term cash flow that can be reinvested at attractive returns.  It's also how Discovery views their operating performance, as well as most other content stocks.  Leverage is a factor here too which is why the P/E doesn't mean a heck of a lot.

 

By the way, I'd pay 15x for a 15% EPS grower all day.  Not sure how long estimates are for 15% growth, but clearly that's not in the current stock price.  it's kind of a pet peeve of mine when people mention earnings growth without saying for how long.  It's kind of a useless figure.