Description

This idea is meant to be a follow-on to Novana’s previous June 21st, 2017 VIC idea on VIAB following the Discovery Communications (DISCA) market sell-off following the signed acquisition of Scripps Networks (SNI). For a general overview of Discovery business model please refer to Novana’s excellent VIC write-up.

This sell-off creates an extremely attractive risk / reward opportunity to acquire a cash generating / low capital business with an improved strategic competitive position that can compound value at high returns for multiple years.

The recent severe drop in share price appears driven by the following major investor fears:

1. media industry pressure because of US cable cord-cutting trends

2. excessive post-acquisition leverage

3. high headline price paid for the acquisition

These fears appear excessive in light of both the strategic and financial pro-forma outlook for the company as I will try to describe in the following paragraphs.

The merger strongly improves Discovery’s strategic position in the industry, creating a truly global media house, with significant IP and content that can be monetized through either linear or non-linear channels to enable continued ability to grow under a variety of media industry outlooks.

Additionally, the ability to finance 70% of the acquisition with cheap debt (3.9% weighted interest), plus the clearly identifiable cost synergies of $350mm makes Discovery into a cash flow engine even under a worst case scenario.

These financial projections should entail an end of 2019 price target of $21.40 (24% appreciation) under a worse case and a price target of $40.74 (136% appreciation) under a base case scenario

Pro Forma Strategic Position

• Women audience industry leader - Positioned as #1 US Women’s Cable Ad Revenue market share with over 20%

• Significantly under monetized - Overall ~20% US Cable Ad Revenue market share, with only ~10% of the economics

• Strong global distribution – Significant revenue and cost synergies by leveraging Discovery’ extensive global network reaching over 220+ countries / territories and 3Bn subscribers

• Robust social, mobile and non-linear platform – Development of 7 billion  short-form monthly streams to drive growth of alternative, non-linear monetization channels

Pro-Forma Financial Position

Worse Case Scenario (SNI / DISC EBITDA decreases 10% / 5% per year in 2018 and 2019 respectively, no tax law reform keeps effective tax rate ~30%, no revenue synergies, assumes all owners cash flow used to pay down debt)

Base Case Scenario (SNI / DISC EBITDA grows 0% / 2% per year in 2018 and 2019 respectively, tax law reform keeps brings effective tax rate to 20% in 2019, no revenue synergies, assumes all owners cash flow used to pay down debt)

Investor Fears - media industry pressure because of US cable cord-cutting trends

Investors are concerned of the future decrease of US revenues as the number of pay-tv subscribers is reducing due to competition from skinny bundles / direct to consumer offerings (eg. Netflix, Hulu, Youtube tv, etc).

While this trend is surely concerning and potentially impacting US revenues with mid-digit decreases, it appears that Discovery has significant mitigants to this headwind.

The pro-forma company is market leader in entertainment, women viewers in particular, and this is conducive to the ability to renegotiate inclusion in cable skinny bundles that exclude the high priced sports content. The creation of these new offerings that have the ability to compete from a pricing perspective with the direct to consumer platforms is accelerating (see the recent announcement of the Philo entertainment streaming service for $16 per month) and should enable DISC to better monetize its viewership market share that is currently significantly under monetized vs. the sports heavy content providers (eg. ESPN).

In addition, DISC has a significant international current presence (almost half of total revenue) and future potential where the pay-tv industry dynamics are still in expansionary mode.

Investor Fears – excessive post-acquisition leverage

DISC is financing the SNI acquisition through a 70% cash / 30% stock structure, which will significantly increase the debt on its balance sheet to over $17bn, which looks significant compared to the current pro-forma market cap of $9.2bn. Also the pro-forma gross debt to EBITDA would be in excess of 4.5x, way above the company’s target of 3.0 to 3.5x.

While high, this debt burden should not pose any liquidity / refinancing risk as all maturities until the end of 2021 ($1,809mm in 2019, $1,385mm in 2020 and $650mm in 2021) should be easily covered by the cash generation of the business.

Even in our worse case scenario the gross debt / EBITDA ratio at the end of 2019 should lower to 3.7x which should enable DISC to maintain investment grade ratings throughout the years.

In addition, the company’s has relatively stable cash flows and high interest coverage (EBITDA / interest expenses ~4.9x in 2018 in our worse case scenario).

Investor Fears – high headline price paid for the acquisition

Bearish investors are mentioning the price paid for SNI is excessive as $90 per share implies a $14.6bn EV purchase price and over 10x standalone EV / EBITDA multiple for a company with uncertain growth trajectory and a shaky Q3 quarter with decreasing operating income.

While I agree that this standalone valuation appears high, we can’t discount the significant strategic advantages of the merger and the potential for revenue and cost synergies which appear conservative at $350mm (less than 10% of the pro-forma cost base, excluding programming and marketing)

Adjusted for synergies, SNI has a cash flow yield of almost 10%

The favorable low interest rate environment, combined with the relatively stable nature of the media company’s cash flows (since 2008 neither company has suffered more than a 5% decrease in operating income year over year) and the lack of dividend commitments, enabled DISC to make an opportunistic deal that significantly strengthens their competitive position and financial outlook.

Quoting master capital allocator J.Malone, the leverage enables to finance 70% of a ~10% cash flow yield company with 3.9% debt, thus creating lots of extra cash generation and shareholder value.

Risks

• Inability to re-negotiate future carrier deals impacting access to final customers and loss in affiliate / advertising revenues

• Economic recession significantly impacting advertising spent

• Merger Transaction not closing

Catalyst

- Publishing of FY2018 proforma guidance 

- Renewal of carrier contracts and inclusion in skinny bundles

- De-leveraging below net 3.5x debt  / EBITDA