Discovery: High Quality & Growth Drivers. Cheap on Pull-Back.

Discovery Communications is a buy with 12 months price target of $92. DISCA offers one of the highest quality earnings mix among its peer group and the recent pullback created an opportunity. The company is a pure play cable networks company and has the highest proportion of earnings coming from the international market, where the pay TV market is still in a secular growth stage. International channels EBITDA contribution to estimated 2013 results is the highest among peers at 41% (vs. 9% for TWX, 8% for VIAB). Both affiliate and advertising revenue streams should benefit from secular growth overseas.

Domestic affiliate revenue growth is likely to moderate to mid single digits in the medium term given additional pressure on affiliate revenue increases which is likely as MSOs' programming costs increase, driven by growing retransmission fees. Pay TV international penetration leaves more room for growth when compared to the U.S, where subscriber base expansion is driven by growth in the number and size of pay TV platforms. The launch of new channels on existing platforms is an additional source of affiliate revenue growth.

With established brands that enjoy strong consumer recognition, Discovery's channels have become "go to" venues for nonfiction content. The company has kept fully distributed channels such as Discovery Channel and TLC fresh by continuously investing in new programming and updating existing content. This past January, Discovery Channel had its highest January ratings ever in total viewers and adults aged 25-54. The company has also focused on rebranding and repositioning several of its other channels. Reflecting these strategies, Discovery has enjoyed strong ratings and revenue growth over the past several years. 2012 revenue of $4.5 billion was up 7.7% versus 2011 and, aligned with the company's solid operating leverage, where normalized OIBDA was up 10%. Including the impact of recent acquisitions, 2Q13 revenue was up 22.6%and adjusted OIBDA was up 23.7%.

With three fully distributed channels in the U.S. and others that continue to gain coverage, Discovery has launched several initiatives over the past few years to fuel revenue growth. These include the company's 2010 rebranding of Discovery Health as the OWN Oprah Winfrey Network through a joint venture with Oprah's Harpo Production company, the rebranding of Discovery Kids as the Hub with Hasbro, the rebranding of Discovery Times as ID Discovery and of Planet Green as Destination America.

The company derived roughly 46% and 51% of total revenue from advertising in 2013 and 2Q13, respectively. About 53% of domestic revenue and 35% of international revenue came from advertising in 2012. Domestic ad revenue grew from $1.1 billion in 2008 to $1.5 billion in 2012. Discovery has considerable upside to grow ad revenue as it realizes value from ratings improvements and expanded distribution on several channels. Management has indicated that it attained mid to high single-digit price increases and record volumes in the 2013 Upfront. Secular trends also remain strong, with ad market scatter pricing above the 2012 upfront level. Cyclical recovery is currently driving domestic advertising revenue growth above long-term trend; growth is likely to be mid single digits longer-term, driven by 1% to 2% aggregate cable audience growth and 4% to 5% CPM increases. Above-industry growth is likely to be driven by market share gains, i.e. audience redistribution.

As international pay TV penetration grows, the medium becomes a more viable option for advertisers, driving reallocation of spending to cable channels. Increasing audience size drives development of cable audience measurement systems, which in turn improves the medium's attractiveness for advertisers. Above-average GDP growth in emerging markets should also drive above-average advertising spending growth.

Discovery continues to expand its offshore footprint. The company has made several acquisitions over the past few years. For example, in November, 2010, the company acquired BBC's 50% stake in their joint venture for $152 million, giving Discovery complete ownership of most of BBC Worldwide, which included the international extension of the Animal Planet channel. In 2011, the company acquired a non-fiction entertainment production company in the U.K. and a Latin American cable channel to increase distribution of TLC content. In 2012, the company acquired five Italian TV channels programmed with children's entertainment. In 2012, the company also purchased a channel in Dubai and a 20% stake in European sports pay-TV network Eurosport. Beginning in December 2014, the company has a one-year call right to purchase a controlling interest in Eurosport.

The company is extending its digital reach. In 3Q11, Discovery announced a non-exclusive licensing agreement with Netflix to give subscribers access to prior season content. Subsequently in 1Q12, the company announced another SVOD deal with Amazon for much of the same content. Discovery believes that these deals do not cannibalize ratings of current season content viewed on its channels. In fact, management feels that SVOD may actually fuel incremental audience growth, as viewers who had not previously watched the series on live TV begin to watch the current season after viewing older episodes on Netflix or Amazon Prime.

While the stock has the highest NTM P/E multiple in the group, its expected EPS growth on a NTM/LTM basis significantly outpaces its peers. DISCA's current PEG of 0.46x is substantially lower than one year ago (0.80x).

Additionally, relative P/E expansion of 1% is below the group average. Even factoring in an expected multiple compression over the next 12 months as growth is expected to slow down (EPS growth on a NTM / LTM basis in twelve months is expected to slow to 29% from the current 45%), with multiple down to 19x from the current 20x, the stock still has upside driven by EPS growth. Based on DISCA's historical relative multiple for periods of similar EPS growth and an assumption of a constant market multiple, applying a multiple of 19x NTM EPS results in a 12-month price target of $90. DCF TP of $99 using a 9% WACC.