Discovery -Value Trap or Undervalued Media Conglomerate in the Making?

Today we are going to be taking a look Discovery Inc. and the potential to make some major gains due to the upcoming merger deal with WarnerMedia.

Introduction:

If you missed the Archaegos blow-up in the first few months of 2021 then you are going to want to buckle up to see how disconnected this stock price is from the value of the business.

Here is a link to my youtube video going over discovery.

Disclaimer: I do not currently own a position in this company, but I am looking to build out a position ahead of the merger. 

DISCA/DISCB/DISCK - Discovery:

“We are a global media company that provides content across multiple distribution platforms, including linear platforms such as pay-television ("pay-TV"), free-to-air, and broadcast television, authenticated GO applications, digital distribution arrangements, content licensing arrangements, and direct-to-consumer ("DTC") subscription products. As one of the world’s largest pay-TV programmers, we provide original and purchased content and live events to approximately 3.7 billion cumulative subscribers and viewers worldwide through networks that we wholly or partially own. As of September 30, 2021, we had 20 million total paid DTC subscribers. We distribute customized content in the U.S. and over 220 other countries and territories in nearly 50 languages. We have an extensive library of content and own most rights to our content and footage, which enables us to leverage our library to quickly launch brands and services into new markets and on new platforms. Our content can be re-edited and updated in a cost-effective manner to provide topical versions of subject matter that can be utilized around the world on a variety of platforms.” Q3 10Q Filing

Discovery owns a lot of its own content and replays them on its own channels. This is going to be huge for Discovery’s new move into the direct-to-consumer space under their service named Discovery+. Also, they currently have an upcoming merger deal that they will hopefully close in the middle of 2022. This deal will merge Discovery inc. with Warner Brothers media. I will touch on this later in more detail, but just know that there is a lot of content that they have already on the sideline that is sought after by viewers.

Below is a list of the channels owned by Discovery:

Discovery breaks itself down into the following segments:

• USA Networks and International Networks each have the following categories

  • Advertising - “Advertising revenue is dependent upon a number of factors, including the stage of development of television markets, the number of subscribers to our channels, viewership demographics, the popularity of our content, our ability to sell commercial time over a group of channels, market demand, the mix in sales of commercial time between the upfront and scatter markets, and economic conditions.” - Q3 10Q Page 36

  • Distribution - “Distribution revenue consists principally of fees from affiliates for distributing our linear networks, supplemented by revenue earned from subscription video-on-demand content licensing and DTC subscription services.” - Q3 10Q Page 36

  • Other - This is miscellaneous revenue related to the specific networks.

Note: There were revenue increases, but this is also due to acquisitions made by Discovery Inc. rather than only the core business. While the acquisitions strengthen the core business now I just wanted to note that in case you see some odd revenue upticks such as 2018 when Scripps was acquired.

Below you can see how the revenues have grown since 2013:

Financials:

• Total Revenue TTM as of Q3 2021: $11.89B

• Profit Margin has been floating between ~12% - 15%

• Current P/E: ~15

  • DISCA: ~15

  • DISCB: ~20

  • DISCK: ~14

• EV/EBITDA: ~3.53

• Current Cash as of Q3 2021: $3.116B

• Total Debt as of Q3 2021: $14.785B

Industry

• One trend that has been noticeable, especially over the last few years, is the move from cable TV to the online subscription model (See Chart 1 below). Discovery just launched their subscription service, Discovery+, at the beginning of the year they have been able to amass 20M subscribers. The large majority of its revenue and advertising are still being brought in from the traditional cable tv market, but that is why they have launched their own DTC subscription service. Fortune Business Insights released a report where they expect the “Video streaming market” to reach an $842.93B valuation with a 12% CAGR. This is up from the $342.44B market size in 2019 (Link). They are going to be competing with companies/services like Netflix, Disney+, FuboTV, Roku, Amazon Prime, Apple TV, and Peacock (There are more obviously, but these are the big ones that come to mind).

  • Now, this industry growth is huge and CEO David Zaslav expects Discovery to gain some market share, especially with the upcoming merger with WarnerMedia. Zaslav stated that “We think it could be [up to] 400 million homes over the long term” when speaking about the expected subscribers.

Chart 1: Cable TV forecast through 2028 from Grand View Research

Merger with WarnerMedia:

• In the first half of 2021 Discovery and Warnermedia announced an exciting opportunity to merge their brands to create a new entity. This deal was an absolute steal because AT&T is essentially spinning this off at a loss and Discovery will have access to a huge lot of movies and shows with large brands. Below you can see the mixture of Discovery brands and Warnermedia brands that are going to be combined under this merger. One item to note is the large number of sports channels that are owned by both companies since there will likely be an offering for live streaming the games or events through the DTC platforms rather than just traditional cable tv channels. One of the great things about Discovery’s TV shows is that they do not cost as much as the high-budget WarnerMedia items because of the way that “live” tv is produced versus scripted TV shows. Also, since these TV shows have already been produced and paid for via the original advertising, both platforms now have the opportunity to sell these brands for a “second” time without needing to incur any more charges besides the cost of maintaining the platforms. While Netflix has been trying to create their own TV show brands they still license a large portion of their current offering which is why this HBO and Discovery merger is such a big move. One of the great parts of merging the companies is that the subscribers likely won’t cannibalize each other due to the difference in content. We will likely see an offering similar to Disney+, Hulu, and ESPN where there are combined packages, but also separate offerings in case you only want one product. As of Q3 2021, Discovery currently reported that they have 20 million subscribers(link) and AT&T reported that HBO and HBO max have 69.4 million subscribers(link).

  

• Financials of the Merger

  • The first item to note is how the actual deal will work for the shareholders and Discovery & AT&T’s portion of the deal. Discovery will own 29% of the new company while AT&T will own 71% of the new company. Also, DISCA, DISCB, and DISCK will be merged into one set of shares which is why I will be buying the C shares and using the C shares valuation for my numbers. These trade at a discount due to the lack of voting rights.

• Now the economics of the deal have been spelled out and shown via the presentation made in the middle of the year (link). The merger is expected to have ~$52B of revenue and ~$14B of expected EBITDA in 2023(Slide 10). Along with this revenue expectation they are targeting $15B+ of direct-to-consumer revenues in 2023. They expect to have around ~4.5x to ~5x leverage compared to their expected EBITDA. Zaslav recently mentioned that he expects the debt leverage to be around 4.5x (link).

• Lastly, the sum of parts valuation presented by The Popular Investor Channel (link to the explanation). There are multiple ways to come up with a sum of parts for this evaluation, but I wanted to use Rob’s video so that new investors can follow along rather than needing to spell it all out here(.....aka I am being lazy). I recreated his sheet on the DCF worksheet if you would like to go in and make your own edits. I think his calculation looks like the correct estimate, but I think the multiple should be 11 while the net debt/EBITDA ratio can be a little higher (This is to be more conservative). I will leave it the same on the sheet so you can see the comparison, but you can clearly see there is a lot of upside on this. You can also use terminal multiples to come to a conclusion if you would rather take a “simpler” approach.

Strengths:

1. Brand Name and reputation - 

   1. Discovery Inc. has a ton of household names for both the channels/production they own and the actual shows that they produce. “Discovery networks are also among the most-watched networks on TV. For traditional TV ratings during the most recent quarter (Q1 2021), Discovery held four of the top 15 primetime networks among its key demo of women 25-54 (TLC ranked #1.” (Link)

2. Subscriber Growth

   1. They have reached 20 million subscribers on just the Discovery+ platform in 3 quarters since it just launched at the beginning of this year. The ad spend has slowed down due to the upcoming merger and they plan to package HBO Max and Discovery+ into an offering for both platforms.

3. Merger

Risks:

1. Current Leverage position

   1. Their total debt as of Q3 2021 is $14.785B and their TTM FCF as of Q3 2021 is $2.082B. While the management team has a good track record of lowering debt quickly it is still an important item to note because of the risk this poses to the business model. If you would like to see the makeup of their current debt you can look on pages 18 & 19 of their Q3 2021 10Q for a better explanation of their debt. This is a big risk to the business if there was any substantial downturn in the US economy since they would likely not be able to keep up with their debt payments. This should be factored in with your margin of safety because of the large debt component. The merger will also have a good amount of leverage, but we are focusing on just Discovery so I did not want to include it on the risks just yet. Once the merger is approved we will add in the new debt here.

2. Merger not being completed or being stopped by regulators

   1. Discovery has a lot of content for viewers, but it is likely not enough to get substantial gains on the subscriber growth front of their business. David Zaslav knows that they need to be operating at scale and see that the merger will allow them to do just that. While there are agreed-upon penalty payments depending on who terminates the merger if it were announced that the merger did not go through we will likely see a short-term decline in stock price. This market has been very reactionary and from the most recent earnings call it sounds like this company has the green light so far.

Discounted Free Cashflow Model

If you would like to see my worksheet the link is here.

The cost of equity is so low due to the amount of net debt that Discovery currently has on its balance sheet. The true upside will come from the merger, but we have to also look at the DCF for the current company if the merger is not approved.

What are their plans for the future?

1. Merge with WarnerMedia and grow out their Discovery+ platform along with HBOMax to give customers value. 

2. Decrease leverage from an estimated 5x leverage going into the merge to 3x leverage.

Closing Thoughts:

There is a lot of risk in respect to the current debt on their balance sheet and the incoming leverage if the merger is approved. The management team has proven that they are aware of the effects of leverage and want to pay it down, but if there is a substantial downturn in the economy it will hurt Discovery the higher their leverage. The opportunity with WarnerMedia is going to be huge if they are able to merge the company’s costs and employees. If/When the merger goes through they will have a lot of the top-performing channels and the top-performing tv and movie series. I currently like this company and plan on adding around the $25-$27 level for DISCK.