We believe DISCA today is a timely, undervalued opportunity.

Discovery Holdings (DISCA) has 50%+ upside over the next twenty four months with reasons to believe you could see the gap close much sooner.   Furthermore, while you wait, the value of the business continues to compound at a high rate. 

 

The previous write-up and discussion was in-depth (please read) so this will focus on new information and why we think this is an even better investment today than it was 17 months ago.  In preview, the stock price is up only 15% but the key issues are much closer to being resolved – specifically, ratings have improved, the Morris Trust window has opened, which could be a catalyst for simplifying the corporate structure, allowing additional corporate communication to investors, management is being shuffled, etc…  

 

 

The valuation of DISCA is too low due to negative sentiment towards their 1) domestic ratings issues, 2) artificially depressed margins due to investments in their international and education businesses, 3) inefficient holding company structure/lack of company guidance and 4) a general pessimism towards the future profitability/economic characteristics of the media industry which is manifested in compressed media multiples.  As discussed below, we believe all these concerns have a good chance of going away, and possibly in the near-term.

 

 

1)  Domestic ratings issues:  Discovery Holdings is facing ratings issues at two of its largest domestic channels, Discovery Channel and TLC. 

 

To address this issue, the company has refocused content on the Discovery channel towards nature/animal and other documentaries and they have reduced their focus on American chopper type shows to once a week.  If you look at recent quartersof ratings data, ratings have increased overall at the Discovery channel and are stable to slightly increasing in their core 25-54 yr old demographic.  This is already a significant improvement from consecutive quarters of ratings decreases. 

 

At TLC, most of the senior team has been replaced and they have stated that they will not make the mistake of focusing all programming dollars on one show (trading spaces) that is easily replicable and will maintain a more diversified programming line-up. They brought in the head of TLC international to run domestic TLC (Abrahams) who has an excellent reputation in the industry.  The focus is now on young professionals so content aimed at healthy living and eating, taking care of the house and family, getting your career started, etc. 

TLC is already showing ratings improvement in the double digits year over year during primetime slots and in the 18-49 demographic.

 

In addition, Head of ad sales, Joe Abruzze, who came from CBS, has a strong reputation and DISC has moved towards a more decentralized ad sales structure which drives more network specific ad sales expertise and is a structure that has been successful for other media companies.

 

Another factor affecting the domestic business is the number of US cable channels that are losing money or barely making money.  The following stats are not the exact profitability numbers, but are our estimates based on independent data services and comps, and give a general sense of the drag these channels are causing for the domestic business.  We believe some of the channels have significant value.

 

Travel channel made $1m in 2004 and approximately $5m in 2005.  Subs:  80m

Discovery Health lost $40m in 2004 and approximately $30m loss in 2005.  Subs:  60m

Discovery Times lost $8m in 2004 and approximately break even in 2005.  Subs:  37m

Science Channel lost $5m in 2004 and approximately break even in 2005.  Subs:  41m

FitTV lost $27m in 2004 and approximately $25m loss in 2005.  Subs:  43

Discovery En Espanol lost $3m in 2004 and approximately $2m loss in 2005.  Subs:  7m

 

Discovery also owns several other cable channels that are gaining household penetration and contributing to advertising and affiliate fee revenue growth in the US.

 

2) Investments in their International and Education Businesses:

 

In terms of the international business, the earlier post addressed the lifestyle investment initiative of $100m over two years.  In addition to this, there are several channels that Discovery has launched abroad over the past couple of years which are still losing money as they haven’t reached scale.  Discovery is also investing in a German broadcast initiative which John Malone announced at the recent annual shareholders meeting.  It is tough to get an exact idea of how much of a drag these initiatives are putting on the business, but we’ve looked at other European channels that indicate margins in the 30s are not unreasonable.  In fact, we believe that given the low cost content originated by Discovery and the fact that they can spread these costs globally, it is very possible they could achieve margins even higher than those indicated above, although we don’t factor this into our model. 

 

While we are not assigning any value to the education business, it has significant option value due to the targeted business model and market potential.   There are approximately 115,000 schools in the country and 70,000 are utilizing Discovery’s subscription service for nature/science content, but some schools are still on a trial basis.  Subscriptions cost $1,000-$1,500 annually for each content subscription.  If you assume that maybe 50% of schools utilize this service and pay $1,000, you get close to $60m in annual revenues.  This revenue would be extremely high margin given that the programming is currently sitting in a Discovery library and has been largely reformatted and the costs would not be huge to distribute this content.  Our research indicates that incremental margins on this business could be approximately 70% yielding $40m in incremental EBIT.  And if this business is a success, Discovery has said they could provide a similar offering with health related content to schools for a similar price and they could also role out this service internationally (ie. it’s possible to get to $100-$200m in incremental EBIT if this business works out).  In addition, Discovery has already rolled out a product called Cosmeo which is a subscription service for students offered via broadband at home.  It offers an online digital library and interactive learning games for kids in grades k through 12. Cosmeo is built on Discovery’s education business which is currently in 70,000 schools which have 30m students so that will be the current addressable market for this new service (although total US schools are about 115,000 with approximately 53m students). If you assume that 5percent of those 30m students pay for an annual subscription to Cosmeo at its subscription price of $129, you get annual revenues from the business of $193m and EBIT margins for that biz could be in the 60-80% range giving incremental EBIT of $116m-$155m.  As you can see, if you start playing with the numbers, you can see that there is a valuable option on this education business as it could get to $200-$350m in incremental EBIT.  We like the optionality here.

 

3)  Inefficient corporate structure:

Our tax expert reiterated that due to Morris Trust rules, Discovery Holdings could not engage in a transaction until 1 year from the date of the spin-off in order to maintain tax free status.  That window opened in July. Several months ago, Discovery holdings changed its incentive compensation plan. Previously, investment banks would independently appraise the value of Discovery Communications and the accretion in value from year to year would be paid in cash to employees. Under the revised plan, employees are paid based on the accretion in value of the public equity shares of DISCA. So if the stock doesn’t move, these employees will no longer see their incentive units accrete as they had in previous years.  We think it is very unlikely that this revision would have occurred unless it was likely that the corporate structure was to be collapsed or some other corporate event was imminent that would increase the value of the stock. 

 

Recently, Broadcasting and Cable magazine issued an article saying the company’s two parties were much closer than before in collapsing the structure.  The article is pasted in below.

Moreover, the company provides no information to the street right now because of their structure, which means the sell-side is very frustrated and many investors are turned off.  That could change with a collapse of the structure.  

4) General skepticism surrounding the media industry:

 

We think this issue has been adequately addressed in the thread around the previous DISCA post and the Viacom post. Overall, we believe that there still remains significant value in cable assets that have great brands.  We have read consumer survey research indicating that DISC has one of the most well known and popular brands on cable television.  Industry experts uniformly support this finding.  In addition, Discovery’s content positions it perfectly to take advantage of opportunities in New Media: VOD, broadcast and mobile. Discovery is currently investing in each of these platforms and we view these as adding to the optionality in this investment.

 

 

The company’s CEO Judith McHale just retired, which we view as positive.  She was doing a solid job but was a long-time employee who was apparently removed from the details and the company was ready for a change.  She will still be involved in the education initiative as a consultant as she was a big believer in that opportunity but the large majority of her time will be spent on philanthropy and public service.

 

DISC hired a new CFO, Roger Millay, who was the former SVP and CFO of Airgas.  He was involved in several complex M&A transactions at Airgas as well as being heavily involved in the improvement of their communications and IR functions.  We believe he has the relevant skill set to help DISC simplify their corporate structure and build out their IR function.  A new CEO, David Zaslav, was also recently hired from NBC Universal.  David has worked with John Hendricks ever since Discovery was first conceived and David has a very good understanding of the type of content that Discovery produces and is very excited about monetizing the content via a variety of distribution channels.  We have heard good thinks about David and think that having a fresh perspective definitely can’t hurt.

 

Also worth nothing that one director has purchased shares around these prices this year. Paul Gould purchased $1.7m of stock bringing his holdings to $5.5m earlier this year. Gould is very familiar with the business as he is the one who introduced Malone to John Hendricks over 20 years ago.

 

We believe DISCA is conservatively worth $25 per share.  Our conviction comes from our research discussed above as well as disaggregating the business into its components of value, which we believe few investors have done, and also looking at it different ways (e.g. value per hour of content).  A summary of our valuation is below.   

 

Summary:

 

DISCA Value Per Share:

Excess Cash  $.70

Ascent Value $1.50

50% Equity Stake in DCI $23.00

Per Share Intrinsic Value $25.20

Current Price Per Share $16.00

 

DCI Sum of the Parts Valuation:

                               

US Business 2008E EBITDA: $868m x 11x Multiple = EV of $9.5B

Various US Cable Channels losing money 2008E Subscribers 221m x $7/sub = EV of $1.5B

Discovery Int’l 2008E EBITDA: $264m x 18x multiple = EV of $4.8B

Consumer/Commerce Bus. 2007E EBITDA: ($25m) x 6x multiple = EV of ($150m)

Education Bus: 2008E EBITDA: $0m = EV of $0m (we think there is a lot of option value here as described above)

Total EV = $15.7B (valuation implies approximately 14.0x 2008E EBITDA)

Net Debt and Min. Interest = ($3.0B)

Equity Value = $12.7B/280m shares = $46.00 and 50% of that is owned by us or $23.00

 

Implied Subscriber Valuation:

 

If you just take the EV for the cable businesses above of $15.7B and you have 1.2b subscribers, this valuation  implies $13.00 per sub on average (market value is under $8/sub). Recent CourtTV transaction implied $17/sub and the recent E! Entertainment transaction had an implied value of $19/sub.

 

Reproduction value of Discovery Communications is the following:

 

The current enterprise value (after netting out the cash and value of Ascent) is $10.2B and Discovery has over 100,000 hours of owned content (and that number increases by approximately 5,000 hours per year), or $100k per hour of programming content.  Industry sources uniformly agreed the cost to produce content is approximately $200-$300k per hour.  While not all the 100,000 hours are up to date etc…the analysis provides an interesting mile post.

 

Note: in an earlier Value Investors Insight Bill Nygren from this year, states his belief the business is worth low to mid $30s.   We don’t feel comfortable using his (implied) assumptions but obviously that would be additional upside.

 

You can currently buy a great business at 10x 2008E EBITDA – CapEx that is under-researched, offers high returns on incremental capital, is pursuing numerous growth initiatives that look attractive, , is positioned well to take advantage of the increasing number of platform technologies and should grow EBIT at a CAGR of approximately 10-15% for several years past 2008. With financial leverage that translates into an even higher growth rate on the bottom line. At current prices, we believe the downside is very limited and the upside is approximately 55%.   

 

Ratings improvement

Collapsing structure

International Margin Expansion

Returns on several of its numerous investments

Continues value creation on a daily basis while you wait.

 

 

Who Will Own Discovery?

 

By John M. Higgins -- Broadcasting & Cable, 8/6/2006 11:49:00 PM

 

As Discovery Communications Inc. (DCI) looks to replace exiting CEO Judith McHale, the company could be facing an even bigger change. McHale’s departure could help trigger a breakup of the partnership that owns the programmer, most likely leaving DCI a publicly traded company controlled by Liberty Media Chairman John Malone.

 

Three inside candidates are in the lead to replace McHale. The best-known is Billy Campbell, president of Discovery’s U.S. networks, who arrived four years ago to broaden the programming of Discovery Channel, TLC and their myriad sibling channels. Campbell has had a rocky ride, with ratings surging then plunging. Discovery and TLC have rebounded in recent months.

 

Lower-profile candidates are Mark Hollinger, senior executive VP, corporate operations (a 15-year veteran, he is also general counsel, a job McHale once held); and Dawn McCall, president of Discovery’s international operations.

 

Headhunter Spencer Stuart is just starting to inquire into outside candidates. Among them are ex-Nickelodeon Networks Chairman Herb Scannell; ex-MTV Networks President Mark Rosenthal, currently on medical leave as CEO of Interpublic Media; and Landmark Communications President and former National Cable & Telecommunications Association President Decker Anstrom.

 

The hiring process could force the hand of DCI’s partners in resolving the ownership issues. DCI’s three owners—Malone’s Discovery Holding Corp., Cox Communications and Advance Newhouse—have for years had on-again, off-again conversations about shuffling the ownership structure: one or two partners selling out, taking DCI public, or—at one point—selling the company to NBC.

 

Malone took the extreme step of spinning the half that had been owned by Liberty off to shareholders, creating Discovery Holding Corp., which holds little other than DCI stock. He had hoped Cox and Newhouse would participate.

 

Cox may be getting ready to cash in. Industry executives familiar with the partnership say that, after taking on $6 billion in debt to go private two years ago, the cable company wants liquidity for its stake in DCI. Cox is interested in trading it for other media assets or rolling it into a publicly traded company.

 

A Cox spokesman declined to comment. Advance Newhouse President Bob Miron—the partner who has long been the least interested in selling or going public—says only that there is "no pressure" for a change right now: "Everybody’s committed to Discovery; it’s still a very united board."

 

DCI’s owners are already prepping for a future as a public company. Before McHale resigned, DCI had already hired a headhunter to replace current CFO Barbara Bennett, who is stepping aside. Industry executives familiar with that search say DCI has a new requirement: a finance background at a publicly traded company.

 

McHale will remain until Dec. 1 and will be an advisor on Discovery’s education initiatives.