Discovery Communications: An In Depth Analysis

DISCK: Discovery Communications Inc. Strong Buy

We recommend Discovery Communications Inc. (NASDAQ:DISCK) (NASDAQ:DISCA) as a Strong Buy, based on strong revenue and profit growth from scientific, educational and non-fiction media content business and ample free cash flows, Fair Value Price of $64.90 per share.

RECOMMENDATION

We are reiterating our Strong Buy rating on Discovery Communications Inc. (NASDAQ:DISCK) (NASDAQ:DISCA) Class C Common Shares and reducing our fair intrinsic value target price from $65.67 to $64.90, which is over 20% above current levels.  We expect to see the company generate earnings per share of $2.70 in 2012 and to increase EPS by 15-20% annually over the following three years.

COMPANY OVERVIEW

Management: John Hendricks Founded the Discovery Channel in 1985 and still serves as the Chairman of the Board.  David Zaslav has been CEO of Discovery Communications since 2007.  He has executed a number of initiatives that have focused the organization on growth, performance and operational efficiency.  He has directed a strategic effort to clarify and strengthen Discovery’s world-class brands, including a renewed focus on creativity and a nearly two-fold increase in investment in original content.  Prior to Discovery, he had worked at NBC since 1989 and played a part in the creation of CNBC and MSNBC.  Zaslav also oversaw NBC Universal’s interests in A&E, The History Channel, The Biography Channel, National Geographic International, the Sundance Channel and TiVo.

Business Overview: Discovery Communications Inc is an industry leading developer of high-profile, educational, scientific, nature-oriented and other documentary quality content for many media platforms including television, digital, mobile and publishing.  Previously headquartered in Englewood, CO, DISCK relocated to Silver Sprint Maryland in 2009 and has offices in New York, Los Angeles, Miami and Sterling, VA.  Discovery Communications Inc. (NASDAQ:DISCK) (NASDAQ:DISCA) has 4600 employees; only about 5.4% are subject to collective bargaining.  On September 17, 2008, Discovery Communications Inc. became a publicly traded company as the result of a corporate reorganization.  The reorganization involved Discovery Holdings spinning off its money-losing Ascent Media subsidiary and merging with Advance Publications’ Advance/Newhouse Communications subsidiary.

The company’s media portfolio includes these popular networks:

 

Source: Discovery Communications 2011 Annual Report

Ownership: More than 30% of the outstanding stock is controlled by the Advance/Newhouse Programming Partnership, an affiliate of Advance Publications.  The partnership owns 33.2% of the outstanding Class A Shares through its Class A Convertible Preferred Stock and 34.7% of the Class C non-voting Shares through its Class C Convertible Preferred Stock. The partnership owns about $7B worth of stock in Discovery Communications.  The Founder and Chairman John Hendricks owns 1% of the stock and his stake is worth ~$214M. Liberty Media Corp (Capital) (NASDAQ:LMCA)’s John Malone has 10.56M shares representing 2.75% of the company (~$578M). The rest of the executives and board members own about 1.7M shares directly and indirectly through options which provide a satisfactory level of alignment between the interests of stockholders, management and other stakeholders. We would prefer that the company end the tri-share class ownership structure as holders of Class A Shareholders are entitled to one vote per share, Class B Shareholders are entitled to 10 votes per share and Class C holders get no votes. Notable Mutual Fund/Institutional Asset Management owners include Harris Associates (Manager of the Oakmark Funds) with 5.2% of outstanding Class C stock and the Fidelity Contrafund with 6.7% of outstanding Class A stock.

SUMMARY OF OBSERVATIONS

We like the fact that the firm has been able to increase its high consolidated corporate operating margins from 20% in 2003 to 41.8% in YTD 2012 and we feel that the company can maintain or steadily expand firm operating margins, due to its increasing scale and balanced growth from acquisitions and organic growth of the core business.

DISCK has increased its revenue from $1.86 Billion in 2003 to $4.235 Billion in 2011 (10.8% CAGR) and its profits from $100 Million to $1.1B Million (35% CAGR) during the same time period.  DISCK achieved this through organic volume growth as well as selective acquisitions during the period.  FY2011 and YTD 2012 saw revenue growth exceeding 12% and 7% year-over-year respectively. We are especially impressed to see that the company had increased revenues each year since 2003. It even increased revenues by over 2% during the 2009 economic trough.

Source: DISCK’s SEC Registration, DISCK’s 2011 Annual Report and Our Estimates

We are attracted to DISCK because DISCK’s networks have a strong following amongst its viewers.  This loyal viewer base lends itself to natural product placement and sponsorship opportunities as DISCK’s networks rank highly in middle class and affluent households.  The company works hard to build relationships with advertisers and evidence of this can be seen through the exhaustive upfront ad sales process. Most cable networks have one upfront presence location in New York but Discovery Communications has an upfront presence in four major cities. Discovery Communications Inc. (NASDAQ:DISCK) (NASDAQ:DISCA)’s networks benefit from barriers to entry, making it extremely difficult for a startup network to simply replicate the content and compete. For example, a new network may be rejected by some distributors, and even willing partners require initial incentive payments for several years.

Source: Facebook and Discovery Communications 2011 Annual Report

We also believe that the firm can continue to achieve its strong operating margins.  In 2007, DISCK’s segment operating margin was 20% of revenue and the company was able to increase it to 41.8 % in YTD 2012.  Even at the bottom of the economic crisis in 2009, DISCK still recorded a 30% operating margin, which is impressive and shows its ability to mitigate its downside from weak economic environments.  Depreciation and amortization of purchased intangible assets only accounts for 2.65% of revenues and more than covers CapEx.

Source: Discovery Communications 2008-2011 Annual Reports and Our Estimates

VALUATION AND PROJECTIONS

Our $64.90 per ADR FV is based on applying a 19 times price to earnings multiple to estimated 2015 earnings per ADR share of $4.80 and discounting the terminal value back to October 2012 at a cost of capital of 11%.  We believe that DISCK is undervalued by 20.9% relative to the current market price.  Although DISCK’s forward Price to Book and Price to Tangible Book ratios are higher than the average broadcast firm, we believe it is justified due to DISCK’s superior franchise and focus on science and outdoor niches, which explains why DISCK’s forward PE is lower than the average broadcast media company.  DISCK also has a lower beta than its peers, even though it offers higher potential return prospects in our opinion.  We also believe that the multiple used is justified considering that the firm has grown faster than its industry on the strength of its superior growth and ability to meet or beat EPS estimates from sell-side analysts.

We believe that the company will continue to grow its core science and outdoor media businesses.  We see continued increases in revenue from advertising and network affiliate revenue. We are glad that the company was able to record a 7% revenue increase in 2012 despite the global economic turmoil headwinds that media companies faced.

RECENT QUARTER (Q3 2012)

The company saw mixed performance during the quarter but year over year sales increased by 7% despite a challenging economic environment.  The company enjoyed positive operating leverage during the quarter as operating costs, depreciation and expenses declined at a slighted faster rate than revenue (2.15%).  Operating income increased by over 2.3%.  We also took note of the strong cash flow generated, as Cash Flow from operations were $771 Million for YTD 2012 and $1.1Billion for 2011, which enabled DISCK to buy back $1.03 Billion in stock during H1 2012 and $900 Million for 2011.  These figures were net of proceeds from employee equity-based compensation program issuance.  The company enjoyed solid growth in internationally (7% from international), which offset a 4% decline in its domestic operations.  Education and other saw a 13.6% decrease in revenues but only accounted for 2.3% of Q3 2012 revenues.

We like that Debt Net of Cash only accounts for less than 34% of adjusted assets. Although the company has total debt that represents 41% of total assets, the company could easily pay it down by devoting 5 years of net income from continuing operations to pay it down. DISCK has $1.55B in cash and $821M in strategic investments in equity method affiliates.  We like to net out the cash from the outstanding debt and this reduces net debt to less than 34% of adjusted assets.

KEYS TO INVESTMENT THESIS

We like that its debt is low-cost and long term.  DISCK’s debt has a weighted average annualized interest cost of 5.2% and less than 20% of its debt is due within the next five years.  In Q2 2012, the company raised $1B in low-cost debt in two tranches ($500M @ 3.3% for 10 years and $500M @ 4.95% for 30 years). Although the company has no outstanding borrowings under its long-term credit facility, it extended the credit facility by two years and it is now available until 2017.

 
Source: Discovery’s Q3 2012 10-Q

DISCK’s prudent cash management on behalf of shareholders. DISCK repurchased $1.45B in stock in 2010 and 2011 net of share issuance for employee stock options.  DISCK has $3B remaining under its current authorization as management increased it by $1B.  DISCK has repurchased 13% of its outstanding stock since the beginning of 2010. YTD as of Q2 2012, the company repurchased another $1.033B in outstanding stock net of employee stock issuance.

We like the low capital expense requirements of the business. We can tolerate acquisition activity by DISCK due to its low capital expense requirements.  We feel that acquisitions of small but established media content properties serve as a great avenue for the company to engage in growing its business. DISCK converted 80% of its 2012 net income to free cash flows, which included the impact of $195M in net business investments such as acquisitions, CapEx and investments in equity method affiliates.

Source: DISCK’s SEC Registration, DISCK’s 2011 Annual Report and Our Estimates

DISCK properties enjoy strong demand. DISCK’s properties have a strong and devoted following.  We referred earlier to DISCK’s availability and Facebook Fans.  The Discovery Channel alone has over 12.3M Facebook Inc (NASDAQ:FB) fans and its other properties also have another 11.8M Facebook fans. DISCK’s network properties are successful because DISCK shows high quality, real-life content and created multiple network brands in order to attract and retain viewers.

TLC is the top rated network amongst adult women. TLC built a broad, stable of returning hits, including 17 series that deliver over 1 million viewers, and TLC is the #1 ad-supported women’s cable network on Friday nights. TLC is in over 125 million homes, and is the #1 women’s network brand in the world versus no international distribution less than 2 years ago.  TLC also has nearly 1.66M Facebook Inc (NASDAQ:FB) Fans.

RISKS TO ACHIEVING FAIR VALUE TARGET PRICE

• Failure of investment community to recognize DISCK’s competitive advantages, resulting in a stagnant or declining price/earnings ratio.

• Carriage disputes between DISCK and cable vendors resulting in lower fee growth to DISCK or even seeing its channels temporarily or permanently dropped.  These disputes forced us to reevaluate our interest in adding AMC Networks Inc (NASDAQ:AMCX).
• New content developed or acquired fails to work out (Oprah Winfrey Network).
• Changes in public and consumer tastes and preferences could reduce demand for its content, reducing business segment profitability.
• Consumer behavior changes resulting from new technologies and distribution platforms.  We think that DISCK will be able to handle it better than other competitors due to the fact that DISCK business segments had utilized the web in order to increase brand awareness of its content.
• Global Macroeconomic changes reducing demand for DISCK’s content.
• Issues relating to intellectual property rights and protections.
• Changes in FCC rules and regulations, particularly with regards to spectrum allocation.
• Issues relating to entertainment personalities on DISCK programs (Discovery Communications Headquarters hostage crisis).

• Loss of key entertainment or business personnel.

MEDIA AND TELEVISION INDUSTRY OUTLOOK

Discovery Communications faces direct and potential competition from other cable and broadcast television networks, online and mobile outlets, radio programs, billboards and print media.  With capital markets showing measured gains, we believe that there is potential for consolidation. Examples include Cumulus Media Inc (NASDAQ:CMLS)’s acquisition of Citadel Broadcasting Corp (PINK:CDELB), Sinclair Broadcast Group, Inc. (NASDAQ:SBGI)’s acquisition of eight TV stations owned by Freedom Communications in a move for Freedom to eliminate its debt, E.W. Scripps Company’s acquisition of The McGraw-Hill Companies, Inc. (NYSE:MHP)’s 10 TV stations and Scripps Networks Interactive, Inc. (NYSE:SNI) acquisition announcement of Travel Channel International.

The broadcast, cable and satellite industry will see a one-year spike in advertising revenues due to expected increases in political advertisement spending for the elections. Excluding political spending, we expect to see measured increases in advertisement spending, as the United States economic recovery is tempered by continued weakness in Europe as well as slowing growth in Asia and Latin America.  Also, we have seen several TV station groups and networks begin to reap a new revenue stream of retransmission payments from cable operators and satellite TV providers. As more of such affiliate contracts come up for renewal over the next several years, this nascent revenue base should ramp up significantly, likely providing TV broadcasters an important buffer for traditional advertising revenues.

Overall, we feel the industry is fairly valued, however we would use declines in the market to add to positions in high quality firms like Discovery Communications and Scripps Networks Interactive, Inc. (NYSE:SNI) and gains in the market to sell weaker firms.  We are especially pleased that Discovery Communications does not appear to have many direct competitors in the segments that it operates in due to the company’s focus on specialty niches. The only competition DISCK has is primarily competition from other interests and consumer tastes, i.e. sports media, movies, business, outdoor and nature themed programming, news, popular music, religious themed content and ethnic-oriented shows, for example.