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DISCA has been written up numerous times on VIC over the past several years, most recently by elehunter.  The previous reports are worth a read as well as the multiple thoughtful comments, and this write-up will assume everyone has gone through this material.

The stock has barely moved in a decade as the stock was initially sold by growth investors to GARP investors, sold by GARP to value and then dumped by value to deep value (or maybe just chumps).  Thus far, the bears have been right.  I’ve owned the stock at the original spinout, sold (with hindsight) too soon and then reentered (see hindsight note) too early and have maintained a position at varying sizes.  Clearly it has not been a great investment the past few years and investment fatigue is very real.

Let’s run through a couple of negatives first:

Cord cutting has accelerated, with a current -7% trend, although perhaps closer to -5% when including the virtuals.  Many see this chart and stop all work – that initial sentiment has thus far been correct.  

Management pays themselves a ton.  Zaslav certainly deserves credit for the Scripps acquisition and for securing placement on some of the virtual MVPDs (virtuals) - many doubted the latter would ever happen.  Clearly, CEO pay in the media industry is incredible, but David Zaslav’s contract is a bit of a standout.  Leave aside the huge grants of stock and simply consider the $22 million targeted cash bonus, with 50% of the bonus subject to softball qualitative terms.  Page 48 of the proxy gives nice sounding, high-level qualitative goal bullets to determine the bonus.  While I don’t have full access to the back and forth discussion evaluating progress on these points, I imagine a lot of fluffy responses and over-the-top answers:  “We own home and food– I can feel the excitement within the company” or “Advertisers are salivating over our channel lineup and I keep telling them these prices won’t stay here.”  I also picture a lot of 10/10 ratings with one or two 9/10 thrown in for balance    While difficult to accept the compensation disclosure, it sometimes feels even harder to listen to the hyperbolic Zaslav – “Netflix of Golf,” “We’re playing a different game.”  Perhaps David interacts better with Oprah and other Hollywood types who interrupt his hyperbolic boasts as visionary, but it is difficult for suffering shareholders to deal with the constant spin (including selective performance disclosure).   

The company has bought back a ton of stock in the past at higher prices – from 2015-2019, they repurchased billions of dollars of stock (and Newhouse’s Preferred) at prices of $25-30 and are currently not in the market despites shares 30 percent below these levels.  Yes, the COVID driven recession has hurt advertising and it will likely take a couple of years for the market to fully recover.  But, consider that DISCA has:

-Very manageable debt levels (estimate ~3x 2020E estimated EBITDA despite EBITDA drop)

-Just quietly renewed deals with some of its largest US and International distributors (Cox, Comcast, Charter, Cox and SKY) with mid-single digit escalators (perhaps 4-7% annually over life of contract with bigger bumps in early years) and full or expanded coverage of existing networks.  It is unclear what is more amazing:  1) DISCA locked in revenue for ~4-7 years at higher prices with no stock reaction (stock down since this announced) or 2) Contracts were signed without Zaslav’s typical over-the-top comments/CNBC appearance.  

-Large amounts of cash and capital availability ($1.5B cash/$2.5 billion of undrawn revolver capacity)

-Places bonds with holders who do not seem to follow the media industry or any of the cord cutting dynamics (5.3% 2049 bonds trade ~120 with 4.1% YTM vs. 17/18% equity free cash flow yield)  

-Produces a staggering amount of free cash flow ($250mm per month run rate disclosed this week – this is skewed by the lack of sports payments and I assume lower number) even in the middle of COVID.

Perhaps the above suggests excessive caution/prudence or…that another elephant deal is imminent?  

While the stated reason for Peter Faricy’s (CEO Global Direct-To-Consumer) departure is that he didn’t want to move to New York and there is still a great team/strategy continues, the departure was clearly a loss.    Faricy’s spearheaded the recent Food Network Kitchen deal with Amazon, helped recruit new talent and offered a more measured/articulate vision of future DISCA OTT vision versus the Zaslav spin.  

In summary, this has been a tough investment for some time and the concerns are real.  That said, there are reasons to think at this price, odds are in an investor’s favor.  

Scripps Networks Interactive, (SNI):  Solid deal

At the time of the deal announcement, there was great concern about leverage levels (DISCA took leverage to nearly 5x to fund the deal), concerns on cultural fit, concerns on the exact synergy number/timing, and concerns about a deeper move back to the challenged US market.  But, fast forward ~2.5 years and  the deal integration has been solid and DISCA crushed the initial $350 million synergy guidance and the combined company generated over $3 billion in free cash flow during 2019 net of the $300 million DTC investments – 2018 and 2019 results were ahead of my estimates at the time of the SNI deal.  As has been noted, the deal likely helped secure positioning on YouTube and Hulu offerings and DISCA has made progress on new product OTT offerings (Food Network Kitchen) as well as introducing SNI content to other overseas investors.  And while DISCA has been and will be hurt by the COVID ad recession, the company entered the slowdown with a relatively strong balance sheet and the capacity to potentially make an offensive investment should an opportunity materialize.  DISCA would appear to be in a better strategic position with SNI now versus pre-deal, yet the stock is not far from the lows reached following the SNI deal announcement.  

OTT:  Still Need Breakout but Trying Lots…Positive Signs on International Front

Thus far, DISCA has not found the magic OTT solution.  But, to their credit, they are trying to place multiple balls in the air with a general strategy of trying to find niche offerings without alienating their distributors.  The partnership for Food Network Kitchen with AMZN may have legs, and there has been progress on the number of people downloading the application.  DISCA has hinted at a US OTT offering with revenue shared with MVPD’s, but no specific details have been released.  

DISCA has made more progress in Europe versus the United States with Dplay (10 markets in Europe – Nordic SVOD penetration is over 50%), Joyn (ProSieben JV in Germany), TVN Player (Poland).  Eurosport has good potential and has likely helped with international distribution renewals, but the OTT execution has been uneven and clearly could be advanced with a scaled partner.  Having European coverage of the Olympic games in 2021 and 2022 should give a fantastic opportunity to enhance DISCA’s OTT packages.  Adding WWE in Italy should also help Dplay.

Source:  BAC Global Research  

The basic strategy in all markets is local entertainment, news and sports.  Faricy helped improve the functioning of the service and greatly aided customer reviews.  The plan is to invest more behind the products.  COVID has interrupted the local sports content popular on Dplay and Eurosport, but rights payments are also delayed until sports resume (or don’t).  DISCA can use international PGA rights and GOLFTV to create another possible DTC offering with potential greatest in Asia, an area where the company has struggled.  And while the National Geography strategy has not been fully fleshed out, there is potential as with the Magnolia (Chip and Joanna Gaines) product whenever it is launched. Total Global DTC revenue is ~$700 million (6% total revenue) with at breakeven economics.  Continued progress on the international front could be particularly useful for drawing out a bid for the entire company.

Ratings Bounce…Sustainable?

David Zaslav has used every opportunity (even when responding to questions that have nothing to do with ratings) to brag about the increase in people tuning into Discovery.  The bounce is noticeable, but it has been most pronounced at the former SNI Food and HGTV channels.  Additionally, the strong ratings for Chip & Joanna Gaines’ four-hour previous augurs well for the Magnolia Network/OTT platform when it launches.  Outside of TLC (where 90 Day Fiancé has had a surge in viewers), there are still ratings headwinds, especially at the core Discovery Network.  It is very possible that there could be a stepdown in ratings following lockdown easings.  That said, DISCA has continued to produce new content during the lockdown and will likely have far more original content than many competitors during the fourth quarter.  

Source:  Nielsen 

Advertising Greenshoots?

Certainly, advertising (I am assuming -15% for 2020) is dependent on overall GDP growth and there all sorts of macro uncertainties over the back half of 2020.  During the recent CSFB conference, DISCA noted that April came in better (-18% vs. -20% expectations during the Q1 call) and May and June were “significantly” better than April.  Zaslav also noted that the scatter market was strengthening week by week and that third quarter cancelations are significantly better than initial expectations (much less than 50%).   Fox Corporation offered similar positive commentary on local markets better while Charter noted that SME revenue was trending better than expectations.  Internationally (with no real upfront commitments) the market is down ~-40% in April but moving towards -20% as markets interrupt.  While not fantastic, it is trending in the right direction and the SKY deal appears to have been executed without the same degree of contentiousness as the last contract and includes a further advertising partnership that could be replicated in other markets.  

If So Cheap...Why no Bids? 

If DISCA was priced at a market multiple, the risk/reward would be uninteresting.  At $19, however, DISCA trades at shall we say rather undemanding valuations.  Clearly, the well hashed argument is that DISCA is a melting ice cube and ultimately all distribution revenue will go to zero and advertising revenue will closely follow.  I would not question that video subscriber losses will continue, but I would argue that distributors will want to have a core video product and this bundle could last longer than many believe.  The exact commentary varies by cable company, but is something along the lines of “some customers value it highly and we’ll offer it but won’t chase unprofitable subs.”  Altice noted in May that its video attachment rate has declined from ~60% to ~45% and this has driven the acceleration in video losses.  But, it then noted that the product is pretty sticky within its Optimum network with 30% of its customers subscribing for at least 10 years and 50% for five years.  This could certainly become worse.  I assume 6% annual declines with 3-5% rate hikes and 1-1.5% virtual offsets.  To the extent that more customers decide to cut and only go with Netflix/Disney and no other skinny, my numbers could be too aggressive.  I would note that the recent Cox, CMCSA, CHTR, SKY signings offer more confidence around this assumption – dropping DISCA does little to solve MVPD’s programming cost/sub dynamic.   Normalized for COVID, I believe DISCA can show very modest revenue growth, but obviously this is far from certain.  I assume an advertising pickup in 2021 and 2022 but also assume that 2023 advertising revenue does not exceed 2019 levels.  The detrimental margins in the advertising drop will be high, but DISCA does have multiple offsets (including cheaper filming costs).   One can question multiple assumptions, but DISCA looks cheap on multiple levels.   

DISCA owners have heard all the arguments about why the company is an attractive acquisition target (owns content, big library that could be faster/cheaper to buy versus reproduce, strong international franchise, etc.) but thus far…no deal.  Why?  It is possible that the rumored targets (AMZN, CMCSA, DIS, T) have thus far concluded that they do not want to pay a premium for DISCA’s franchise.  Or it could be that they are interested but busy with existing integrations (Sky, Fox, TWX).  Or it could be that they are interested at $30 but not with a 4 handle.  I think DISCA has some nice pieces that could be better utilized within a larger distribution platform and clearly the takeout scenario is the real upside scenario…but it is far from certain.  DISCA could help themselves a lot with further progress at Food Network Kitchen, Dplay, Magnolia or GOLFTV.  That said, for as bad as the DISCA proxy reads, page 67 suggests that Zaslav could earn over $170 million assuming he can orchestrate a deal at above $30.50.  And certainly the payday escalates further for each dollar above this.

At ~$19, it takes little for the stock back to jump back to $30 – a stabilizing advertising market and/or the reintroduction of a buyback plan might do it.  If the below cash flow estimates are directionally correct, DISCA could take out 25 percent of its share count in 2021/2022, and there seems to be a good chance they start the buyback program later this year (I do not assume this).  Around $30, an investor could reconsider the investment (hindsight is 20/20 but I should have followed this advice)  - it would still be statistically cheap and a buyout still would be possible – and certainly Dr. Malone’s purchases last year suggested far more upside.  But, absent the buyout, DISCA likely needs further progress on the OTT front to convince investors that the asset can consistently grow and thus deserve a higher multiple.  One can make an argument that a dividend could make sense should there not be meaningful progress on the OTT front and/or if a buyout/attractive acquisition opportunity does not materialize.  While anathema to Liberty investors historically, QRTEA and LGI are exploring non-buyback capital return options in the face of uncertain buyback IRRs and/or local market preferences for dividends.  Perhaps DISCA may consider this at some point if the rating agencies would agree to keeping the lowest ring investment grade rating at ~3x leverage.  But, as noted, the last big deal was a big success and perhaps another attractive opportunity can be found.   Ultimately, the shareholder base contains creative/rational players and at this valuation level, there seems to be more ways to win versus lose.   

Catalyst

-Resumption of buyback

-Strengthening of advertising market

-Sale of company