Description
Discovery Holding Co. is the latest spin-off from Liberty Media, the gift that keeps on giving. As with all of John Malone’s financial maneuvers, this spin-off isn’t quite as straightforward as you’d like it to be, but that’s exactly why you have a chance to buy an excellent company at a discounted price. Over time, investors should focus on the core fundamentals of DISCA’s primary asset, which is a business with superior economics, forecasted profit growth in the mid-teens for a number of years, and strong asset value in a robust private market. There are also a couple of potential catalysts in one or two years, but more on that later. The stock has sold off a moderate amount since it started trading independently three weeks ago, and I don’t know if the selling pressure has ended or not, but my one-year target price is approximately $21-25/share, or 50-78% upside.
SUMMARY AND VALUATION
Liberty spun out Discovery Holding Co. in July, one share for every ten Liberty shares, and like Liberty, it has supervoting B shares for John Malone et al., and A shares for the rest of us plebes. The B shares don’t really trade, so I am recommending the A shares, ticker DISCA. The share count is 280 million shares. Discovery Holding Co. owns two assets: a 50% stake in Discovery Communications and 100% of Ascent Media.
Discovery Communications, or DCI, is a collection of cable networks that includes the Discovery Channel, TLC, Animal Planet, Travel Channel, and Discovery Health. I assume most of you are familiar with these channels and I discuss them further below, but the important point to know is that DCI is probably the largest, and certainly the best, collection of cable channels held outside the giant media conglomerates (Viacom, Disney, etc.). Three-year trailing EBITDA growth has been 40%, and future growth should be in the mid-teens, if not 20%. At a conservative FY07e EV/EBITDA multiple of 15.0x, DCI is worth $17.78 per DISCA share. At a slightly more optimistic, yet still reasonable multiple of 16.5x, it equates to $20.10 value per DISCA share. Using a per-subscriber valuation, which I think is most relevant in a takeover scenario, DCI is worth $21.61 per share.
Ascent is a post-production services company, meaning it does all the final cleaning and polishing up (editing, sound, color, storing, etc.) of movies, TV shows, and commercials, in exchange for a fee. It’s the biggest post-production firm worldwide, although admittedly the market is fragmented and competitive. Liberty had rolled up the industry hoping to gain economies of scale, but that really hasn’t happened yet to any meaningful extent. Nevertheless, it’s not a bad business, just not a particularly exceptional one. Some observers think that the shift to digital and the explosion in content delivery channels (Hi-Def, wireless, internet, VOD, etc.) could create a surge in demand for Ascent’s services, and that's definitely possible, but I'm not incorporating that into my valuation. Ascent was placed into DISCA only to satisfy requirements for a tax-free spin, and it’s worth one-eighth of DCI on a good day, so rather than spend much time on it here, I’m just going to be conservative and value it at 7.0x FY07e of roughly $100 million (it did $97 million last year, so this is no heroic assumption). Just in case this isn’t conservative enough, I’m ignoring the $120 million and $372 million in federal and state tax NOLs that Ascent has because I have no idea how to value this given the lack of disclosure. But they paid no cash taxes last year despite reporting $35 million in GAAP taxes, and they probably won’t pay any cash taxes this year either. In any case, at 7.0x EBITDA, Ascent gets you $2.50 per DISCA share.
Liberty injected $200 million of cash into DISCA right before the spin, so at the holding company level, DISCA has no debt, $215 million in cash, and minimal overhead of maybe $1 million year – it has zero employees and reimburses Liberty for management and administrative services. Rounding down the cash to $200 million, that’s another $0.71 per share for DISCA.
So, to sum up the valuation:
DCI 15.0x EBITDA $17.78
Ascent 7.0x EBITDA $2.50
Net cash $0.71
TOTAL, low case $20.99 per-share value
DCI 16.5x EBITDA $20.10
TOTAL, optimistic case $23.31 per-share value
DCI per-sub $21.61
TOTAL, takeover case $24.82 per-share value
The stock closed today at $13.97, so the upside to fair value is 50-78%.
DISCOVERY COMMUNICATIONS (DCI)
Since DCI comprises 85-90% of the value here, it warrants further discussion.
The cable networks that DCI owns have as their unifying theme a focus on “nonfiction” or “factual” programming, such as documentaries. DCI has the undisputed top brands in this space – besides the flagship network of the Discovery Channel, it has TLC, Travel Channel, Animal Planet, and Discovery Health. An established cable network is almost without fail a very good business, and DCI is among the elite. It’s among the handful of networks that have great distribution, broad and loyal viewership, solid demographics, brand strength, and durability. Cable MSOs absolutely love DCI. You can find this out through discussion with any MSO, but two research pieces provide good data points. In a 2003 industry survey of MSOs, the Discovery Channel came in third (after ESPN and ESPN2) in terms of perceived value per subscriber. And in a survey done by the trade rag Cable World earlier this year, cable operators picked DCI as the best value of all networks.
Advertisers also love DCI. The CPMs for DCI tend to be on the high side among the major cable networks, and there’s a feel-good factor for advertisers – they love being associated with “good for you” fare like Discovery. They all chase the high-rated trash like Joe Millionaire, of course, but buyers also want to go home to their kids feeling good about themselves, so they allocate dollars to DCI, too.
All this is evident in DCI’s numbers. DCI has 1.2 billion cumulative subscribers worldwide, with just about half in the U.S. and half International. It has presence in over 160 countries and 35 languages. The flagship Discovery Channel claims to have the widest paid distribution worldwide of any network, with over 190 million subs. Just a couple of months ago, the Discovery Channel and ESPN became the first two cable networks ever to reach 90 million homes in the U.S. ESPN is in a category all by itself, so that’s not a comparison I want to make, but after ESPN and MTV, I don’t know if there’s another cable network group with a better franchise, economic model, and growth outlook than DCI. The financials attest to that: Revenues were $2.4 billion last year with an EBITDA margin of 25%. In the past three years, revenues and EBITDA have compounded at 15% and 40% a year.
What makes DCI so good? Discovery’s economic model derives from the nature of its content, which has two highly favorable characteristics. One, it has amazingly broad appeal. I’ve heard management describe it as the only network with programming that appeals to every single person on this planet, and I’m not sure that’s much of an exaggeration. A lot of it isn’t culture specific. It’s not language specific. It’s not age specific. It’s about sharks and the solar system and King Tut and the Titanic, stuff that a grandfather in Turkey can enjoy as easily as a six-year old girl in Canada. Second, the content is low-cost and highly adaptable. Sharks don’t demand higher pay. A shark special is easy and inexpensive to adapt for distribution in various countries – all you have to do is change the voice-overs. It’s also the kind of content that translates well to other delivery systems and uses, such as High-Definition, on the web, and in the classroom. These two characteristics, the broad appeal and low-cost adaptability, make Discovery just about unique in that its addressable market is probably larger than any other cable network’s. This is important, because what it means is that growth is sustainable long into the future, and the potential margins are tremendous. It’s a virtuous loop – it can spread out its programming costs over wider distribution, allowing it to create more quality programming, allowing it get more distribution – that just reinforces the brand and makes the profitability better and better each year. It’s almost impossible for anyone to knock DCI off its perch as the king of non-fiction content.
How to value DCI? There are no good public, pure play comps. But you can back into a rough estimate of how investors value the cable networks at the conglomerates like Viacom, Disney, and Time Warner, and you’ll find that it tends to be in the mid-teens multiple of EBITDA (and many would also argue that these big media conglomerates are all too cheap on a sum-of-the-parts basis). So a 15.0x for DCI, which is faster growing than most of the others and should fetch a premium in a takeover, is actually quite conservative. The big growth engine is the international business, where it has about half of its subs but only a quarter of its revenues and 15% of its EBITDA. International EBITDA is growing very quickly; last year it grew 43%, and the pace will slow this year because of increased investments in growth. But rapid International profit growth should be sustainable over the longer haul, given that the margins are still 20 points below domestic margins and there’s no reason why that gap can’t narrow. In 2Q05, international subs grew 42% year over year, and increased distribution inevitably translates into greater profits down the road. Total DCI FY05e EBITDA will be about $644 million, and a couple years of 16% growth should get that to $866 million by FY07e. I use FY07e to establish a one year target price because that’s what investors will be looking at a year or so from now, and this year’s profits are somewhat depressed by a dramatic increase in investments and temporarily poor advertising results.
FY07e EBITDA $866 million
Multiple 15.0x
Enterprise value $12,990
Less debt $2,484
Less misc obligations $550
Equity value, DCI $9,956
50% stake $4,978
Divide by 280 mil shs $17.78/share value
The 15.0x EBITDA multiple is at the very low end of the going rates in the private market. Multiples paid for established networks have generally ranged from mid/high-teens to mid-20s, with forays above 30x not uncommon. A sampling of multiples paid over the past decade are:
AMC/IFC/WE 14x EBITDA
Bravo 18x
BET 19x
Family Channel 24x
Comedy Central 32x
Of these, Bravo is probably the closest in niche to DCI, although it’s still quite different. NBC bought Bravo in 2002, and GE is about as disciplined an acquirer as you will find, so I think you can be comfortable that they did not overpay. Thus, 15.0x for DCI would merely be a good starting point for DCI in an auction. In my more optimistic, though still reasonable, scenario, I use a 16.5x multiple, which gets you to $20.10 per share for DCI.
A per-subscriber valuation is actually preferable to slapping on an EBITDA multiple in valuing DCI, because it can better account for the various unconsolidated affiliate networks and the non-network operations like retail stores and education sales that are losing money in aggregate but clearly have some economic value that is not captured by EBITDA. The per-sub method can get a little involved, but here’s a simplified version:
FY06e
Subs, mils per sub Value, mils
U.S. Discovery 90 $28 $2,520
U.S. TLC 89 $22 $1,958
U.S. Animal Planet 88 $22 $1,936
U.S. Travel 84 $20 $1,680
U.S. Other 304 $5-8 $1,712
Europe/ME/Afr 185 $12 $2,220
Latin America 98 $7 $686
Asia 410 $5 $2,050
BBC America JV 42 $1 $42
TOTAL SUBS VALUE $14,762
Retail, Education, and Misc. at 1.0x sales $329
TOTAL ENTERPRISE VALUE $15,133
This Enterprise Value translates to a value of $21.61 per DISCA share. The $20-28 per sub values for DCI’s major U.S. networks are in the low to middle range of the deal comps:
AMC/IFC/WE $18 per sub
Bravo $21
Family Channel $27
Comedy Central $32
BET $47
The takeover valuation is appropriate to use, because DCI is an obvious consolidation candidate. It would be an excellent strategic fit for all the major media conglomerates. Most have stated at some point or other that they’d love to buy DCI, and most would admit that they’d be willing to pay top dollar for it. Viacom has been especially vocal about coveting DCI, and their proposed split may make them more aggressive in pursuing it down the road. In Viacom’s 1Q conference call, for example, Tom Preston, who will head the cable networks side of the split, said “We love the cable network business. If a cable network comes up for sale, particularly something that has an older skew, where we have less inventory than kids, teens, or young adults, we would be very interested.” Disney and News Corp would be no less interested in buying DCI if it were to ever become available. As the only major stand-alone cable network group left, DCI is a scarce property, and that should provide some level of support for the stock price.
ISSUES & CATALYST
There are two main issues depressing the stock’s valuation: a large drop in the EBITDA growth in 2005 and DISCA’s holding company structure. As I explain next, both issues should resolve itself in the next two years, as EBITDA growth normalizes and the holding structure diminishes, and these should provide catalysts for the stock.
The first concern about slowing growth arises because 2005 EBITDA is expected to increase “only” 10-12%, compared to 30% in 2004. What Wall Street seems intent on ignoring is that if it weren’t for an intentional hike in growth expenditures, 2005 EBITDA growth would be 20-25%. DCI announced several months ago that it will invest $200 million into new initiatives over a 2-3 year period. International cable networks is spending $100 million over two years to create lifestyle brands, and the Education segment is spending $100 million over three years to ramp up growth. The lifestyle brands are offshoot channels under the Discovery umbrella, such as Discovery Travel & Living and Discovery Home & Health. This should be a fairly low-risk undertaking, since previous offshoots, like Discovery Health in the U.S., have been successes to-date, and much of the expertise merely builds on what DCI is already good at – e.g. the new Discovery Travel & Living brand builds on the U.S.’s Travel Channel and TLC. Education is a bit more venturesome, although DCI has had a presence there for some time. DCI purchased a couple of education-focused companies in the past few years that sell videos and broadband clips to schools. Management is particularly enthused about a broadband product they have called Unitedstreaming, which provides on-demand videos and interactive materials that schools can subscribe to and use in their classrooms and students can use at home. This is a nascent market, and the payoff is unsure, but it’s probably not a bad way to leverage and extend their franchise.
The good thing is that I don’t have to make any forecasts now regarding these two initiatives. The way I look at it, at the end of the 2-3 years, if the initiatives are successful, the incremental spending should begin having tangible benefits and shareholders will be happy. If the initiatives are not successful, the incremental spend will recede, and DCI’s underlying margins and growth will return to the fore. At the very least, the negative impact on the EBITDA growth rate disappears after this year, because they anniversary the spending, so that should provide a catalyst for the stock. You can calculate the rough impact to EBITDA by adding $100 million divided by two and $100 million divided by three, for $83 million total. Since 2004 EBITDA was $591 million, that’s a 14 point negative impact on the 2005 growth rate. This seems like an elementary calculation to make for investors, but Liberty’s complexity has drawn attention away from this. Its many pieces have kept disclosure poor on any individual business, and while DCI’s independence will improve the situation for DCI somewhat, it unfortunately won’t be by much. Liberty has said that because of DCI’s semi-private status, disclosure will be kept to a minimum as long as DISCA only owns a partial stake.
Clouding this issue somewhat are recent ratings problems at the two largest domestic networks, the Discovery Channel, where ratings have stagnated, and TLC, where ratings have dropped significantly. I believe the problems at both channels are fixable, and that DCI is taking the right steps. Over the past couple of years, both Discovery and TLC began chasing short-term ratings and overplayed certain shows and formats. Discovery strayed from the traditional documentary programming that made it so valuable and ran a lot of American Chopper-style “gearhead” shows. TLC had one huge hit show, Trading Spaces, and flooded the schedule with spin-offs and re-runs of the show. Contrary to popular belief, ratings weaknesses don’t automatically lead to revenue declines (see Big Three Networks for proof), and DCI is still seeing good CPM increases and affiliate fee growth, even in the U.S. But the brand, and therefore viewer/advertiser loyalty, has been slightly tweaked, which is a no-no. Management has made it clear that they are re-focusing their programming back to their core strengths, and this should be evident on the airwaves by later this year for TLC and earlier for Discovery. The most important point here is that people are way over-associating this ratings blip with the EBITDA slowdown. The underlying growth rate even with the ratings blip is 20%+, a very healthy rate.
The second issue is the dislike of the holding company structure, which I think is the bigger reason for the stock’s discount. Public shareholders of DISCA are two layers removed from the primary asset, Discovery Communications. John Malone effectively controls the holding company through his ownership of supervoting B shares. And the holding company itself only owns 50% of Discovery Communications, with no access to its cash flow. The other two DCI owners, Cox Communications and Advance/Newhouse (25% each) effectively have veto power over any major capital structure decisions for Discovery, since at least a majority of votes is needed to approve any such action. Investors are extremely disappointed that Cox and Newhouse didn’t contribute their 25% to the spin, which Malone had initially indicated as more likely than not, and that has contributed to the lack of enthusiasm to what would otherwise be viewed as a great opportunity to buy a one-of-a-kind, top-tier, pure play cable network stock.
This disappointment is way overdone, for one simple reason. In order for Liberty to effect a tax-free spin, Cox and Newhouse would have had to give up their combined 50% voting clout which they weren't willing to do. However, and this brings us to the second catalyst, this problem will disappear two years from now, when those tax reasons will expire. Cox and Newhouse should be able to contribute their stakes at that time, and Discovery Holding Co. will be more than happy to structure it in such as way that Cox and Newhouse will retain their 25% voting interests. Thus, I see it as more than likely that Cox and Newhouse will contribute their share in two years or so, and that will remove a large part of Wall Street’s dislike for the structure of DISCA. Even without this catalyst, I think DISCA’s discount should narrow or disappear. If management or ownership were not first-rate, the unusual structure might be an issue, but DCI’s management is top-notch, and your fellow shareowners of John Malone, Cox Communications, and Newhouse are as good as they get in the media world. This is not a land-line telecom company whose value is deteriorating and so should be sold now to maximize value. This is an extremely well-managed, well-financed global brand growing at a strong double-digit pace, and Wall Street is failing to distinguish between the two in its rush to apply its mechanical rule of thumb regarding structure and governance.
WRAP-UP
So, to summarize, DCI should be worth $20.99 to 24.82 a year from now, and some sort of favorable corporate reorganization could help reduce that discount. I consider this range of values to be fairly conservative, given that caution was applied at each step of the valuation process, whether it be in ignoring the NOLs, using the low end of private market multiples for DCI, or giving very little consideration to a potentially big opportunity like Education.
Catalyst
Elimination of margin drag from stepped-up investments.
Resumption of strong domestic growth from re-focusing of programming.
Possible contribution of remaining 50% stake of DCI by Cox and Newhouse in two years.