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In finding great investments it is sometimes a good idea to follow the smart money, aka the Hedge Funds. Seeking Alpha provides a rich resource of hedge fund buys and shorts. While one may be too late to profit on the initial investment, one may be able to get an idea of what industries are either undervalued or growing. In researching a few hedge fund picks I came across John Paulson's latest small cap pick, AMC (AMCX). If you don't know, AMCX is the cable TV company behind the hit shows Breaking Bad, Mad Men and The Walking Dead. I did further research into the industry and found another similar company, Discovery Communications, (DISCA). DISCA creates the content behind the Discovery Channel, Animal Planet, Investigation Discovery, Velocity, Destination America, OWN and The Hub. DISCA has produced hit shows such as Gold Rush, Jungle Gold, Call Of The Wildman, and Through The Wormhole with Morgan Freeman, just to name a few. We believe both AMCX and DISCA are strong growth candidates in the coming years.

The purpose of this post is to follow up on my investment thesis of creative content providers posted on my blog:

As software and computers continue to improve exponentially, repetitive tasks will become obsolete, the only tasks or jobs that will need to be done our creative ones. Computers are not creative, at least not yet. So I believe any company that provides products that are creative, that require creative talent, and foster creativity will survive and prosper in the coming decades. For example Netflix (NFLX) is realizing this and has started creating their own creative content.

We will look at DISCA's past financial performance but most importantly analyze its current valuation and project its future performance. We will use ratio analysis to evaluate the financial performance of DISCA and a discounted cash flow model to value the company.

Currently the stock is trading at a high of $70. It has been a strong year for DISCA, the stock has traded up 11% since the beginning of January. We have a price target of $85.

source: stockcharts.com

Let's look at some profitability ratios.

Profitability Ratios

Company

Industry

Sector

Gross Margin (TTM)

70.61

60.18

29.06

Gross Margin - 5 Yr. Avg.

67.48

54.64

26.95

EBITD Margin

62.87

--

--

EBITD - 5 Yr. Avg

59.93

26.3

13.38

Operating Margin

40.71

6.36

9.45

Operating Margin - 5 Yr. Avg.

35.87

12.39

7.36

Pre-Tax Margin

33.07

7.31

10.57

Pre-Tax Margin - 5 Yr. Avg.

29.7

11.57

7.75

Net Profit Margin

24.25

1

7.69

Net Profit Margin - 5 Yr. Avg.

19.04

6.45

5.94

Effective Tax Rate

26.68

21.44

27

Effective Tax Rate - 5 Yr. Avg.

35.9

25.31

27.46

source: reuters.com

Gross margins of DISCA have been quite strong at 70.61% of sales in comparison to both its industry peers and sector. What's important to note here is that DISCA's TTM gross margins are much higher in comparison to DISCA's 5 year average gross margins. Operating margins are also stronger at 40.71% of sales in comparison to the industry and sector. Operating margins of DISCA have grown significantly at 40.71% in comparison to its 5 year avg. of 35.87% All in all these ratios are very positive for DISCA and clearly show that DISCA has a working business model that makes money. Obviously DISCA's flagship shows have continued to bring in recurring revenue viewership and its new shows have grown DISCA's customer base.

Let's now look at DISCA's liquidity and debt ratios. These are probably some of the most important ratios to look at when analyzing a company and represent the true financial strength of a company. Liquidity and debt ratios measure a company's ability to pay off its short-term and long-term debt obligations.

Liquidity Ratios

Company

Industry

Sector

Current Ratio (MRQ)

3.63

0.78

1.58

LT Debt to Equity (MRQ)

83.16

55.83

33.2

Total Debt to Equity (MRQ)

83.5

58.72

55.72

Interest Coverage

8.29

25.14

40.46

source: reuters.com

The current ratio, aka working capital, represents DISCA's ability to pay off its short-term debt. In a last resort scenario if the company were to become completely insolvent, a strong company would theoretically be able to pay off all its current liabilities by selling its current assets. As you can see DISCA has a strong financial position in comparison to its industry and sector. A current ratio of 3.63 is very strong in comparison to the industry standard of just 0.78.

It's interesting to note that total debt to equity of DISCA at 83.5% is much higher than the industry average. This is not necessarily a bad number just that there is a higher number of creditors vs. equity investors in the company compared to industry competitors. Generally larger companies have a greater amount debt obligations and can do this without much trouble.

Interest coverage on outstanding debt for DISCA, while lower than the industry, is at 8.29, which is quite strong. This ratio represents DISCA EBIT over interest expense. The ability to stay current with interest payment obligations is absolutely critical for a company as a going concern. Usually interest coverage below 1.5 is something to be concerned about. We have no doubt that DISCA is currently financially sound and strong going forward.

We will now evaluate management from a quantitative perspective.

Management Effectiveness Ratio

Company

Industry

Sector

Return on Assets

8.73

1.89

8.35

Return on Assets - 5 Yr. Avg.

6.02

4.54

6.42

Return on Investment

9.32

2.29

12.19

Return on Investment - 5 Yr. Avg.

6.46

2.21

10.26

Return on Equity

16.84

4.84

14.07

Return on Equity - 5 Yr. Avg.

9.55

6.21

11.99

source: reuters.com

Let's take a look at DISCA's return on assets. This ratio indicates how profitable a company is relative to its assets. It illustrates how effective management is in employing its total assets to make a profit. As you can see DISCA's TTM return on assets of 8.73 is significantly higher than the industry standard. Management obviously has utilized its assets effectively.

Return on Equity is quite strong. This represents management's ability to utilize and monetize shareholders' equity. Keep in mind this could be manipulated because of changes in the equity base especially if a company has a larger debt portion to equity, which DISCA does have. We feel this is a small factor because we have compared ROE to DISCA's industry competitors with relatively similar debt/equity structures.

Valuation

We will now compare DISCA to its closest competitors using value ratios and then conclude with a discounted cash flow model valuation. While some of the companies below may be diversified in other industries or sectors, these companies are all creative content providers in some shape or form.

Valuation Ratios

DISCA

AMCX

(SNI)

(TWX)

(VIAB)

(DIS)

P/E Ratio

25.61

28.13

18.92

19.27

14.29

17.46

P/E High - Last 5 Yrs.

74.52

21.04

155.62

22.49

--

16.73

P/E Low - Last 5 Yrs.

14.65

21.04

14.85

13.33

--

11.98

Beta

0.95

--

1.12

1.31

1.26

1.2

Price to Sales

3.8

3.17

4.13

1.68

2.27

2.32

Price to Book (MRQ)

2.91

--

5.71

1.61

4.19

2.47

Price to Tangible Book (MRQ)

--

--

224.19

--

--

19.29

Price to Cash Flow

8.18

17.32

7.48

13.72

12.04

12.04

Price to Free Cash Flow

16.06

16.43

18.81

25.48

18.93

23.49

As you can see from strictly a P/E valuation perspective, it looks like investors must pay a premium for DISCA. DISCA's P/E of 25.61 is higher than its competitors, which may be an indicator that the stock is overvalued. Investors are obviously expecting higher growth in the future. It's interesting to note that DISCA's current PE is trading lower than it has in the past.

The Price to Sales ratio also confirms investors' bullish growth sentiment on the stock as well. DISCA's 3.8 P/S is only second to AMCX's P/S of 3.17, both indicating investors must pay a premium for these potential growth stocks.

On the other hand the Price to Cash Flow and Price to Free Cash Flow of DISCA does look relatively undervalued compared to its peers. Some financial analysts prefer to focus on a company's cash flow rather than its earnings, the reason being cash flow is not as easily manipulated but earnings on the other hand can be affected by depreciation and other non-cash factors. As you can see the Price to Cash Flow ratio of DISCA is just 8.18 compared to TWX 13.72, VIAB, 12.04 and TMCX's whooping 17.32 Price to Cash Flow ratios.

The same can be said of DISCA's Price to Free Cash Flow of 16.06, which is smaller than SNI, TWX, VIAB and DIS.

Discounted Cash Flow Analysis

Base12345678910Terminal Year
Revenue Growth Rate12.00%12.00%12.00%12.00%12.00%12.00%12.00%12.00%12.00%12.00%2%
Revenues$4,235$4,743$5,312$5,950$6,664$7,464$8,359$9,362$10,486$11,744$13,153$13,416
Operating Margin42.48%38.74%36.87%35.93%35.47%35.23%35.12%35.06%35.03%35.01%35.01%35.00%
EBIT$1,799$1,838$1,959$2,138$2,363$2,630$2,935$3,282$3,673$4,112$4,605$4,696
Taxes$630$643$686$748$827$920$1,027$1,149$1,286$1,439$1,612$1,644
EBIT(1-t)$1,169$1,194$1,273$1,390$1,536$1,709$1,908$2,133$2,387$2,673$2,993$3,052
+ Depreciation$119$133$149$167$187$210$235$263$268$274$279$285
- Capital Expenditures$58$65$73$81$91$102$114$128$144$161$180$694
- Chg WC$217$117$131$147$165$184$206$231$259$290$325$61
FCFF$1,013$1,146$1,218$1,329$1,468$1,633$1,822$2,037$2,253$2,496$2,767$2,583
NOL $0$0$0$0$0$0$0$0$0$0$0
Terminal Value $29,054
Cost of Capital Calculations
Tax Rate35.00%35.00%35.00%35.00%35.00%35.00%35.00%35.00%35.00%35.00%35.00%35.00%
Debt Ratio7.15%7.15%7.15%7.15%7.15%7.15%13.72%15.36%18.10%23.57%40.00%40.00%
Beta1.151.151.151.151.151.151.141.131.121.111.11.1
Cost of Equity9.78%9.78%9.78%9.78%9.78%9.78%9.72%9.66%9.60%9.54%9.48%9.48%
Cost of Debt20.00%20.00%20.00%20.00%20.00%20.00%20.00%20.00%20.00%20.00%20.00%20.00%
After-tax cost of debt13.00%13.00%13.00%13.00%13.00%13.00%13.00%13.00%13.00%13.00%13.00%13.00%
Cost of Capital10.01%10.01%10.01%10.01%10.01%10.01%10.17%10.17%10.22%10.36%10.89%10.89%
Computed Variables (These are measures of how efficiently your firm is investing over time)
Total Capital Invested$10,736.00$10,785$10,839$10,901$10,969$11,046$11,132$11,228$11,363$11,540$11,765$12,235
Reinvestment Rate13.34%4.09%4.29%4.40%4.46%4.49%6.67%7.22%8.12%9.94%15.38%15.38%
Increase in Revenue/Increase in Capital10.4110.4110.4110.4110.4110.4110.418.377.16.240.56
Return on Capital11.12%11.80%12.82%14.09%15.58%17.27%19.17%21.26%23.52%25.94%13.00%
Present Value Calculations
Cumulative WACC1.100083441.2101835661.3313028961.4645442641.6111208861.7749550711.9555167442.1552866032.3785009362.63750066
Present Value of FCFF$1,041$1,007$998$1,002$1,013$1,027$1,042$1,045$1,049$1,049
Present Value of Terminal Value $11,016
The Valuation
PV of FCFF during high growth phase =$10,274
PV of Terminal Value = $11,016
Value of Operating Assets of the firm =$21,289
Value of Cash & Non-operating assets=$2,096.00
Value of Firm = $23,385
- Value of Outstanding Debt =$1,413
Value of Equity = $21,972
- Value of Equity Options =$0
Value of Equity in Common Stock =$21,972 Treasury Stock Approach
Value of Equity per share =$84.19 $85.16
Summary Output
Revenues$4,743$5,312$5,950$6,664$7,464$8,359$9,362$10,486$11,744$13,153$13,416
EBIT$1,838$1,959$2,138$2,363$2,630$2,935$3,282$3,673$4,112$4,605$4,696
EBIT(1-t)$1,194$1,273$1,390$1,536$1,709$1,908$2,133$2,387$2,673$2,993$3,052
- Reinvestment$49$55$61$69$77$86$96$134$177$226$470
FCFF$1,146$1,218$1,329$1,468$1,633$1,822$2,037$2,253$2,496$2,767$2,583

In conclusion, when using valuation ratios, we see that investors are expecting greater growth for DISCA in the future, therefore the higher P/E. But when using the Price to Cash Flow and Price to Free Cash Flow, DISCA is undervalued.

DISCA's 1 year growth rate stands at 12%. If we forecast that DISCA will continue its successful flagship shows and continue to innovate with new upcoming shows, we feel confident in projecting compounded annual growth revenues of 12% for the next 10 years. Analysts' consensus has projected 5 year growth rates as high as 20%. I will use the average past 5 year operating margins of 35% (as shown above). Keep in mind if you remember above, DISCA's TTM operating margins have grown to over 40%, so we feel we are being conservative on this variable going forward. We will use a weighted average cost of capital of roughly 10% going forward. This is based on a cost of debt of 20%. Using these variables we come to a present equity valuation of $85. This represents a 21% premium on the current market value. We have a buy on the stock.

Source: Discovery Communications: A Quantitative Perspective