Discovery Leads Advertising Recovery

Discovery Communications (NASDAQ:DISCA) reported another good quarter, making it five in a row since the company went public in September 2009. The upside was not as big this quarter than prior quarters but that is due to factors beyond management control: higher expectations and analyst estimates and a still tough environment for advertising sales. What is in management's control continues to perform as well or better than any peer media company. Ratings are good, channel upgrades are on target and creating value, and cost controls remain strict.

DISCA shares are up 90% since Northlake's initial purchase in mid-September 2008 on the first day of the market crash. I still think upside remains but it will take more help from an economic and advertising recovery to drive future gains. I expect continued strong operating performance and support from merger activity at other cable networks to combine with an ad rebound and take the shares to the mid-$30s in 2010.

In 3Q09, DSICA reported revenues of $854 million, EBITDA of $364 million, and EPS of 22 cents. Revenues were slightly ahead of estimates and EBITDA was a significant positive surprise. The upside did not flow through to EPS, which fell short of the 27 cent estimate solely due to a large non-cash charge related to stock-based compensation.

DISCA's fundamental drivers are advertising sales and affiliate fees. Domestic ad sales rose an industry leading 5%, better than expectations for a 1% gain. DISCA is converting outstanding ratings into ad sales. International ad sales were up 9% in local currency, at the high end of guidance, although foreign currency translation led to a reported figure of -22%.

The news on affiliate fees was equally positive with domestic fees rising 10% after adjusting for the deconsolidation of Discovery Kids (now part of a joint venture with Hasbro (NASDAQ:HAS)). International fees rose 5%, again pressured by currency translation.

The company raised its EBITDA guidance but was only cautiously optimistic about 4Q and early 2010 ad sales. I think management is playing it safe due to the uncertain economy and the high amount ad sales taking place very close to airing. This theme was repeated throughout 3Q media conference calls. The trend of improving ad sales is obvious and established but like much in the economy the situation is fragile. I think DISCA management captured it well when they said "difficult pricing prevents full monetization of ratings" and "the environment is "improving but challenging." I suspect that when DISCA reports 4Q in early February it will be another positive quarter.

For 2010, I think revenue growth can be in the high single digits with slightly more margin expansion leading to low double digit EBITDA growth. The company does face two headwinds in 2010. The rebranding of Discovery Health to the Oprah Winfrey Network will cost $20 million in EBITDA and the sale of Travel Channel will cost DISCA an attractive ad sales contract that proves 1-2% of EBITDA. Nevertheless, as noted, I think another good year of industry leading financial and operational performance is on tap.

Disclosure: DISCA is widely owned by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.