Description

Introduction

We believe Viacom today represents a good outright short and a compelling short against a long position in Discovery Communications. I will therefore structure the write up as a pair trade.

For a good overview of Viacom’s business please look at Mustang’s write up from January 2016.

The gist of the write up below is very simple: both stocks got significantly hit by obvious headwinds in the US Pay-Tv ecosystem but Discovery’s prospects are much rosier than Viacom’s. The market currently values both stocks equally on c. 8.5x EV / EBITDA 2017. Under any reasonable scenario, Discovery should dramatically outperform Viacom. In our base case scenario, we see c. 15% upside to Discovery and c. 25% downside to Viacom over a 12 months’ investment horizon.

Summary investment thesis

The advantage of having a pair trade is that we can isolate the idiosyncratic competitive advantages / disadvantages of the two companies and ignore, to a certain extent, the big elephant in the room: cord cutting. Is the decline in linear TV distribution going to accelerate to 3%+? Is US TV advertising going to fall off a cliff? Is the OTT cannibalisation trend about to accelerate? I don’t know and, to a certain extent, I don’t care. Viacom will perform far worse than Discovery no matter what happens to the wider ecosystem. Our thesis is based on the following 5 key beliefs:

1.       Viacom type of content is inherently the most exposed to OTT cannibalisation and SVOD competition and it is the most at risk from being cut from the bundle. Also, Viacom is over-earning on its non-core channels

2.       Discovery’s business is more resilient than Viacom’s

3.       Viacom has no material international business to hedge its US business

4.       Paramount Studios recovery is well priced in and adds very little upside

5.       Viacom is highly leveraged and has no balance sheet flexibility

We believe the trade is particularly interesting also because it’s highly contrarian. 16 out of the 38 analysts covering Viacom (42%) have a Buy on it, Discovery has only 3 out of 29 Buys (10%). Vice versa, Discovery has the largest number of Sells than any other large media company in the US (6). Finally, Discovery is the 3rd most shorted stock in the S&P500 after Under Armour and Nordstrom, with a short interest above 20%. Conversely, Viacom’s short interest is just 4%.

Viacom has the “wrong” type of content

Viacom’s key stations are Nickelodeon, MTV, VH1 and Comedy Central. Without going into too much detail on each channel, Viacom’s success of the past decade is linked to its current demise. Those networks target, by and large, a very young audience, often millennials (especially VH1). This young audience used to be the most coveted by advertisers. Unfortunately for Viacom, this is also the type of audience most likely to switch viewership from traditional linear to OTT / SVOD. Younger children no longer need to watch Nick Jr. to find their favourite episodes of Peppa Pig, Teletubbies and Max & Ruby. Most of these can be found on YouTube. My eldest son (aged 11) is very much into music and doesn’t know what MTV is. SNL Kagan estimated MTV’s EBITDA alone to be almost $500m and it’s very hard to see a scenario where this will not drop going forward. Furthermore, Viacom originally signed content deals with Netflix in 2012. After expiration of these deals, they signed a new deal with Amazon in 2013. This means that Viacom content can be accessed from different platform and its monetisation potential is therefore affected.

Another problem with Viacom type of content is that it never focused on a specific, targeted and well defined segment of its audience. It used to be very “generic” content, which is perfect for “binge watching” type of consumption for a potentially large share of the population. Unfortunately for Viacom, the customer has become a lot more sophisticated and is looking for very specific type of content. Many TV watchers are fed up with the heavy load of advertising and will not watch ad-based television if not for the very specific shows they are interested in. Viacom didn’t cultivate enough of a loyal fan base which could be maintained in the face of cord-cutting headwinds and competition from Netflix.

Many of the above-mentioned dynamics are not present with Discovery. Discovery never did meaningful licensing deals, preserving 100% of its IP. Its CEO, David Zaslav, spent a lot of time discussing the need for the company to cultivate a loyal base of “super fans”, focusing on “quality” of viewers, not “quantity”. In other words, Discovery content is very specific, very differentiated and can therefore count on a small, buy loyal, customer base. Shark Week / Naked and Afraid / Deadliest catch are certainly not for everybody, but these are shows that can be found only on Discovery. Nothing similar can be found elsewhere. OWN, the Oprah Winfrey Network, targets a very specific type of audience and there are virtually no substitutes for this kind of content on Netflix. Discovery is therefore less exposed to the structural headwinds affecting the industry compared to Viacom and should therefore outperform it on a relative basis.

At the top of the funnel, the difference in performance between the two networks is clear from their respective viewership share over time. As per chart below, Discovery continues to gain market share, Viacom on the other hand continues to lose:

From a financial standpoint, the above dynamic is manifest in 2 ways. First and foremost, advertising revenue suffers because of viewership decline in the case of Viacom. Discovery consistently outperformed Viacom in terms of advertising growth over the last 4 years by over 300bps a year on average:

We believe that this outperformance will continue as Discovery continues to gain viewership share.

The second way their contrasting performance manifest itself in the numbers is through distribution (affiliate) revenues. Both suffer from overall cord-cutting headwinds but the pressure on Viacom is greater for several reasons:

·         Looking at the power ratio (monetisation over viewership), both companies sit on the “right” side of the equation, monetising below their share of viewership (Fox and Disney are the 2 networks wildly over-earning) but compared to Viacom, Discovery is significantly under-earning. We believe this gap will narrow over time via pricing. Discovery can negotiate steeper step-up because of its under-monetisation

·         Affiliate contracts are typically long term, often 5 years, and in the short term are therefore not connected to viewership. However, as per chart above, Viacom share of viewership went from 18% to 13% and for Discovery from 7% to 10%. As contracts get renegotiated, they will take into account the new viewership reality

·         Because Discovery content is “must have” for a small base of loyal fans, it cannot be dropped. Viacom’s content if often fungible. It is therefore not surprising that smaller cable companies like CABO have already dropped Viacom with a subsequent positive impact on margins. No cable to date has dropped Discovery Communication

·         Because of the above, some cable companies are looking to tier their packages. For example, Charter has recently introduced a tiering system that puts Viacom in their top “gold” package. In other words, customer looking for the “basic” package will not have Viacom. Viacom is currently fighting this but the outcome seems inevitable

Due to the above reasons, Viacom distribution revenue has underperformed Discovery’s by c. 200bps a year. We note that this revenue stream has been much more stable for Discovery than for Viacom due to a number of SVOD deals, but fundamentally Viacom underperformed Discovery consistently. We believe this underperformance will continue and, if anything, the gap between the two networks will grow wider:

Finally, Viacom has a very specific idiosyncratic issue to deal with. The company and its new management, led by MTV’s former head Bob Bakish, have expressed the desire to focus the effort and the distribution priority on the 6 core channels, where one would expect the biggest improvement in ratings. However, according to SNL Kagan, the non-core networks contribute approximately $1bn in EBITDA (c. 30% of media networks) which are at significant risk of being dropped by distributors as de-emphasized by Viacom in its quest to make core channels relevant again. This issue exists only to a very limited extent at Discovery, as most economics are derived from its core channels. This will be an incremental headwind to Viacom compared to Discovery.

In summary, Discovery outperformed Viacom on advertising by c. 300bps a year and in affiliate fees by c. 200bps. For the structural reasons explained above, we expect this divergence to continue and, if anything, grow larger. We therefore believe Viacom’s domestic business should trade at a discount to Discovery’s. We don’t know what is the right multiple, as this is a function of how bad market headwinds will be. We can say though with a high degree of certainty that whatever multiple one applies to Discovery, a smaller one should be applied to Viacom.

Business resilience

Irrespective of whatever views one may have on the status of the advertising cycle, Discovery is better equipped to deal with the inherent cyclicality of the advertising market for 2 key reasons.

First and foremost, Discovery margins are best in class in the industry, primarily due to the type of content produced. Discovery has very little scripted content with minimal long term commitments beside the European ones for Bundesliga rights and for the Olympics. Because of this, US margins are in the high 50s. This is also thanks to the fact that Discovery’s content travels well across languages and geographies and can therefore be leveraged across a global distribution platform. Conversely, Viacom exhibits worst in class margins in the low 30s in its domestic market, precisely because of the nature of its content (scripted, geographically difficult to export, often based on long term commitments). Operating leverage at Viacom is therefore a lot higher than at Discovery. Furthermore, the ability to cut content costs at Discovery is also a lot higher. In a recessionary environment, the downside to operating margins at Viacom is much greater than at Discovery.

The second important reason is purely mathematical. US advertising represents approximately 38% of Media Networks Revenues (i.e. of the “cable” business excluding Paramount). For Discovery, US advertising represents approximately 25% of the total. Operating costs are fairly fixed in the short term so the bottom line impact of an advertising recession is far greater for Viacom compared to Discovery.

Combining the two important differences allow us to better understand why Discovery business is a lot more resilient than Viacom’s. We illustrate the point below. Assuming everything else equal (i.e. no change in the distribution business, no change in international business and excluding Paramount), the EBITDA impact of a 10% advertising recession would be twice as big for Viacom than for Discovery:

That’s another reason why we think Discovery should trade at a higher multiple than Viacom.

Lack of international business

Our basic premise is that relative to the domestic business, the international Pay-Tv business is a better one. There are numerous reasons for this:

·         Pay TV is in decline in the US whereas it’s still growing everywhere else. Even in very developed and mature markets like the UK, Pay TV penetration is only at 50%. Internationally, Pay TV is still a growing business

·         Cord-cutting is not as big of a challenge internationally as it is domestically. The main reason is price. In the US, a full cable package costs as much as $100 a month. In Europe, it’s anywhere between $30 and $60 per month. Netflix is clearly cheaper but not much cheaper. Internationally, Netflix is very much seen as a complementary service rather than a competing one. There was a very interesting study made in the UK showing that Netflix penetration was higher in homes with a Pay TV than in those without

·         Pay TV is still taking market share away from Free to Air television, something that doesn’t really exist in the US

·         Netflix content in the US and some other countries may be good enough for some customers but in countries with different languages / preferences (e.g. Brazil, France, Italy, Germany), Netflix is considered a nice add-on, certainly not a substitute for local content rich Pay TV networks

For the above reasons, we believe that fundamentally the international Pay TV business should trade at a higher multiple than the domestic one. Again, we don’t know exactly what the right multiple is (looking at competitors such as Mediaset, Canal Plus, RTL, Mediaset Espana etc. we’d argue it somewhere around 9x EBITDA) but it’s certainly higher than the domestic one.

From this perspective, Discovery is much better positioned than Viacom. Not only Discovery’s international business represents almost half of total revenue compared to Viacom’s 20%, but prospects for Discovery internationally are also much brighter. Discovery is growing its international distribution business double digit and growth is set to accelerate. Margins are also set to expand for Discovery after years of content and technology investments, having acquired Bundesliga rights and Olympic games rights for its Eurosport channel and having launched digital distribution platforms like Dplay and Eurosport player. From this perspective, Viacom finds itself behind the curve.

If the international business can be considered some sort of “hedge” to the main domestic business, Viacom is relatively unhedged compared to Discovery and should therefore trade at lower multiple.

Studios recovery already factored in

One of the bull cases on Viacom (which doesn’t exist at Discovery) is the upside from the recovery at Paramount. We would argue it’s already priced in. Paramount lost nearly half a billion dollars in operating income in 2016 and is expected to be in the red again this year. In each of the last 5 years, revenues declined year on year. The business is expected to generate little over $3bn in sales this year and the most bullish analysts believe that operating income could reach $200m by 2020. Even assuming they can eventually generate $300m in operating income, which would be the highest figure ever generated by Paramount under Viacom ownership, and apply a 12x multiple, we would get a $4bn valuation. This would represent only 15% of current enterprise value. Every analyst on the street already models for a steep recovery in its fortunes so the incremental value that Viacom will generate from Paramount will be minimal at best.

Viacom has no balance sheet flexibility

In our view, Discovery should trade at a premium to Viacom due to a better balance sheet situation, allowing them to deploy capital in shareholder accretive manner. Both stocks trade on c. 10-11% free cash flow yield but Viacom is currently over 4x leveraged Vs. 3x for Discovery. The difference is material. Discovery can use 10% of its market cap every year in different ways. At the moment, it’s using it to buy back stock. All else being equal, buybacks add c. 10% of EPS growth a year. Assuming just 5% net income growth per year, Discovery is a 15% EPS grower for the foreseeable future thanks to its cash generation. Alternatively, Discovery could use cash to start a dividend or to make strategic acquisitions. This balance sheet flexibility deserves some sort of premium.

Viacom on the other hand is intent to reduce its large pile of debt. It pays a meagre 2% dividend and the rest of the cash is used to improve its over-leveraged capital structure.

We believe a valuation premium for Discovery is justified not only because of the upside potential from capital deployment, but also because of recession resilience. We discussed above why Discovery’s business is more resilient than Viacom’s from an operating perspective. This is all the truer if we consider their respective balance sheets. In a full-blown recession, leverage level would blow out of proportion for Viacom and the stock price would trade at distressed levels.

Valuation considerations

Whilst on P/E basis Viacom appears cheaper than Discovery, this is only due to its higher debt load. On EV / EBITDA, they trade very much similarly at c. 8x EV / EBITDA:

As hopefully clear from the points above discussed, we believe this is fundamentally wrong. Discovery has done much better than Viacom in the past (EPS growth 2015-17E for Discovery was +33% and -30% for Viacom!) and should do better going forward. It is interesting to note that Viacom share price over the last 2 years dramatically underperformed Discovery’s but this was not due to a derating, it was due to a fundamental underperformance of the business. In fact, if we look at the valuation of the two businesses since August 2015 (when the whole media complex collapsed following Bob Iger negative comments on ESPN), Viacom’s multiple expanded whilst Discovery’s compressed further. We believe this does not make any sense and it will revert over time.

Below, we are going to try to come up with a fair value for both stocks. We are making 3 simple assumptions which should be fairly non-contentious in light of what we discussed above:

1.       We are valuing the domestic cable (media networks) business of Discovery at 1x EBITDA turn premium to Viacom to reflect the advantages Discovery has over Viacom (higher growth in affiliate revenue, higher growth in advertising, higher margins, balance sheet flexibility, lower cord cutting exposure etc.)

2.       We value Paramount at $4bn, arguably generous

3.       We value the international business at 9x EBITDA. Arguably, Discovery’s international business should trade at a premium to Viacom’s but we don’t assume that just to be conservative

On a 12 months horizon, we see c. 15% upside to Discovery and c. 25% downside to Viacom:

Another way to look at this, assuming again $4bn valuation for Paramount and a 9x multiple for the international business, the market is effectively pricing Viacom’s domestic business at a 20% premium to Discovery, which is clearly absurd:

Risks

The single biggest risk is in our opinion M&A activity. We have seen the trend towards vertical integration with the acquisition of Time Warner by AT&T. Many see this move as the first in the sector with more to come. Both Viacom and Discovery are potential targets. Similarly, both companies are potential targets for horizontal M&A with other cable networks that are looking to gain leverage in the negotiations with distributors. There are many different potential scenarios including a merger between Viacom and CBS and one between Discovery and Scripps Networks. These are both upside and donwnside risks to our thesis that are difficult to handicap.

Catalyst

* Quarterly results showing divergence in performance

* Further tiering on Viacom content

* More distributors potentially dropping Viacom