Description

Investment Thesis:

Discovery Communications (DISCA) is a classic value play and not surprisingly it has garnered a lot of attention on VIC with 6 separate write-ups since 2010.  The stock has gone nowhere since 2012 so one wouldn’t be wrong to label it a value trap thus far. Since the announcement of its acquisition of Scripps Networks (SNI) on 7/31/17, the stock is basically flat, with the market up 30% in the meantime, and forward consensus estimates for 2019 EPS have increased by about 30%, so the stock has effectively de-rated by roughly 30%, to a P/E of 7X.  And with free cash flow running about 20% higher than net income, the free cash flow yield is over 15%. With leverage (at 3.3X net debt to trailing EBITDA) now in its target range of 3-3.5X, excess cash will likely be used to buy back stock. Note that from 2010 to 2017, right before the Scripps merger, the company regularly bought back roughly 5% of its outstanding shares per year, reducing shares by 34%.  We’re not going to beat a dead horse and waste white space with background filler, but we think the market is being overly pessimistic here and think this is an opportunity. Discovery emerged from the Scripps acquisition with greater scale, at a time when there is a renaissance in TV ad spending, and cost synergies are driving margin expansion. We think 2Q19, which showed an acceleration in all 4 of Discovery’s key operating metrics (U.S. ad growth up 6% y/y, U.S. affiliate fee growth up 5% y/y, international ad growth up 5% y/y, international affiliate fee growth up 3% y/y) was not a fluke, and that growth will continue through 2020.  In a nutshell, the stock is priced for no growth to perpetuity. A mere 10X FCF would yield 55% upside to $43.  

Content is King:

In the U.S., Discovery has the second largest share of U.S. TV viewing behind NBC Universal, representing 20% of total viewing time.  It has 25% of U.S. female viewers aged 25-54. Discovery has the top 4 channels in America for women, and no one’s ever done that before: ID, TLC, Food and HF, and they have the number one channel for African-American women with OWN.  Even though Discovery is the number one place to reach women, its cost per thousand (CPM) is less than half that of the broadcasters, and therein lies opportunity. They have developed a package called Discovery Premiere which allows clients to advertise exclusively in a carefully curated mix of premiere episodes from the most coveted series across Discovery’s portfolio of trusted passion brands, like Deadliest Catch, Gold Rush, Shark Week, and Property Brothers.  

Discovery has been working hard to integrate Scripps content largely on its own networks.  They are re-branding in the UK with the UKTV assets, they have launched whole channels in Germany, and they have commitments for launches in Latin America for HG and Food.  The monetization of these efforts is ahead of us. What we haven’t seen yet is selling sponsorship and high CPM packages to endemic categories - something that has been done demonstrably well in the U.S.  The international Scripps opportunity was originally presented as having 3 layers: the first layer being the cost savings, the second was utilizing the content on our existing platforms and the third was launching networks - we’re now at the point where we’re seeing the initial benefits of that third layer.  

What’s been discussed in previous write-ups and Q&A but should be included here is that Discovery’s core legacy networks like Animal Planet travel extremely well to international markets.  There’s very little local production of nature shows so Discovery’s offerings will be the default choice for most bundles.

A winning Direct-to-Consumer (DTC) Approach:

Discovery produces over 8,000 new hours of original real-life programming per year, and they have nearly 500 free-to-air and pay-TV channels with roughly 10-12 in every key market around the globe.  The combination of their strong and trusted brands and huge marketing reach give them a head start in building a DTC portfolio around immersive experiences. Their strategy is to organize their DTC portfolio around 3 broad consumer categories: sports, lifestyle and factual.  In sports they have 3 main products: the Eurosport Player across Europe, Golf TV - a global platform, and Global Cycling Network. Within lifestyle they are working on 3 different subscription-based offerings, all with different product cycles: Motor Trend, focused on car lovers, Magnolia’s unique home decor online market, and in Food they have Food Network Kitchen which I’ll describe in more detail below.  Within factual, they bring the best of Discovery and BBC real-life content to offer a comprehensive “view and do” experience. The tech platform buildout, which will serve as the backbone for Food, Home & Lifestyle and Natural History services, should be completed by the middle of 2020 with launches occurring soon after.

Discovery is in year 1 of a new PGA streaming service and it’s going very well.  Golf is great IP because it’s 52 weeks a year, 50% of the PGA tours are local, plus there’s a European tour, an Asian tour and a Latin American tour.  With Golf Digest you can read about any golf course and figure out where to take a golf vacation. Discovery is seeing great traction on their DTC golf app.  With Golf Digest, Discovery got the greatest editorial staff, the greatest photo library on golf and they put it together with the PGA. Ultimately there may be 100M people who come to golf for free - that’s an advertising platform - they are pre-screened.  They are there because they love golf. They want to see scores, they want to see what people are wearing, and they want to know what’s going on in the golf world. That’s the new broadcast network of the future. Some fraction of that 100M will want to take golf lessons with Tiger Woods. Some of them will want to see all the PGA tours live on their device.  That’s the pay model. Discovery has already climbed the learning curve successfully with Eurosport, and now they are applying that insight to golf.  

The “View and Do” model:

In late October 2019, Discovery launched “Food Network Kitchen” (FNK), the first of what is expected to be a series of DTC services that focus on interactive entertainment within Discovery’s core verticals described above.  It will offer live and on-demand cooking classes taught by celebrity chefs, integration of grocery delivery (click to order ingredients fulfilled by Amazon/Peapod/Instacart) and 24/7 live cooking advice and support. Management believes the target market is tens of millions of subscribers in the U.S.  Note that Food Network reaches 17M unique households on a weekly basis, and foodnetwork.com has 33M average unique monthly visitors. The service will cost $6.99 per month, and it will be available on various platforms with additional functionality integrated with Amazon Alexa. FNK will support 2 other revenue streams: 1) ad-supported, free access to recipes, sample classes and tutorials and 2) e-commerce revenue sharing with Amazon.  The cost of launching the service is low as Discovery will market the service using current distribution channels. The cost is already accounted for in management’s guide of $300M - $400M in DTC costs in 2019. Given the low cost structure, FNK offers the potential to be a meaningfully higher margin DTC offering, as every 5M subscribers could generate $300M-$400M in annualized subscription revenue, boosting Discovery revenues by 4-6%.  

Valuation:

DISCA is generating roughly $3B in free cash flow per year ($4.30 per share), and even with virtually no growth in OIBDA, through debt paydown and stock buybacks, FCF per share is set to increase by about 7%/yr.  Applying a pretty punitive 10X multiple on ‘19E FCF would fetch a $43 stock for 55% upside. As a gut check, on consensus FY20E P/E this would be a 10.9X multiple and on consensus FY20E EV/OIBDA it would be 8.3X (using end of year 2020 forecast net debt).  

Risks:

Competition: New OTT TV competitors such as Netflix, Hulu, and Amazon Video compete for consumer time and ad dollars.  To compete against these threats as well as video games like Fortnite and Apex Legends, Discovery’s production costs are rising while viewer ratings are falling, implying structural margin pressure.

Negative Mix Shift: The transition to the internet platform puts downward pressure on pricing power.  For example, Youtube pays 1/10th traditional TV revenue ($0.03/viewer/hour vs $0.30/viewer/hour) to content owners.  Typical ad loads in premium video content like Discovery’s in the digital world have 80% lower ad loads for the same content in the linear TV ecosystem.

Ratings Pressure: Ratings declines put downward pressure on ad revenue because advertising is sold on a CPM viewers’ basis and lower ratings limit Discovery’s ability to take advantage of the strong scatter market since valuable advertising inventory must be used for audience “make-goods” (audience deficiency units) rather than sold for cash.  

Catalyst

• Earnings 11/7/19 premarket: Yes, no time to act unfortunately unless you can buy after hours.  We do think this is setting up well for another beat and raise but this pitch is not based on an earnings call.

• Summer Olympics: late July/early August should provide a revenue spike in 3Q20, but with elevated expenses the profit uplift will be more modest.

• DTC Initiatives: Will play out through 2020, but early focus will be on the Food Network Kitchen launch.  AMZN should be an important stimulant for growth.