Has Discovery Peaked? Not by a Long Shot

Discovery Communications (NASDAQ:DISCA), which owns over 100 television networks in 35 languages, has soared ever higher since being added to the S&P 500 about a month and a half ago. The stock has touched another all-time high price as of Wednesday morning on continued positive momentum. However, as you can see from our historical ratings chart, we continue to view DISCA as Undervalued at the current price level. According to our methodology, the stock has improved fundamentally so strongly that the price appreciation is not yet concerning.

Discovery is relatively young as a public stock after being spun out from Liberty Media (LCAPA) in 2006, but they have an attractive, established set of networks that include Discovery Channel, The Learning Channel, AnimalDISCA Planet and many other networks with mostly family friendly programming. These channels have steady ratings and strong programming with many devoted viewers.

There is fresh excitement surrounding DISCA’s partnership with media mogul Oprah on the upcoming Oprah Winfrey Network, which has been in the works since January 2008 but is due to launch Jan 1, 2011. In a recent preview of what a 24-hour Oprah-focused network would show, in addition to about a dozen new shows, Ms. Winfrey revealed she will be in front of the camera for “Oprah’s Next Chapter” two to three times a week. Oprah will begin her new show on her own network shortly leaving her regular daytime talk show format late in 2011, and the kind of viewership and following that Oprah has the potential to draw is very exciting for Discovery, particularly in some very sought after advertising demographics.

The potential of Oprah’s new network is certainly exciting, but we think Discovery’s current fundamentals are sufficient to draw interest from investors. The company grew earnings per share by more than 50% last year climbing to $1.30 from $.85 the year before, and current estimates for this year call for further earnings growth. Wall Street expected fiscal 2010 EPS of $1.51 to $1.76 per share, which implies growth this year of anywhere from 16% to 35%. Of course, we will know more about their results when DISCA reports 1Q earnings on April 30th, but we expect strong profit growth through this year and beyond.

Based on our valuation methodology, the market has just begun to see the potential in Discovery Communications. For example, since its spinoff from Liberty Media, the market has historically given shares of DISCA a multiple of cash earnings of between 18.4x and 32.4x, but even at its all time high price the current price-to-cash earnings is only 14.1x. Furthermore, the current price-to-sales of 2.76x is below the historically normal price-to-sales range of 3.12x to 5.77x. If the market were to value DISCA’s cash earnings and sales more in-line with its historical norms, we would expect to see the stock rise into the mid-$40’s per share and possible even above $50 before we would start to look more negatively on the valuation.

Jim Cramer covered this stock on Mad Money Tuesday night after a caller asked about them and how the addition of Oprah could affect the stock. To which Cramer responded,

“This is a winning stock. You’re a winner and Discover’s a winner, and so is David Zaslav. Discovery’s got all those programs. It’s not just the meerkats anymore. There’s a lot of good stuff. Every time you put it on they’ve got the stuff, you can watch the DVDs a million times. This is the only station you can watch with your kids…Oprah or no Oprah, I don’t care. This stock rocks!” – CNBC’s Mad Money 4/20/2010

We are anxious to hear the company’s results on April 30th, but barring something unforeseen the stock appears headed to more new all time highs. Their networks are performing well and advertising dollars are returning along with consumer spending and consumer confidence, thanks to general macroeconomic improvement. Discovery has climbed well already, but we see no reason to think that this stock cannot go even higher.

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