Major Value Chain Shift Positions Discovery Channel for 60%+ Upside

Discovery is a niche content producer with a focus on non-fiction programming that is popular across cultures and countries. Its business model is unique in that it allows Discovery to leverage content produced for a given market on a global scale. Additionally, unlike many other media companies it owns most of its content. This provides tremendous flexibility in terms of content distribution and is a crucial differentiator in the OTT (over the top) world. The traditional video ecosystem is under some pressure from OTT aggregators (NFLX, AMZN, Hulu, HBONow) and therefore, poses a significant threat to weaker networks in the cable bundle.

However, we believe Discovery’s strong brand, unique content, and solid network ratings will enable it to thrive in a world where there is a shift in the value chain from distributors to content creators. Moreover, while Discovery’s share of viewership in the U.S. is 12% its share of wallet is only 5%. The probability that its networks are kicked out of the bundle is very low. In the case where Discovery's networks are not part of the cable bundle, Discovery can choose to do a direct OTT offering to consumers since it owns almost all of its content.

The superior economics of Discovery’s business model are affirmed through its average return on tangible capital in excess of 50% and an average FCF margin of around 20%. Over the past couple years, margins in the international business have decreased as Discovery has been investing heavily in content in Europe. Once this investment phase is complete, we expect Discovery to gain significant subscribers and EBITDA margins in the international business to revert back to its long-term average of ~40%.

Currently, the market is concerned about the softness in the U.S. TV advertising market caused due to shift in advertising dollars toward digital. We believe this concern is overblown and is a result of the inadequacy of the current viewership measurement system to capture viewership across multiple platforms and access points. Management of multiple media firms have communicated this issue to investors on earnings calls and are diligently working with network rating companies to resolve it. On Disney’s most recent earnings call, its management’s comment about a slight loss in ESPN subscribers has led to further price declines in all media stocks.

In our view, Discovery's strong presence in international markets serves as a hedge against any potential weakness in the U.S. DISCK is currently trading at an attractive valuation multiple of 12.5x-13.5x forward FCF. Its management team led by CEO, David Zaslav, has been prudent in taking advantage of its undervalued stock from time to time via share buybacks and has reduced share count by 29% over the last four years. Management has also been opportunistic in buying content globally to further strengthen its IP portfolio and grow its market share. We take solace in the fact that Dr. John Malone, a cable industry veteran and an outstanding capital allocator, owns 5% of the common and is also a board member.

Based on our estimates, we think DISCK can produce FCF per share of $2.50 - $3.00 in the next 2-3 years driven by high single digit to low double digit EBITDA growth and share buybacks. This results in an intrinsic value estimate of $45-$50 per share or an IRR of 20% - 30% on the current price

We believe Discovery is well-positioned to weather an overly skeptical view of content producers in the U.S. While we are confident in the future prospects of the U.S. operations and believe there is money to be made from the current mispricing, DISCK separates itself from other U.S. content producers with their strong international presence. Our view is that one is paying very little for potentially robust international growth and improvement in margins.

Valuation
Consensus estimate for Discovery’s current FY FCF per share is $1.70 - $1.80. After backing out the impact of FX headwinds, FCF per share estimate increases to ~$2 per share. This represents a very attractive FCF yield of 7.5% - 8.0% on current price with the potential to grow at high single digit to low double-digit rate. We believe DISCK’s valuation is inconsistent with the company’s attractive dual revenue stream business model, growth opportunities in the international segment, strong FCF generation, high-quality management team, and opportunity to aggressively repurchase shares at an extremely favorable valuation.

Based on our estimates over a 3-year horizon, we expect Discovery to grow its top line at a mid single digit rate and generate total company-wide EBITDA of ~$3.1 billion. This translates into FCF of ~$1.6 billion. As the international business becomes an increasingly greater contributor of profits, management estimates the overall tax rate to drop from the current 35% to 30% or below. Assuming Discovery reduces its share count by 5% annually, we end up with a FCF per share estimate of $2.5 - $3.0. We believe a business like Discovery that has high returns on capital and attractive growth opportunities deserves a FCF multiple of 17.0x – 18.0x. This results in an intrinsic value estimate of $45-$50 per share, representing 60%+ upside or an IRR of 20% - 30%.

Risks
*Skinny Bundles / OTT Threats
*Networks Ratings Weakness
*Overpaying for Content
*Consolidation among MVPDs

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