Karl Hunt, of the Global High Conviction strategy, examines one of their more interesting investments. A stock that could be end up being taken out by a bigger fish or, if not, could end up being a compelling media play in its own right.
Discovery Inc (DISCA.NASDAQ), formerly Discovery Communications, is the US media company that you are probably most familiar with through watching various documentaries on TV on channels like Discovery Channel, Animal Planet, Investigation Discovery, Eurosport, TLC, Travel Channel, the list goes on. It operates in over 220 countries and territories, and has over 300,000 hours of program library and produces 8,000 hours of programming each year. Discovery essentially focuses on making content and this is distributed through agreements with broadcasters, content platforms, and available over the internet through various providers etc.
There continues to be increasing consolidation in the media industry with Disney acquiring Fox while Comcast recently acquired Sky. The internet has been the biggest disruptor in recent years as companies such as Netflix and YouTube have taken eyeballs and revenue away from the incumbent players and so they have to respond either through new investment or more often, through acquisitions – it is easier, quicker and more likely to succeed.
Discovery itself made a big acquisition in 2018 of Scripps for US$14.6bn a business similar to itself focusing mainly on documentaries/real life content (HGTV, the Food Channel, Travel Channel). The reason for the acquisition was to combine costs and to distribute the Scripps content more internationally (before the acquisition Scripps content was only broadcast in Poland outside the USA), thus enabling group profits to rise further.
More media is being consumed online through Netflix and YouTube and this is posing a real headache for traditional distributors like TV broadcasters and cable companies. However, the one thing they all need is content to capture those eyeballs. Netflix so far has focused on making its own content for a unique offer, but this is proving extraordinarily expensive. As a rough rule of thumb, it costs US$5m an hour to produce scripted content (movies, dramas, etc) as opposed to US$400,000 an hour for the sort of content produced by Discovery. A lot more internet-based companies aspire to expand their media presence so they will need to make their own content or acquire it from the likes of Discovery, Disney, and the movie studio owners.
The problem comes if there are too many distribution channels (internet, broadcast TV, cable, etc) all showing pretty much the same programmes. So, companies are trying to focus on some form of exclusivity to ensure end consumers buy their platform. So recently we saw Disney, which produces wildly popular content based on Marvel comics, take back that content from Netflix. Actions like that obviously make distributors nervous because they don’t have exclusivity and long-term security of content. There will continue to be a lot more mergers and takeovers in the media industry as a result of all this competition and a lot of it will center on the content companies of which there are very few that are still independent.
Following its big acquisition of Scripps at the beginning of last year, Discovery’s biggest negative is its debt pile. Its total debt stands at US$14.5bn, Debt/Equity ratio stands at 190% and interest cover is 1.5x. The good news is that it is a very cash generative company and that its annual free cash flow is expected to be running at US$3.5bn+ so this high debt level should come down considerably over the next few years. It’s valuation in terms of Price/Earnings ratio is very modest at 7.5x 2021 earnings reflecting its level of debt. This compares favourably to other media companies such as Walt Disney on 22x, Nine Entertainment on 13.5x, and Comcast on 12.5x.
We feel Discovery is a very interesting investment at these levels as profits are set to rise as cost cutting through combining the Scripps business comes through, selling the Scripps content in more countries and reducing debt as strong free cash flow comes in over the next few years. This should lead to a re-rating of the company’s PE ratio and a substantial lift in the share price from $29 to over $40. The other possibility is that Discovery is taken over by one of the other media companies as the industry consolidation continues to take place.
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TAMIM Asset Management provides general information to help you understand our investment approach. Any financial information we provide is not advice, has not considered your personal circumstances and may not be suitable for you.