Discovery Communications Q4 2009 Earnings Call Transcript

Discovery Communications Inc. (NASDAQ:DISCA)

Q4 2009 Earnings Call

February 10, 2010 8:30 am ET

Executives

David M. Zaslav – President, Chief Executive Officer, Director

Bradley E. Singer – Chief Financial Officer, Senior Executive Vice President, Treasurer

Peter Liguori – Chief Operating Officer

Craig Felenstein – Senior Vice President of Investor Relations

Analysts

Benjamin Swinburne - Morgan Stanley

John Jenedis - Wells Fargo

Jessica Reif Cohen - Bank of America Merrill Lynch

Anthony Diclemente - Barclays Capital

Doug Mitchelson - Deutsche Bank

Richard Greenfield - Pali Research

Imran Kahn - J.P. Morgan

David Joyce - Miller Tabak and Co.

Operator

Good day, ladies and gentlemen, and welcome to the fourth quarter 2009 Discovery Communications Incorporated earnings conference call. My name is Latisha and I will be your operator for today. (Operator Instructions) The speakers on today’s call will be Discovery’s President and CEO, David Zaslav, Chief Financial Officer, Brad Singer and Chief Operating Officer, Peter Liguori. I would now like to turn the call over to your host for today, Mr. Craig Felenstein, Senior Vice President of Investor Relations. Please proceed, sir.

Craig Felenstein

Thank you, Latisha. Good morning , everyone and welcome to Discovery Communications’ fourth quarter and full year 2009 Earnings Call. As Latisha mentioned, joining me today is David Zaslav our President and Chief Executive Officer, Peter Liguori , our Chief Operating Officer and Brad Singer our Chief Financial Officer.

Hopefully you have all received our Earnings Release, but if not feel free to access it on our website at www.discoverycommunications.com. We will begin today’s call with some opening comments from David, Brad and Peter, after which we will open the call up for your questions.

Before we begin I’d like to remind you that comments today regarding the company’s future business plans, prospects and financial performance are forward-looking statements that we made pursuant to the safe harbor provisions of the private securities litigation reform act of 1995. These statements are made based on management’s current knowledge and assumptions about future events and they involve risks and uncertainties that could cause actual results to differ materially from our expectations.

In providing projections and other forward looking statements the company disclaims any intent or obligation to update them. For additional information on important factors that can effect these expectations, please see our Form 10-K for the year ended December 31st 2008 and our subsequent filings made with the U.S. Securities and Exchange Commission. And with that I’ll turn the call over to Brad.

Bradley E. Singer

Thanks, Craig. We appreciate the opportunity to discuss our fourth quarter performance and current operating environment with you. We enjoyed our strongest top-line growth of the year during the fourth quarter as advertising, pricing and demand strengthened sequentially in our domestic and international operations. Total revenues increased 7% compared to the prior year, led by 16% international revenue growth, excluding $19 million of favorable currency impact and complimented by 3% U.S. network growth.

Our total operating expenses increased 2%, excluding $18 million of unfavorable currency impact. As we continue to reduce our SG&A spending. We lowered our SG&A costs by $16 million in the quarter, but increased our cost of revenues primarily due to content and period charge increases of $20 million compared to the fourth quarter of the prior year.

Our adjusted OIBDA grew 8% to $390 million compared to the prior year. Please note our fourth quarter results reflect a deconsolidation of Discovery Kids reducing revenues by $11 million and adjusted OIBDA by $5 million and include $5 million in expenses related to the Oprah Winfrey network.

Our net income increased to $155 million reflecting our improved operating performance and lower impairment charges, offset by mark-to-market increases in our share based compensation. Our free cash flow more than doubled to $236 million, primarily due to improved operating performance and favorable working capital during the quarter.

Looking back on our full-year 2009 performance, our ability to grow revenues, adjusted OIBDA and free cash flow is a testament to the strength of our business model, and our ability to execute in a challenging economic environment. Our team produced 12% adjusted OIBDA and over 40% free cash flow growth, adjusted for the tax impact of the Kids’ transaction, while delivering a hard fought 2% revenue growth. David will take you through how we were able to achieve these results in such a tough environment for operating units.

Our U.S. operations performed well during the fourth quarter. Domestic revenues grew 3% with distribution revenues increasing 4% from higher rates and expended distribution of our digital networks. Offset by the deconsolidation of the Kids’ network revenue. The affiliate revenue growth was 8% compared to the prior year.

Our domestic ad sales team continued strong performance, growing revenues 2% in an improving market. We are encouraged by the scatter pricing tightening throughout the fourth quarter premiums to broadcast upfront in the high teens to mid-20% range across our networks. However, while the scatter pricing improved over 1,000 basis points in premiums to broadcast upfront from the third quarter, we were comparing against 20%-35% premiums in the fourth quarter of the prior year. The tough scatter comparison combined with modestly down broadcast upfront pricing resulted in 2% increase, despite strong national demands.

Our domestic operating expenses increased in the fourth quarter by $26 million, compared to the prior year. The increase was primarily due to approximately $20 million of program impairments at TLC, Animal Planet and Science and to startup expense related to (inaudible).

For the year, our U.S. domestic team tightly controlled this cost structure, reducing SG&A expenses by $42 million or 9%. More than offsetting the $24 million increase in cost of revenue, enabling us to expand our 2009 adjusted OIBDA margins by 200 basis points or 56%.

Our international team finished the year with their strongest quarter of 2009, revenues increased 22%, which included a 10% increase in affiliate revenues, a 24% increase in advertising and a 7% increase due to favorable foreign exchange rates. International affiliate revenue was led by strong growth in Latin America. Our international advertising revenue continued to accelerate with 18% growth in the fourth quarter, compared to the prior year excluding the favorable impact of foreign exchange and a $6 million favorable one-time item related to the settlement of our impact CAPEX scheme.

Ad revenue growth was broad based with all of our regions experiencing double digit growth rates. Excluding the $18 million negative currency impact to our expenses, our operating cost went up 1%. OIBDA revenue increased 8% from the prior year primarily due to higher content amortization and distribution costs, while SG&A declined 6% from lower marketing and other general expenditures. Excluding the $1 million positive foreign currency impact our international operations increased adjusted OIBDA 44%, and margins increased to 43%.

Our international network (inaudible) outstanding operating leverage with over 95% of incremental revenue translating into adjusted OIBDA for the fourth quarter. Fourth quarter kept a strong performance throughout 2009 for the international team, with 10% revenue growth and 24% adjusted OIBDA growth, excluding the impact of currency movements. Their performance improved operating margins over 400 basis points and delivered 83% of incremental revenues to adjusted OIBDA.

Overall the company’s performance during the fourth quarter of 2009 slightly exceeded the high end of our revenue and adjusted OIBDA expectations, as conditions approved globally in the advertising markets. As we look forward to 2010, we are encouraged that the improved pricing and ad trends we experienced in the fourth quarter have continued through today. However, we do remain cautious given the recent and potentially recurring global economic volatility.

For 2010 we are forecasting a range of $3.625 billion to $3.75 billion or between a 3%-7% increase in revenues. Our outlook incorporates low to mid single digit U.S. ad growth and high single digit international ad growth, excluding foreign currency. We believe affiliate revenues adjusted for divestages(ph) will grow in the mid to high single digits both domestically and internationally. For comparative purposes please note that our 2010 revenues do not include Discovery Kids, which produced $19 million prior to May sales of 50% interest and $11 million related to Animal Planet Japan will no longer be consolidated in our financial statement.

We also anticipate losing approximately $15-$20 million of revenues on a representation of the travel challenge, due to its ownership change in the first half of 2010. Based on current exchange rates we anticipate foreign currency will minimally impact operations compared to the prior year. We anticipate adjusted OIBDA of $1.56 billion to $1.64 billion or to between 5% and 10% growth for 2010.

Our adjusted OIBDA growth will be primarily driven by our revenue growth, majority of the incremental revenue translating into adjusted OIBDA. We anticipate low single digit operating expense increases in 2010. Please note that 2009 will be recast and 2010 will not include the revenue and expense of the Oprah Winfrey network and Animal Planet Japan through the implementation of OWN. We have provided a supplementary schedule that details the 2009 impact in our earnings release. We anticipate net income from continuing operations of $660 million to $725 million and capital expenditures of $50-$60 million. Our outlook incorporates the current share price in capping the LTIP impact to net income.

We anticipate generating free cash flow between $700-775 million in 2010, we expect to significantly improve our cash from operations due to the growth in our revenue and operating leverage. We do anticipate a higher level of tax payments in 2010 than our estimated long-term 37.5% economic tax rate due to the expiration of the Section 181 tax deduction for domestic (inaudible) production, which will add approximately $70 million to our tax payments as prior deductions are accelerated and recouped. As a result we anticipate our 2010 tax payments will $425-$460 million which is comparable to 2009, which included $108 million related to the gain on Discovery Kids transaction.

We also incorporate in our guidance the adverse impact to our working capital of the long-term incentive compensation payments accrued in 2009, which will total approximately $120 million. As a result of the expiration of the section 181and the LTIP payments, our 2010 anticipated run-rate free cash flow is reduced by over $150 million, which is reflected in our outlook.

With a strapping financial position we will continue to selectively increase the duration of our capital structure to better match the long lives of our assets and increase our financial flexibility. Our strapping financial position enables us to direct our capital resources where they are expected to generate the highest return for our shareholders in the future. We will continue to work hard, insuring the best use of the capital we generate. The recent volatility in the market may provide us an opportunity to employ our capital from more efficiently an internal as well as externally.

Before I finish up, I would like to remind everyone that the successor of Planet Earth, Life, will be premiering the last week of March on Discovery and please be sure to catch the Police Women, (inaudible) later this month on TLC as well as the season premiere of River Monster on Animal Planet. With that I will turn the call over to David Zaslav, our President and CEO.

David M. Zaslav

Thanks, Brad. Good morning, everyone, we appreciate you joining us for our year end call, it’s a great opportunity to reflect on what Discovery Communications accomplished over the past year and also look ahead to 2010.

Brad has taken you through our fourth quarter results, a strong end to a year in which Discovery outperformed on nearly every single financial metric. Despite challenging economic conditions throughout most of 2009, we managed to deliver top-line revenue growth while diligently cutting costs leading to double digit adjusted OIBDA growth and free cash flow growth.

Our growth was consistent with revenue and adjusted OIBDA gained every quarter excluding foreign currency. Our growth was diverse with both domestic and international platforms delivering advertising and subscription increases and our growth was balanced, with expansion from both revenue growth and targeted cost reductions.

On our call 12 months ago we laid out the rational for why we were confident Discovery would outperform in 2009 and deliver real financial growth despite a tough macro environment. I’d like to revisit and underscore some of the strategic advantages that enabled us to deliver such strong results in 2009, as they also lay the foundation for why we expect to be successful again in 2010.

First advantage we cited a year ago, one that was going to be especially valuable given the uncertain economic environment at the time, was that nearly 50% of our revenues come from recurring subscriber fees through our multi-year contractual relationships with our affiliate partners. Fees that provide top-line sturdiness and helped insulate the company from the choppy and difficult environment.

These affiliate fees delivered sustained growth through 2009 with affiliate revenues of 8% excluding foreign currency in the removal of Discovery Kids. And this growth was geographically diverse, the U.S. program capitalized from the escalators embedded in our affiliate contracts as well as the 5% expansion of the subscriber base, primarily from further penetration of our digital networks to deliver 9% affiliate revenue growth excluding Kids. And Discovery’s international networks leveraged the continued secular growth trends of Pay-TV around the globe expanding its subscriber base and delivering 9% affiliate revenue growth this past year excluding foreign currency.

Our cable network affiliate fees gave us a real competitive advantage in 2009, and will continue to provide a strong foundation for growth in 2010 as digital subscribers continue to penetrate domestically and Pay-TV grows internationally.

The second advantage we cited a year ago was the strength of the company’s brand portfolio. Ratings momentum the portfolio was generating towards the end of 2008, gave us real confidence that we would continue to grow our market-share in the year ahead. This was even more important than usual in the tough and uneven economy, it was imperative from an advertiser perspective to maintain this momentum throughout 2009 and I’m proud to say we did that and then some.

Every one of our rated channels delivered increased audiences this past year, and we grew our ratings for the portfolio as a whole every single quarter. Primetime ratings delivery across our domestic networks was up 8% among our key demo in 2009, while the rest of cable was down slightly and broadcast declined 7%.

We were led this year by the remarkable turnaround at TLC. This was a channel in 2008 which was completely off-course, we put in a new management team last year, led by Eileen O’Neil and it is now a top ten network for women with ten shows averaging over 1 million total viewers. In 2009 it had its highest audience in five years and delivery was up 13% in its key women 25-54 demo led by double digit increases from returning shows, Say Yes To The Dress, L.A. Ink, Jon & Kate, Little People Big World and 18 Kids And Counting. As well as new hits, Police Women of Broward County, Little Couple, Toddlers & Tiaras and Cake Boss.

Animal Planet also had a tremendous year, increasing its viewership 16%, among adults 25-54 and delivering its best audience in six years. The Animal Planet Rebrand is working, ratings gains were led by new hits, River Monsters, which premiered in the second quarter and was the best performing series ever for the network. As well as by returning hit Whale Wars, which in its second season delivered 18% growth and is the second highest rated series in Animal Planet history.

Discovery Channel also grew in 2009, up 4% led by the best year ever for returning hits, Deadliest Catch, Man Vs. Wild, Dirty Jobs and Storm Chasers. Several new shows also showed real promise that will be brought back for a second season, including The Colony, Ghost Lab, Swamp Loggers, Swords and Pitchmen.

Another big growth story among our cable nets this past year was the continued rating gains at Investigation Discovery, ID. ID had its best year ever among nearly every demo, including a 27% increase among its key women 25-54 demo. Since its launch in January 2008, ID has grown it’s targeted audience nearly 200% and delivered 24 months of sustained viewership growth, ID has moved from the 49th ranked network for women 25-54, a year ago in the U.S. to the 38th ranked network today, despite being in less than 60 million homes.

ID has established itself as America’s leading investigation network led by hits, On The Case With Paula Zahn, The Shift, Disappeared and I Almost Got Away With It, which premiered after the quarter and delivered the largest audience in the history of the network. We still have a long way to go in our quest to make ID a top 20 network, but Henry Schleiff and his team have done a great job establishing ID as a preeminent channel for crime and forensics programming.

But the ratings growth is only part of the domestic story, our diversified portfolio which reaches a broad range of demos across our networks and delivers devoted engaged and upscale audience, is an attractive value proposition for clients, especially when forced to make tough choices with shrinking ad dollars. Additionally, we have what I think is the best ad sales team in the business, led by Joe Abruzzese, they continue to be innovative and develop additional ways to provide value to their clients and they certain delivered this past year.

Our domestic ad revenues were up 2% this year, pretty remarkable when you look across the media space and see that no other media company delivered sustained ad growth in 2009, and we did so in every single quarter. However, when I look at the ratings success we achieved in 2009, it’s apparent that the economic downturn hampered our ability to fully monetize our growing audiences and our dynamic brands, which is why I’m so optimistic about domestic advertising in 2010.

Our ratings momentum is poised to continue this year, with a broad and deep development slate of new and returning series across all our networks. In fact, ratings in January were up 12% giving us a great start to the year. We will also be buoyed by the March premier of Life on Discovery, which includes 11 hours of original programming narrated by Oprah Winfrey and produced by the same folks who delivered the hugely successful Planet Earth series.

We do face an advertising hurdle, given that our upfront pricing was down slightly. But we anticipate making up these declines with strong ratings and hopefully a continued robust scatter market. Scatter pricing has steadily improved since last quarter and has further strengthened in January along with increased demand. The stronger scatter market improved visibility and continued ratings momentum, we expect to deliver accelerated ad growth domestically in 2010.

Similar to the U.S. the weak economic environment throughout most of 2009, hindered our ability to monetize our viewership growth internationally. We did manage to translate increased audiences across EMEA, Latin America and Asia Pacific all of which experienced double digit viewership increases into 10% advertising growth, excluding foreign currency.

But the opportunity exists to further expand this revenue stream as the economy continues to stabilize. There were continued signs of recovery during the fourth quarter with international advertising in local currency up 18%. But we will remain cautious given the limited albeit improved visibility internationally.

As our international market share continues to expand through increased viewership and reach, the company remains well positioned to deliver heightened ad growth in 2010 as we capture an increased share, what we expect will be a larger pool of ad dollars in the marketplace.

The last strategic advantage we discussed a year ago was our operating flexibility and our stringent focus on permanently reducing our cost structure, the tough economy allowed us to be more aggressive and act with a greater sense of urgency, but as we headed into 2009 we are certain there were additional areas where we could be more efficient and cost effective.

Over the last 12 months the company took significant steps to restructure our work force, refine our marketing spending and reduce our research costs, the net results of all these cuts was lower SG&A spending of 10%, excluding foreign currency. The majority of which has been permanently removed from our overall cost structure. And while we were aggressive in lowering our overall cost base, we did not sacrifice the quality of what is on the screen. We’ve been resolute in stating that we will continue to invest in quality content because it is the driving force behind our business.

We told you throughout last year that we would offset any increase programming costs during 2009 with cuts to SG&A that we delivered. Our cost of revenues was up 7% this past year excluding FX but we more than offset that with lower overhead costs. The net result was operating expenses down 2% in 2009, which when combined with our revenue growth resulted in real operating leverage as margins expanded to 42%.

In the year ahead we plan to further invest in our brands and original content but the focus will remain on success based investment, putting our money to work where it is proven to generate a return, such as at Animal Planet and ID.

As Brad mentioned despite this investment, we expect margins to continue to rise in 2010 but that growth should be driven primarily by revenue expansion and a focus on maintaining a stable cost base, rather than largely through cost reductions.

Lastly, during 2009 we also took several strategic steps to better position us for long-term growth. The highest profile of these initiatives was undoubtedly the progress we have made at OWN. Christina Norman has done a great job focusing the strategic direction of the network and Oprah.com and she and her team are wrapping up the programming line-up in anticipation of the launch next January. Just last week we announced five shows which will be part of next year’s slate, including a behind the scenes series which Oprah will narrate, documenting the last year of the Oprah Winfrey Show in syndication.

We’re excited about the direction of the network and look forward to showing advertisers the progress we’ve made at this year’s cable upfront. Oprah and I are actively involved in all aspects of the network and we are working together to further define her on air presence following the announcement that she will be ending her long running syndication show in 2011.

We’ve also made substantial progress at our joint venture with Hasbro, including announcing that it will be branded The Hub. Magret Loesh and her team have been working diligently on strategy and program development in anticipation of the launch later this year. Hasbro team led by Brian Goldner have been great partners and we are excited about the passion they bring to the venture as well as the content ideas they have developed thus far.

During this past quarter we also announced a partnership with Sony and IMAX to launch the first 24 hour, 3-D network and while it is very early in the consumer lifecycle for this technology we anticipate being the leader in 3-D content, much like we did with high definition when John Hendrix launched the first high-def channel back in 2002 with Discovery.

Finally, we also have implemented several management changes, which we feel will improve our operations going forward, including transitioning Mark Hollinger to take over at our international networks. Mark helped build our international platform over the past 20 years, is a superb operating leader and he is the ideal choice to lead the division for the next stage of growth.

We’ve also named Peter Liguori as our Chief Operating Officer, Peter has been one of the most successful leaders in the media industry over the past 25 years and has an extensive track record for developing innovative marketing and programming. Peter is a world class creative leader, I look forward to partnering with him as he helps the company continue our transition from a great platform company to a great content company.

2009 was a challenging year. But despite an economy that was weaker than anticipated, Discovery delivered on our expectations, achieved real growth and outperformed our peers. As we head into 2010 in what we anticipate will be an improved operating environment, the company 's sustained ratings momentum, distribution strength and a leaner cost structure position discovery to deliver continued strong growth in the year ahead.

Before we take your questions, I'd like to turn the call over to Peter Liguori for a few brief comments.

Peter Liguori

Thanks, David. Good morning everyone. It's great to be here with you today. I met several of you in the last years from my old job at NewsCorp and I really look forward to sitting down with you in the future to talk about our story here at Discovery.

I've only been here for about three and a half weeks so there's still plenty for me to learn, but what's fairly obvious is that Discovery is extremely well positioned with a diverse portfolio of strong brands married to an extensive distribution platform. Discovery has always been synonymous with high quality content and David and his team have continued this tradition while taking bold steps to transform the company, further positioning it for long term growth.

My focus here will be on taking the company's diverse brands and refining and accelerating their audience appeal and their brand entitlement. There's no need for wholesale changes, we're already headed in the right direction. My goal is simply to help figure out the best way to get the most out of the assets that we have. We have unique opportunities ahead from further developing the global appeal of iconic brands such as Discovery and TLC to also finding the upside in existing brands such as Animal Planet and Science, where there are big opportunities to also building new brands from the ground up, such as ID or Investigation Discovery. And of course our joint ventures with Own and the Hub. As David said, we're focused on continuing Discovery's evolution from what is already a great platform company with strong brands into a great content company with engaged audiences around the globe. I'm very excited to be part of the team, and I couldn't be more excited to be working with David, Brad and everyone that they've assembled back at Silver Spring. So I look forward to meeting all of you again and down the road I hope we're going to be able to share some more time and I'm going to turn this back over to Craig.

Craig Felenstein

Operator, we're ready to take the questions now.

Question and Answer Session

Operator

(Operator's Instructions) Your first question comes from the line of Benjamin Swinburne. Please proceed.

Benjamin Swinburne - Morgan Stanley

Two questions for you, I guess. Starting with scatter pricing, Brad I think you mentioned scatter over scatter was a headwind in the fourth quarter, but it sounds like there's been improvement there. When I look at your advertising guidance for the U.S. I think you said low to mid-single digits. It would seem with your ratings strength if we start to get scatter over scatter being up year on year that could prove to be pretty conservative. I just wondered if you were making an explicit assumption about that pricing in your guidance or at least could comment on my thought process.

And then second, maybe for Peter and David, when you look at the international business at Discovery and Peter when you compare that to what NewsCorp built in the Fox International business which has become a big business for NewsCorp. Is there anything you would take from the NewsCorp experience that you think could improve what Discovery's been doing internationally, or do you believe that the strategy of re-purposing U.S. content overseas which has been a huge margin driver for Discovery remains core and the way to move forward? Thank you.

Bradley E. Singer

Hey Ben, I'll take the first one then I'll turn it over to David and Peter to discuss the international operations. With regard to scatter pricing as you highlighted in the fourth quarter we might have been up 15% to 25% depending on which network but we were going up against premiums that were 35% you know with their broadcasts up front. In the first quarter of the prior year the premiums are not as high as they were in the fourth quarter of 2008. So right now we're running slightly ahead of the 2009 scatter market, where we're pricing today. And scatter premiums have picked up slightly from the fourth quarter so they're a bit higher than that 15 to mid-20's range. If that holds and the ratings hold you'd be at the higher end of our guidance and that's how it's conceived. Right now for the first quarter, given the map we've just walked through we'd be running around 5%-ish, maybe a little bit better, depending on if the ratings hold throughout the quarter.

So I think that all the math you went through is consistent with how its playing out.

Benjamin Swinburne - Morgan Stanley

Okay, got you.

Peter Liguori

On your second question, in looking at the experience from NewsCorp versus Discovery, I really do feel that Discovery is at a specific advantage. When you look at the difference between scripted programming, especially things like comedy to non-fiction, you realize how non-fiction translates overseas almost flawlessly. You know, the world of science, natural history, investigative work, real people, real families – there's no known international boundaries – they're the same across the board. So I think these brands, especially with the content that's provided are particularly well positioned for overseas growth and I look forward to working with Mark on exploring the upside with our international distributors.

Benjamin Swinburne - Morgan Stanley

Thank you.

Operator

Your next question comes from the line of John Janedis with Wells Fargo. Please proceed.

John Janedis - Wells Fargo

Hi, thank you. Can you just talk a bit more about the ratings at the Discovery Channel. They've been a bit mixed (inaudible) I guess I'd say, David you mentioned Life but I'm wondering to what extent you've got some other mirrors coming over the next few months and if you've changed the number of new programming hours during prime time? Thanks.

David M. Zaslav

Well we're very excited about Life and that will be premiering in March and we have a big promotion against that because we think it's break out programming like Planet Earth was – the same team put it together. Our series' are very strong, we're – Deadliest Catch will be coming back, a few of you may have read that we lost one of our captains last night, and it's been quite a dramatic season. But overall our series' remain very strong. We have a new leader in there, Clark Bunting and we're reinforcing the creative leadership team and Peter is working with Clark on that very simple mission which we started three years ago, which is what is Discovery at its best. So you'll be seeing us kind of leaning in, because we think that curiosity at it's very heart, which is what Discovery is all about has meaningful upside, domestically and around the world. So we're continuing to invest in that, and we think we can build it.

John Janedis - Wells Fargo

And Brad one other question related – or unrelated I should say. Can you help us think about the cost indebted in your outlet for Hasbro (inaudible) I'm sorry if I missed it earlier.

Bradley E. Singer

John, because of the accounting change for FAS 167 neither of those costs flowed through our current incomes statements. They're just picked up on an equity basis.

Craig Felenstein

Next question Operator, please.

Operator

Your next question comes from the line of Jessica Reif Cohen of Bank of America Merrill Lynch. Please proceed.

Jessica Reif Cohen - Bank of America Merrill Lynch

Thank you. I had a couple questions. I was wondering if you could help us or elaborate a little more on the international potential. How much is the sub-growth growing over the next couple of years, how much upside is there on affiliate-cy rate increases. I think that the Disney Channel numbers showed surprising growth from outside the U.S. and how much of a share shift have we seen and how much more is there to go from advertising shifting from broadcasting to cable/satellite?

David M. Zaslav

Hi Jessica. Let me deal with it generally. We've been rebuilding our ad sales team as you know. It's only been in the last two years that we've been selling in those markets and we're finding that and building the strength of our team around the world. We still have – the majority of the money we make outside of the U.S. is in affiliate fees, so on the affiliate side, as we build our brands and we grow our ratings that enhances our hand as our deals come up. About 70% of our deals are locked through the end of 2011 and so we will have an opportunity as we build those brands to take advantage of the fact that our channels are stronger and continue to grow.

On the advertising side we showed in the fourth quarter that we've been able to build on our strength by having good people on the ground and by selling locally, we put up a very strong number 18% growth in the fourth quarter. And we still haven't taken full advantage of the additional viewership and market share that we've gotten around the world.

In terms of the overall growth of subs, it really depends on the market but there are a number of markets that are like the U.S. in the late 90's – we're seeing significant growth in India, significant growth in Brazil and in Chile. A lot of the emerging markets are very strong and then it's a mixed bag. There are some markets like Southern Europe and the UK that are about as mature as the U.S. But on balance there are a number of big markets where we're well positioned with a number of channels in low channel position with good sub fees where as the market grows we will grow with it just by the fact that we were there early and we have market share.

Jessica Reif Cohen - Bank of America Merrill Lynch

And then, Brad commented specifically about first quarter trends in advertising. Can you guys give us some color on what you're seeing internationally in advertising?

Bradley E. Singer

Hey Jessica. It's a little early to tell. You know the favorable trends we had in the fourth quarter seem to be continuing but that market isn't as fully developed in terms of there's not a large upfront in many of the countries or anything that's an analog to that sales profit. So it does come together later. It's encouraging what we've experienced in January but we just don't have the same visibility that we have in the States.

Jessica Reif Cohen - Bank of America Merrill Lynch

And then one final question I guess I have for Peter. Peter you mentioned that Science you see a lot of upside. Can you just give some more specifics as to how you plan to direct the channel?

Peter Liguori

Yeah, you know just in my first few weeks here, going out to the creative community it is just remarkable how many big name storytellers look at all the Discovery networks – but you know especially a fascination with Science overall. And in just discussing what opportunities there are for content on Science you do see storytellers responding to it. David and Debbie and Clark have Steven Spielberg doing some work specifically on the Science channel to bring to life what would normally be considered somewhat of a dry topic, but bringing to life the stories around science innovation and the future of science. So when we look at that network it's going to be able to move more from an explanation of science to the life of science which we experience every day. So I'm highly encouraged by the reception that the creative community has had for that channel.

Jessica Reif Cohen - Bank of America Merrill Lynch

Thank you.

Craig Felenstein

Next question, Operator please.

Operator

Your next question comes from the line of Anthony Diclemente of Barclays Capital. Please proceed.

Anthony Diclemente - Barclays Capital

Hi, good morning. Brad did you give an expectation for domestic advertising growth in the current quarter?

Bradley E. Singer

We did not. What I did highlight Anthony was that it's running right now – I'd call in the mid-single digits a little better than 5% potentially but again, we're not done with the quarter, our ratings aren't done – we still have the Olympics to go through but based on where we're at today that would be our expectation.

Anthony Diclemente - Barclays Capital

Okay, thanks. And then on your comments on use of free cash flow, I just wondered Brad if there are any acquisition or M&A opportunities that you see globally out there and if not any reason you wouldn't be in there buying your stock back right now?

Bradley E. Singer

Well, right now we probably have several things that we're looking at. They're not in the billion dollar range - they could potentially be an aggregate in the several hundred million dollar range. So there are opportunities that we think would be good returns on the capital we'd invest. If we cannot find productive uses that generate good returns you should anticipate it, we'll be repatriating money back to our shareholders over the course of this year.

Anthony Diclemente - Barclays Capital

What types of things are those? Are there international cable networks that are out there?

Bradley E. Singer

The one's that we're looking at right now are either potentially buying in parts of joint ventures we don't own, bringing in some capability, and they have basically for the most part been internationally oriented.

Anthony Diclemente - Barclays Capital

Okay, thank you. And then one for David just more broadly on your digital strategy. I think you've been a bit more reluctant to release some of your content onto new digital platforms, and I'm just wondering if you could update us all on your strategy for monetizing online content in view of the relationship you have with your cable operators? Thanks for the questions.

David M. Zaslav

Sure. We have held back – we have a great library – 20 year library we own virtually all of our own content, but we haven't put out much long form because we really are holding it back for a business model that works which is our cable channels. But more importantly we found that we can very effectively get our content out there in best of and clips and in different ways by like having channels on YouTube where people upload myths that they can bust and have a communication back and forth with the Myth Busters. It's a much more effective way to build our brands as people play on all these other platforms, so that's number one.

Number two is that we're really getting aggressive in what I would call social-viral community. As we look at one of the advantages that we have – because we're non-fiction across our 13 channels here in the U.S. and around the world, as you take a look at Facebook and YouTube and Twitter, we have a chance to lean in on those platforms because we have real people, that have real fan bases – whether it's the Captains from Deadliest Catch or Jamie and Adam from Myth Busters, or a lot of the great characters like Buddy from Cake Boss – so we've been really pushing all of our characters who have a real connection with viewers domestically and around the world to participate on all of the social platforms. And that seems to be working quite well for us and so as we look at new media we don't just look at it as ways of pushing our content out, we look at it as ways of reaching out to fan groups that can reinforce from a marketing perspective the importance of our personalities and our brands and our shows.

Anthony Diclemente - Barclays Capital

Thank you.

Operator

Your next question comes from the line of Doug Mitchelson of Deutsche Bank. Please proceed.

Doug Mitchelson - Deutsche Bank

Thanks very much. A couple for Brad and then sort of a big picture question. Balance sheet then if you might start returning capital or have some deals lined up – what's the right long term leverage target? And then you talked Brad about advertising and didn't mention sellout at all. Can you give us a sense of what the sellout levels were in the first quarter for 2009 last year so we get a sense if there's upside there as well and then I have a question for David.

Bradley E. Singer

Sure, let me take them in order Doug and then I'll turn it over to David. In terms of balance sheet what we've said in the past and I think we're still in the same place is that we'd like to maintain an investment – you know great credit rating – so that generally will be three times-ish or slightly less is the maximum leverage. We could go up to three and a quarter if you read what the credit analysts from the agencies say. Right now where we're at in our leverage is about – it's under two and half times, so we're definitely within the comfort range and I think we'd like to maintain a sensible cost at capital, so we don't want to decline our leverage much more from where we are today either.

With regard to sellout and expectations. Our sellout did increase in the fourth quarter. We saw it accelerate from starting kind of late in the third quarter into the fourth quarter so we are selling more in the cash market. That has continued in the first quarter and that's been part of the success. I mean we're ahead in the first quarter of where we were a year ago in terms of our pacing. And so – you know that is part of the process which is pricing firming up, the cash market is greater than it was a year ago and our ratings are up. And that's what's translating into an increase in advertising, but you are finding a little bit of low single digit upfront that made up a portion of that advertising base.

Doug Mitchelson - Deutsche Bank

Got it, thanks. And then for David, I just wanted to further the digital conversation a little bit because the iPad had a lot of people talking about the potential for over the top video, and I know you sort of had a discussion about putting your shows online in terms of downloads or streaming or ad supported. But any thoughts about the potential if you know an Apple or Amazon came forward and wanted to wholesale your channels and aerate them and sell them online in a paid TV package would you support that?

David M. Zaslav

Well, we're always looking for different ways to reach consumers, and if there were strong business models that can carry our content whether in long form or short form we're always aggressive about pursuing them. We're in talks with everybody – we just believe our content has significant value and we want to make sure we get paid meaningful value for our content. But we also recognize the value of the cable business and the value of the cable operators that are paying us more and more for our channels. So it's that balance.

Doug Mitchelson - Deutsche Bank

Are there any contractual obligations that would hold you back from online streaming?

David M. Zaslav

No. We have a right to do what we want with our content and we're just going to figure out the best way to reach our viewers and to go with the best business models we can find to create the best value.

Doug Mitchelson - Deutsche Bank

Great, thank you very much.

Operator

Your next question comes from the line of Richard Greenfield of Pali. Please proceed.

Richard Greenfield - Pali Research

Hi, a few questions – the first for Peter. I was wondering how you think about the opportunity – you have HD Theater, Fit TV and Military Channel, none of which seem particularly core or have a lasting brand image right now. I'm curious how you think about the potential of those three networks and what you could do with them? Two, a question on Own. Where is carriage right now for Discovery Health and do we know yet – is there any specific plan to have broader carriage by the time the network launches in early 2011? And then just lastly a question for Brad on Life versus Planet Earth. Planet Earth ratings were kind of a surprise and no one expected it to be as big as it is. How will Life be monetized and are you in a better position to monetize it – fully monetize ratings success versus Planet Earth and how does it flow through to DVD – what should the timing of that etc. be?

Peter Liguori

Let me take the Own one first because it's quick and then I'll pass it to you. Right now, Discovery Health is in about 75 million homes and we'll see some growth on that Rich before Oprah launches just by the natural growth that we'll get so figure 77 million, 78 million homes by the time we launch, maybe close to 80.

But that doesn't take into account that we're building – we have a fantastic brand, we have Oprah behind us, we've got some great programming and a great leadership team, and we're going to go out there. We're going to be looking to get more carriage for the channel and to get a different compensation structure from the channel over time. And so our expectation is that over time the channel will grow, it will grow significantly, and over time we'll be able to get some meaningful fees for high quality content. And a great brand.

David M. Zaslav

Let me discuss the Fit, HD, D of it all. Though your position is not necessarily being core, it's part of the core strategy to have a diverse portfolio of content. Now with all that being said and taking a look at some of those networks we're going to approach it on a couple levels. First we're going to look at natural growth within our cost structure to make sure that we're investing in content that can in fact bring more attention and more value to those networks and then two – you know we will continually recognize that there is strong distribution in place of those networks and that's beachfront property. If there were any larger strategic opportunities to take a look at those networks, we'll evaluate them on an individual basis. Fortunately, again those networks are locked in with many long term deals and it allows us the time and ability to look at certain investment opportunities.

Peter Liguori

One last thing on HD because it's an important point for us strategically. We have seven HD channels here in the U.S. we were a very early mover. We're now in 45 countries in HD. Maintaining our lead as a platform company is critical to us and I think it's starting to pay dividends. It's hard when you look at the research to really completely line it up, but at least anecdotally when you see how people view content when they get an HD set they spend a lot of their time on the HD tier. And that tier might have 30, 40, 50 channels, but we have six or seven of those. And so over time, having that platform advantage and the fact that our content looks great in HD, we think domestically and around the world will help us grow ratings and will help us grow brand value.

And it's one of the reasons we were so quick to get out with 3D and we're going to be the first to launch a 24 hour 3D channel, and we're going to do that because our content looks great in HD and as people move to that closer to real in terms of the way that they view content, that they'll continue to view us as the place to go to see content that looks great closer to real.

Bradley E. Singer

And Rich, your last question with regard to Life and how we approach it, I think our sales teams have been very thoughtful in terms of working with potential advertisers and what's the best structure of how we partner with them, and we've done a really good job of monetizing and having a ratings expectation that is hopefully in line with what actually happens. And Life is no surprise to us in terms of the success

I think people are working really hard and we have high expectations for it but we believe it should be delivered and our teams are working to monetize that delivery.

Richard Greenfield - Pali Research

And you would expect the DVD out before the end of the calendar year?

Bradley E. Singer

Yeah, the DVD won't be out until the second half of the year but it will be out – the economics I think David mentioned aren't – we don't get off with 100% economics it's still part of our partnership with the BBC but we do get to monetize it in the second half of the year.

David M. Zaslav

One thing that we did clean up this time is that last time there were two versions – we were selling it and the BBC was selling it. And there was an Attenborough version from the BBC and then there was our version. This time there'll be one version sold in the U.S. - it will be the Oprah version, it will be our version and it will be jointly sold by both of us and there will be a split. So we will be coordinated and will get some piece of everything that's sold.

Richard Greenfield - Pali Research

Thank you.

Craig Felenstein

Next question, Operator.

Operator

Your next question comes from the line of Imran Kahn of J.P. Morgan

Imran Kahn - J.P. Morgan

Yes, hi. Thank you for taking my question. It's Imran Kahn from J.P. Morgan. Two questions, one for Brad and one for David. Brad, you know I'm trying to understand here – I think you talked about international advertising guidance in high single digits. Why are you assuming international ad revenue growth to decelerate, are you seeing any trend or are you taking a conservative view because of the macroeconomic trend. And for David a more high level question. What kind of revenue base do you need in the international market to take your (inaudible) to march in the international market closer to the U.S. level? Thank you.

Bradley E. Singer

Imran, with regard to our outlook for the international advertising we do take a conservative view in terms of our outlook. We have been achieving in the third and fourth quarter – we were at 9% in the third quarter we were at 8% in the fourth quarter and fourth quarter is typically our strongest quarter. So going into this year as we did our budgeting and we did a bottoms up the high single digits made it to low double digits. That was the range that we were comfortable looking at it from a ground up level. If the economies do improve around the world then we may do better than that.

David M. Zaslav

On the margins side, international we'll never be able to sync up with where we are in the U.S. The U.S. is just an incredibly efficient operation – we serve 96 million homes essentially out of one factory. We are really – we're a true international company so we're doing business – we're not sending content around, we're actually doing business running channels all around the world. We have gotten more efficient – we think we can get more efficient in the way that we do our marketing and how we use our content. Having said that – so we think there's an opportunity to increase our margins in addition as Brad said as the revenues grow both in terms of our sub-fee revenue and our ad revenue, we've built a very strong engine in terms of having the overwhelming majority of that come down to operating cash flow. But having said all of that we will always have additional cost, we still do a fair amount of local content in the market – that's one of the reasons why we're able to build market share. You know, here in the U.S. Discovery has about a 1.5% market share. You go to some countries we have a 5% market share and part of that – that strength is in order to maintain that, we need to do some local content which we will continue to do.

Imran Kahn - J.P. Morgan

Thank you.

Craig Felenstein

We have time for one more question, Operator.

Operator

Your next question comes from the line of David Joyce of Miller Tabak and Company.

David Joyce - Miller Tabak and Co.

Thank you. I was just wondering if you could help frame the digital subscribers that you have, subscribers that are accessing Discovery content on digital tiers internationally. It's obviously a long run away of growth as the platform's just been upgraded but I was wondering if – since more programming would be likely available if you could help us think about that.

David M Zaslav

I'll give it to you generically. We have an average of five channels in 173 countries and in most cases three or four of those channels are on a lower tier. And so it is in many of these markets it's the paid TV tier that is beginning to accelerate the way it did here in the U.S. in the mid to late 90's. In those markets where they have a traditional analog pay TV tier, there's also digital that's being rolled out to a lot of the emerging markets and in Asia. In every case, because we have distribution teams on the ground we're adding our channels into those markets on digital. But the big driver for us in terms of the overall – our advertising upside at least in the next year or two will be more of the growth of the traditional paid TV tier around the world but we are well seated on the digital side. I don't have the exact number of digital.

Bradley E. Singer

David, a good way to think about it is – I mean a fully distributed network is Discovery internationally and Discovery grows in the high single digits. It has for 2009. So the digital growth rates are higher than Discovery because – it's the most fully distributed and analog in some countries only. So it really varies country by country. With certain parts like Western Europe which has a higher digital penetration and in other parts of the world you'll have a lower digital penetration, and some might be satellite reached which is all digital. And so you have to look at it market by market and how they're approaching it.

David M. Zaslav

The other thing that you see that's sort of a companion to this – we saw this in the U.S. is that as the paid TV penetration grows, the advertisers get more and more comfortable going from the broadcast platform to the paid platform. And the CTM's also grow because of that as advertisers come – we saw that here, we're seeing that in a number of markets around the world which as a trend over the next few years should be helpful to us and the other players in that space.

David Joyce - Miller Tabak and Co.

Great, thanks for the color.

David M. Zaslav

Thanks everyone, we appreciate your participation in our earnings call.

Craig Felenstein

Operator, you can end the call now.

Operator

Thank your joining today's conference. This concludes the presentation, you may now disconnect. Good day.

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