Discovery, Inc. (DISCK) is cash flow machine but the changing media landscape has investors nervous smaller players will struggle to deal with the transition from traditional cable/satellite TV to OTT platforms. This has left Discovery trading at some attractive multiples (EV/EBITDA- 7x & P/E- 7x, P/FCF- 6x), all below the industry averages.
While it is true that scale is an essential factor for this transition, Discovery has a library with over 60,000 hours of content and can produce roughly 8,000 hours annually (Discovery owns its content and as the saying goes “content is king”). Discovery’s launch of its own OTT service is expected in Q1 2021 and its low cost of production (unscripted shows), planned niche offering, and expected affordable price point should allow Discovery to create a successful streaming service. Discovery is also still making solid margins in the cable TV business and will continue to do so despite the secular industry shift.
Company background and recent developments
Discovery is a global media company that provides content across multiple platforms such as pay TV, FTA, authenticated TV applications, and OTT platforms. Its channels include Discovery, HGTV, TLC, Animal Planet, and Eurosport. They operate in two segments; U.S. Networks and International Networks. The U.S. Networks segment generates 65% of revenue and 80% of adjusted OIBDA (operating income before depreciation and amortization). Advertising and distribution revenues make up 98% of their revenues and their largest costs relate to producing and acquiring content. John Malone, the famed media mogul, is a major shareholder and has significant voting power.
In March 2018, Discovery purchased Scripps Networks Interactive, Inc. for $12B ($8.8B cash and $3.2B stock). At the time of the acquisition, Scripps was generating approximately $3.6B in revenue, $650M in net income, and $900M of fcf on an asset base of $6.5B (based on Scripps FY17 numbers). At the time of the deal Discovery expected $350M of annual cost savings from the deal, but this was later adjusted up to around $600M. The deal added female focused channels such as HGTV, Food Network, and Travel Channel to Discovery’s predominantly male portfolio. Analysts agreed with the acquisition’s rationale (consolidation to increase leverage over cables providers and to create a larger library of content), but viewed the deal as expensive and not enough to offset the secular move away from traditional cable TV. The stock fell to around $15 after the acquisition was announced (was trading around the $25-$30 before rumors of the deal) but recovered to $20 by the time Discovery took control of Scripps. The stock currently trades at around $24.
The media industry has been undergoing a secular transition away from cable TV and towards content streamed over the internet, consumers now prefer choosing what they watch and when. This has led to the rise of OTT services (Netflix, Amazon Prime, Disney+, Hulu etc.) and consumers cutting-the-cord, where Discovery has historically operated. Discovery has been slow to release their own U.S. streaming service, expected in Q1 2021, but has added options such as TV Everywhere (where you can log into an app and stream using your cable TV provider) and Eurosport Player. Discovery’s streaming is not planning to compete directly with the large streamers, instead focusing on their lifestyle niche and continuing to take advantage of their structural position as a low-cost producer of unscripted content.
Discovery is objectively cheap on pretty much any valuation ratio. However, to understand whether it trades below its intrinsic business value we need to analyze how they will navigate cord-cutting, the potential structural advantages Discovery has in OTT streaming, and the planned transition. We’ll go over these items below before looking at valuation and potential risks. We’ll focus on the U.S. due to generating around 65% of revenue and over 80% of operating profit.
There are currently around 82M households paying for traditional TV in the U.S., this may sound like a lot, but there were over 105M back in 2010 (the peak of cable). Tv distributors have shifted their focus to broadband, where their offering is more competitive, leaving pay TV prices high and not optimally priced to maximize subscriber numbers. This has accelerated cord cutting as consumers have other options, and paying $150 a month for cable doesn’t compare well to $30 a month for a few of your favorite streaming services. We’ll attempt to quantify the continued cord-cutting trend by making some (broad) assumptions and the impact on Discovery’s revenue.
Discovery’s U.S. advertising revenue was $4.2B in 2019 on 82M households (we’re going to assume every household has Discovery’s channels for simplicity and $3.5B of that revenue relates to traditional pay tv). This implies that for every pay TV household in the U.S., Discovery currently earns $45 in revenue from advertisers (annually). Now, we are expecting pay TV household numbers to drop significantly over the next 5-7 years, with some analysts predicting the subs to stabilize at around 50M. Let’s assume we have a constant drop over the next 7 years to 50M pay TV subs and annual ad revenue drops to $40 per sub as viewership declines on cable TV and the value-added decreases. This leaves us with $2B in ad revenue for U.S. Networks, a 45% decline or 8% CAGR over 7 years.
Distribution revenues have managed to offset sub declines by raises in contractual rates (renegotiated with MVPDs every 2-4 years). Discovery generates industry low amounts from MVPDs despite their solid ratings; Discovery Channel charges around $0.50 a month per sub, with most other flagship channels around $0.30 (Channels like Disney & TNT charge closer to $1). This is from lack of leverage, no sports content, and the fact they are not tied to a major broadcaster. This does leave room for price increases though as they are starting from a lower base. Let’s assume 2% CAGR decline for distribution revenues as they can offset a lot of the sub declines with price increases. On a base of $2.4B, this leaves us with distribution revenues of $2.1B in 7 years. This means U.S. Network revenue related to traditional cable TV would be approximately $4.1B (from $5.9B currently).
Source: Cord cutting
Before we look at the OTT transition and potential sub numbers required to offset the decrease in traditional pay TV revenue, let’s have a look at Discovery’s business model and how it allows them to consistently generate cash flow margins of approximately 20%. First, their cost of content is incredibly low compared to the competition. Discovery’s production costs are around $400K per hour of content due to Discovery’s focus on unscripted shows. Prices for premium scripted TV dramas are much higher (where most streaming services focus), with estimates around $5M per episode for a premium scripted series. These costs can explode to movie type production budgets, with hit shows like Game of Thrones & The Mandalorian running closer to $15M an episode.
Additionally, Discovery’s OTT offering is not trying to compete directly with the big players in the streaming industry. They are appealing to a niche set of consumers and as a supplement to other streaming services (Discovery aren’t trying to be a consumers main streaming service). This does mean a lower subscriber base (and lower ad revenue for an AVOD), but as they will be a low-cost operator, they can run profitably off this lower expected base.
Finally, they own their content. This will allow Discovery to launch their product with content people know and already watch, as well as new content that they hope will gain traction and draw subs. There will be some limitations as they will be required to abide by exclusivity deals with MVPDs, but the launch should come with a significant amount of content available.
Discovery is expected to announce an early 2021 launch for their streaming service, expected to be called Discovery+. The key question is can the streaming service offset the expected loss of revenue from traditional TV (the current valuation prices in a decline). Although details on the streaming service have been light, there are pieces of information we can piece together and create an expected model, price point, and estimate subscriber numbers Discovery+ requires to be a viable streaming service.
Source: Streaming services
It’s been reported there will be two tiers, a higher priced ad free version and an ad supported version at a lower price point (5 mins of ads per hours). There isn’t much information out there on the price of these options, but it will most likely fall in the $4-$7 for the ad supported tier and $7-$10 for the premium version (we’ll use $5 & $8 for our analysis). For revenue from the ad supported tier we’re going to assume a CPM of $30 which is towards the higher end of the range for current TV ads (this is because ads can be targeted and therefore add more value to advertisers), and we’ll estimate that 60% of users are on the ad supported tier (Hulu’s split between tiers is around 70% on ad supported but their price differential is slightly higher) and each subscriber is going to spend 20 mins a day watching the service (average time spent watching OTT is 70 mins per day so we’re assuming under 30% of streaming time is spent watching Discovery+).
Now for subscriber numbers, these were left until last because estimating the subscriber rate involves the most guess work. Instead, we’re going to calculate required subs to offset the drop in traditional TV revenue above and then look at whether we think the number is attainable.
The table above shows Discovery+ will need to get around 15M subs in 7 years to roughly offset our estimated traditional TV declines for the U.S. 15M subs appears attainable for a supplementary streaming service at a reasonable price point. We can expect an international expansion, if the U.S. launch is successful, which will increase potential upside.
For costs associated with OTT initiatives, Discovery’s guidance before the pandemic was a $600M loss. They have subsequently pulled the guidance, but we can expect pressure on margins for the transition to Discovery+ as they build out the apps and negotiate deals with distribution providers (Roku, Amazon etc.). For long-term expected margins from OTT streaming it is difficult to estimate as businesses are currently spending to attract subs, but margins will be lower than cable TV for an extended period (maybe indefinitely). The valuation section below attempts to (conservatively) quantify this expected squeeze on margins.
For the valuation we are using a full DCF with a forecast period of 7 years and then a terminal growth value. We’ll perform a sensitivity on both the terminal and discount rates due to their large impact on the output. Key base case inputs have been detailed below:
For U.S. Networks we are projecting a 3% decline in revenue for FY20, continuing for a few years as subs ramp up for Discovery+ and traditional TV revenues continue to drop, before starting to accelerate towards the end of the forecast. This results in a CAGR of 1% for the period.
For International Networks we’re projecting a drop of 9% for FY20 as the pandemic cases surge and lockdown measures have been reintroduced (international markets use less upfront pricing so have more flexibility in cutting ad spend). Olympics should provide a boost in 2021 (assuming they go ahead), along with a decline in margins. The PGA Tour deal will produce additional growth as the product launches in other markets. This results in a CAGR of 3%.
For U.S. Networks we’ve forecast opex at an average of 50% of revenue (previous 7 years have averaged 43%). This considers the expected increase in spending for Discovery+ and shrinking margins in traditional pay TV.
For International Networks we’ve forecast opex at 76% of revenue (previous 7 years have averaged 70%), with increases in opex during Olympic years.
Note: For cash flow purposes we’ve assumed content expense (made up mostly of amortization) will equal cash spend for content.
Debt has been forecast at 130% of sales over the forecast period. Discovery has reduced debt since the Scripps acquisition and appears comfortable with current debt levels.
9% has been used. Like to use a consistent discount rate as cash is cash no matter what business it comes from and adjust for risk with the margin of safety required.
Terminal growth rate
2% has been used as the terminal growth rate. Discovery is in a changing industry, but people’s appetite for content is strong and the media industry is expected to continue to grow as connection speeds and ease of access continue to improve.
See below for income statement output along with a sensitivity analysis on the discount and terminal growth rate; this will give us a visual of projected numbers along with potential valuations.
Our DCF yields a value around $36 (or $26B market cap) and Discovery currently trades around $24 (no discount has been assigned to Class C’s limited voting rights). The value is very sensitive to the assumptions above, but the tables should help give us an idea of the projected performance and expected value.
The largest risks to Discovery are a failed OTT product launch, cord-cutting accelerating ahead of industry projections, and streaming industry economics being less attractive than legacy cable TV.
A failed Discovery+ launch would leave Discovery with a declining business in traditional TV and needing to find another way to participate in the rise of streaming. A long drawn out failure would be more damaging than a quick (Quibi type) failure. If they get some traction with acquiring subs, but not enough to be viable, Discovery could find themselves in a position where they’re using large amounts of capital on a bet that eventually fails. However, if it becomes obvious very early that consumers have too many streaming services and Discovery can’t acquire enough subs to be viable, they can cut their losses (which would still be steep) early and move on to focusing on licensing their content to other streamers. As a low-cost provider, they would most likely to be able to profitably operate in this form, however, the company would have to be reorganized to deal with the new reality.
The acceleration of cord-cutting is an obvious one for Discovery, their current business model is built on cable TV ads and distribution fees from MVPDs. Any acceleration above current expectations will lead to sharp declines in revenue as Discovery receives less fees from distributors (less people receiving the channel), and less value to advertisers (less people watching the ads).
OTT streaming industry economics are unknown. Brands are aggressively pursuing subs, but what does the industry look like after this has played out? Margins will likely be lower than the legacy model as the internet has added options for consumers and the fight for people’s time has extended outside the world of TV (video game streaming, podcasts, social media etc.).
All these scenarios lead to pressure on both revenue and margins. However, Discovery’s low cost of content, established brands, and significant current cash flows mean they will be a player in OTT streaming in some form.
Discovery is priced like a legacy cable TV channel business that will decline in line with traditional subscribers (trades at 6x fcf, 7x earnings, 7x EV/EBITDA, 1.6x p/s). If Discovery were to simply optimize the traditional business and make no attempt to enter the OTT industry (wind down operations), there is an argument the business is still undervalued. The OTT transition makes sense and the lower bar to profitability (low cost model, niche market etc.) makes the bet one with big upside and good downside protection from the library of content (licensing content if Discovery+ fails). There is definitely a lot of uncertainty ahead for Discovery, but the current price and valuation ratios make the bet attractive. Thanks for reading and hope the above article helped in your assessment of Discovery.
Disclosure: I am/we are long DICSK. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.