Discovery (DISCA) has a tremendous portfolio of content after the Scripps acquisition. For some, this company could be an interesting short-term opportunity, but when considering the company’s debt levels and difficulty to create a compelling direct-to-consumer (DTC) platform, I would avoid this stock as a long-term investor.
The positive side: great content
In short, Discovery generates sales primarily in two ways: 1) selling advertisements on linear and digital platforms, and 2) selling distribution rights to cable operators, DTH satellite operators and telecommunications companies. The company has a portfolio in the U.S. that most will recognize but also some abroad sources of revenue, including Eurosport. The top 4 brands in the U.S. (Discovery, HGTV, Food Network, and TLC) were all in the top 25 by viewers in the US in 2019. This last quarter, HGTV, Food Network, and TLC, all were top non-news networks for women between the ages of 25 and 54.
In sum, Discovery has a tremendous amount of talent that viewers love as a result of its original content and content acquired in the Scripps acquisition. A key competitive advantage is their huge library of unscripted content, which can easily be adjusted to fit the company’s various overseas operations.
COVID-19 has had a direct impact on the business despite the additional time spent at home by most consumers. On one hand, the stay at home growth has likely increased the interest in certain networks like Food Network and HGTV, which introduce viewers to new cooking recipes and DIY home-improvement projects. However, advertising interest has sputtered as a result of a slower economic environment. According to the company’s latest conference call, they believe that advertising is starting to bounce back. Going forward, as the global economy recovers, advertising spending will likely continue to recover so long as consumer strength remains robust.
The company is severely indebted, which gives rise to some concern. The positive spin is that the company does not have a significant amount of debt coming due at once and has a reasonable amount of cash on hand. The company’s debt is likely not a huge concern until March 2023, when its 2.950% note is due. However, in aggregate, the company’s debt is meaningful and will decrease flexibility in the long run.
Unfortunately, there is not a very clean comparables set to compare Discovery to in order to perform a relative value analysis. The closest peers are ViacomCBS (NASDAQ:VIAC), AMC (NYSE:AMC), and Fox (NASDAQ:FOX). Based on this set of comps, the company’s present valuation from a pricing perspective does not look overly cheap, but take this with a grain of salt as the comp set is not robust by any means.
As I have explained in previous articles, my investment philosophy is very fundamentally oriented. I generally focus on DCF valuations in order to justify whether or not to buy a certain stock.
Based on my assumptions, I arrived at a valuation of Discovery at about $32/share, roughly in line with its pre-COVID levels. Key assumptions for my model include:
1) High growth rate of about 4%, which is roughly in line with the global media industry average (Source: Damodaran online). For years 6-10, the growth rate is adjusted downwards to smooth out to the terminal growth of 2%.
2) Sales to capital ratio of 0.90 vs. industry average of 1.13. Discovery has been a bit inefficient at investing and adapting to the streaming world, so I decreased its reinvestment efficiency relative to the industry in my model.
3) Operating margins of 22%, which is in line with media average, and slightly less than its current pace of about 26% on a TTM basis.
4) Probability of failure of 5% given its significant debt load.
5) Cost of capital of about 5.5%. I used a bottom-up beta for the Media industry of 0.73, and adjusted it for the company’s capital structure. Given the company’s large debt load, I assumed that their BBB- rating would become BB.
Source: Based significantly on Author’s assumptions. This is not investment advice.
Before investing in a stock, I first analyze whether or not I think the stock is “cheap”. Then, I ensure that there is an adequate “margin of safety” as DCF models can be highly sensitive to my assumptions. Finally, I consider what could go wrong to bring about trouble to the company.
Based on current valuations, I can understand why an investor would purchase Discovery. It has plenty of cash flow each year, has dominant content and brands, and is likely trading at a discount to its intrinsic value. In the short run, the company’s repurchase program will likely help support the stock from these levels. It is not unforeseeable for the company to bounce back to its pre-COVID levels.
I have a few reservations about this company that have made me decide to steer clear.
1) While the company has strong short-run liquidity, it will continue to have to pay down its debt for years to come. In my eyes, this will decrease some of the flexibility that management will have in the future.
2) I am a bit weary about the company’s adjusted OIBDA figure that it points investors to. To me, this is a highly flawed figure because it does not factor in content expenses, which are amortized each year as content assets are a capitalized figure. For a media company, content expenses are one of the most important factors that drive cost. The company’s statements of CFO reconcile the differences between its content amortization and actual cash flow spent on content assets each year.
3) The company keeps investing in a DTC platform, but has yet to roll it out. The question that will drive growth in the future for the company is whether or not this DTC platform succeeds. Netflix, Disney Plus, Hulu, and others already get a fair share of consumer’s spend on streaming platforms. Will individuals go for another platform? At a certain point, will all of this unbundling actually be more costly than cable/satellite?
People love the content of Discovery, but my view is a lot of this content is something that plays better on a linear platform, or a more diverse DTC platform. Based on my personal biases, I think these types of shows are great when there is not much else on TV, but I question whether consumers would actually pay for an additional platform to watch this content. I don’t see a strong catalyst to drive people to a DTC platform, so the key factor will be whether the company can continue to deliver compelling content that would make someone need to sign up. Other platforms, like Netflix, have a value proposition to consumers that is more compelling than a Discovery DTC platform, which is a bit more niche.
Finally, there is nothing stopping Netflix from continuing to develop more unscripted content that can directly compete with Discovery. Netflix already has a fair share of cooking, home improvement, and other shows that compete with Discovery’s lineup. Discovery undoubtedly has the upper hand right now in terms of content, but I am not sure this is a strong competitive advantage given how cheap unscripted content is to produce.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.