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Discovery Communications (NASDAQ:DISCA)

Q2 2014 Earnings Call

July 31, 2014 8:30 am ET

Executives

Craig Felenstein -

David M. Zaslav - Chief Executive Officer, President, Director ,Member of Executive Committee, Chief Executive Officer of Discovery Communications Holding LLC and President of Discovery Communications Holding LLC

Andrew C. Warren - Chief Financial Officer and Senior Executive Vice President

Analysts

Todd Juenger - Sanford C. Bernstein & Co., LLC., Research Division

David Bank - RBC Capital Markets, LLC, Research Division

Kannan Venkateshwar - Barclays Capital, Research Division

Benjamin Swinburne - Morgan Stanley, Research Division

Jessica Reif Cohen - BofA Merrill Lynch, Research Division

Anthony J. DiClemente - Nomura Securities Co. Ltd., Research Division

Alexia S. Quadrani - JP Morgan Chase & Co, Research Division

Michael Nathanson - MoffettNathanson LLC

John Janedis - Jefferies LLC, Research Division

Operator

Good day, ladies and gentlemen, and welcome to the Q2 2014 Discovery Communications Earnings Conference Call. My name is Mark, and I'll be your operator for today. [Operator Instructions] As a reminder, this conference is being recorded for replay purposes.

I would now like to turn the conference over to Craig Felenstein, Executive Vice President of Investor Relations. Please proceed, sir.

Craig Felenstein

Good morning, everyone. Thank you for joining us for Discovery Communications' 2014 Second Quarter Earnings Call. Joining me today is David Zaslav, our President and Chief Executive Officer; and Andy Warren, our Chief Financial Officer. You should have received our earnings release, but if not, feel free to access it on our website at www.discoverycommunications.com.

On today's call, we will begin with some opening comments from David and Andy. After which, we will open up the call up to your questions. [Operator Instructions]

Before we start, I would like to remind you that comments today regarding the company's future business plans, prospects and financial performance are forward-looking statements that we make 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 could affect these expectations, please see our annual report for the year ended December 31, 2013, and our subsequent filings made with the U.S. Securities and Exchange Commission.

And with that, I'll turn the call over to David.

David M. Zaslav

Thanks, Craig. Good morning, everyone, and thank you for joining us. Before Andy provides some context around our second quarter results and the momentum we continue to generate across our global portfolio, I know industry consolidation is on everyone's mind, so I want to talk about Discovery's market position, our overall operating performance and why I am so excited about our growth profile in both the short and long term.

It's a great time to be in the content business. There are more consumers assessing more content on more platforms in more countries than ever before. The consumer experience is evolving and the key to exploiting this dynamic marketplace is to capitalize on the brand and distribution strength of the company by following the same strategic formula we have employed since I came to Discovery 7 years ago.

That strategy is based around 4 operating principles:

first, invest in more content and ensure spending is focused on the screen, all screens, not just the TV screen; second, leverage our unparalleled beachfront real estate to build stronger, more valuable brands; third, accelerate our strategic advantage and brand position across the global pay-TV marketplace; and lastly, build additional scale and market share in key growth markets.

Let me speak to each briefly. Increasing our content investment to build stronger brands and solidify category leadership in our programming genres is core to our growth strategy. We continue to prioritize developing must-have programming with compelling characters and storytelling, while owning all the global and digital rights. Over the past 7 years, we've more than tripled our overall content investment. And by nourishing our audiences and super fans, we've expanded our viewership across our U.S. Networks by 53%, now reaching between 11% and 12% of the cable audience. The growth is even more dramatic internationally where our overall viewership has increased over 200%, including our best quarter ever this past quarter. Without question, people are spending more time with our content than ever before. And equally as important, given the investment we have made, we are turning that higher viewership into sustained double-digit ad growth across the company. Even domestically where the market is more mature, there is still plenty of room for continued ad growth and we remain confident that we will outperform over the long term, given the strength and diversity of our creative offerings, the quality of our ad sales team and the potential of many of our new brands that we have built. ID remains the perfect example of this. The channel is now the #4 network for women in Total Day, has the longest length of tune of any network on cable or broadcast and has driven sustained double-digit audience growth since its launch in 2008. And while we have made real progress on the pricing front over the last few years, its CPMs don't reflect anywhere near that level of success. As the CPM gap closes with its performance, we expect multiple years of significant growth from this network alone, here in the U.S. and around the world.

We are also seeing more and more companies and platforms looking for content than ever before. And given our market leadership in nonfiction, we are confident we can nourish this growing audience segment on multiple platforms in markets around the world for many years to come. To further satisfy this demand for content, we have taken advantage of new opportunities to increase our global rights and ownership of valuable IP. We just acquired control of Eurosport, which includes rights to all content on all platforms in Europe. Earlier this year, we acquired U.K.-based producer Raw and in the second quarter, we announced the 50-50 joint venture to purchase All3Media, a leading production company with a vast portfolio of properties across a wide range of genres. These acquisitions allow us to increase our content library, expand our stable of top creative leaders and exploit more formats and more IP around the world.

The second pillar of our growth profile is our sustained ability to exploit and develop our global beachfront real estate, the great distribution Discovery has in the U.S. and around the world. We are thoughtfully investing in new brands that identify white space in the market and that have real potential to deliver significant audiences and drive value to our ad and affiliate partners. This strategy has worked extremely well domestically over the past 7 years where we have launched more new brands than any other media company and these brands are finding real audience strength and advertiser support.

This past quarter alone, ID delivered 16% viewership growth; OWN was the #1 cable network on Tuesday and Wednesday nights with African-American women; Destination America and Velocity were both up 20% in their key demo; and our newest brand, American Heroes Channel, was up almost 10%. Most of these channels did not exist 4 years ago and are now positioned for substantial growth in the years ahead. And earlier this month, we announced our latest network, Discovery Life, which will debut in January on what is now Discovery Fit & Health.

The growth of our portfolio is also delivering significant value to our distribution partners. The deals we have completed reflect the value of our must-have content with increased annual escalators, while also providing additional subscribers for some of our emerging networks. The result is faster organic affiliate growth this year than a year ago, but we expect this trend to continue as we complete additional agreements in the years ahead.

On the International front, Discovery celebrated its 25th anniversary in the second quarter. And since the initial launch of Discovery Channel in 1989, the company has been steadily investing in local infrastructure, brand awareness, commercial relationships in almost every market in the world. Today, we have an unmatched global platform with an average of 8 channels in more than 230 countries, reaching over 2.5 billion subscribers. We are still seeing pay-TV expand nicely, with subscriber growth across the portfolio, especially in countries like Brazil and India where there is increasing demand for content from burgeoning middle class. But the real upside is turning this valuable distribution into an even stronger content offering like we did recently with the launch of TLC in Germany and ID Extra in CEEMEA. Having the distribution to light up new global brands and utilize content that has universal appeal is a key element driving our steady and consistent organic growth.

The third driver and a key differentiator of the company's success is, without question, our international business and unrivaled global portfolio. The company passed a key inflection point this past quarter. As a result of the organic growth of our International business, coupled with the closing of our controlling interest in Eurosport, we now generate more than half our revenue outside the U.S. Over the years, we have immersed ourselves in individual market dynamics and establish key relationships to meet demand and deliver value to advertisers, affiliates and audiences. We've also been extremely successful in globalizing our homegrown content and brands. 2 notable examples of the power of our global brands of the success of TLC and ID. TLC now reaches 260 million subscribers in 187 countries and territories, making TLC the #1 most distributed women's brand in the world. And ID has over 80 million subscribers in 155 markets. And in 2014, we have taken content from Velocity and Turbo brands around the world, now reaching nearly 40 countries and over 60 million viewers outside the U.S. and we continue to see strong interest in this category and channel. Our investment in building stronger brands, growing our distribution and opening local offices with sales teams on the ground is fueling strong organic advertising growth, and we are still very much in the early innings as the drivers of this growth should be sustainable for years to come.

The continued penetration of pay-TV will continue to be a catalyst as we broaden our reach and attract more ad volume. And much like the U.S., where ad pricing on our younger networks is well below parity for the audiences they are generating, the discount internationally is even greater. As we close this gap, as well as the significant gap between broadcast and cable, we have the opportunity to deliver consistent organic growth over the next several years.

Finally, we are always looking for ways to build scale in key markets to take advantage of our first-mover advantage in many regions and continue to strengthen our portfolio and offerings. Our first priority remains driving the momentum across our existing international portfolio, so we can maximize the organic opportunity that our international platform provides, but we are also always looking for external opportunities that will further deepen our relationships with advertisers and distributors over the long term. We are seeing that in the Nordics as our Discovery suite of networks benefit from the increased scale we now have in the region. In addition, we couldn't be more bullish about the opportunities we have with Eurosport, which reaches more subscribers across Eastern and Western Europe than ESPN in the U.S.

We view sports as a form of factual entertainment and must-have content that complements our existing global portfolio. It's only been a month but we are already seeing opportunities to co-sell, co-package improve rights offerings and augment our nonfiction portfolio. A nice example is the French Open, which delivered its best ratings ever for Eurosport and the semifinal and final matches were also broadcast on Discovery MAX in Spain with record ratings, over 20% share.

Moving forward, we will be exploiting our local infrastructure and teams to maximize the flagship Eurosport across more than 70 countries, while bolstering and launching targeted Eurosport feeds into growth markets. Eurosport will have access to Discovery's global reach, local sales expertise, strong global brands, seasoned management team and the opportunity to optimize content and attract more audiences across Discovery's suite of networks.

Discovery gains Eurosport's must-have sports content and IP, it's live production capabilities, pan-regional sales expertise and innovative digital services.

Besides Discovery, there are not many media companies that have the relationships and infrastructure to take advantage of opportunities like these in markets around the world.

Overall, Discovery has had a great first 6 months in 2014, delivering strong organic financial results while further investing in content, growing our global business, creating strong brands and building scale in key growth markets around the world.

With sustained momentum across our global portfolio and a relatively healthy operating environment, we are well positioned to deliver additional growth through the remainder of the year.

Looking further ahead, we feel we are uniquely positioned to deliver sustained growth and build long-term shareholder value given the brands we have built and the upside our global footprint provides.

And now, I'll turn the call over to Andy.

Andrew C. Warren

Thanks, David, and thank you, everyone, for joining us today. In the second quarter, we continued to execute very well on our primary financial goals of achieving solid global revenue growth, expanding base business OIBDA margins, delivering strong adjusted earnings per share growth and returning over $500 million of capital to shareholders through our share repurchase program.

On a reported basis, total company revenue in the second quarter increased 10%, led by 23% international growth, which is partially offset by a 2% decline at the U.S. Networks for the inclusion last year of licensing revenue related to a Netflix agreement. Excluding the impact to licensing revenue and foreign currency, as well as the contribution from Eurosport, [indiscernible] consolidation as of the end of May, total company revenue growth was 9%, with double-digit advertising growth and high single-digit distribution growth.

Total operating expenses on a reported basis increased 12% in the second quarter, primarily due to the inclusion of the Eurosport business. Excluding this acquisition, the content cost associated with the year-ago licensing agreement, as well as the impact from foreign currency movements, total company expenses increased 7% versus 2Q '13, primarily due to increased content cost as we continue to invest in strengthening our global network portfolio.

On a reported basis, adjusted OIBDA in the second quarter increased 6%. Excluding the impact of Eurosport, foreign currency and licensing revenue, adjusted OIBDA grew 11%, which resulted in margin expansion of nearly 100 basis points versus the second quarter a year ago.

Net income available to Discovery Communications increased 26% to $379 million driven by the strong operating performance, as well as by a $29 million gain associated with the step-up value from raising our ownership interest in Eurosport to 51% and a $31 million pretax gain from the sale of our display base digital business, HowStuffWorks.

Additionally, the quarter included $15 million of higher equity earnings, primarily from improved results at OWN as we successfully lowered our effective tax rate by 250 basis points to just over 35%.

Note that Eurosport's contribution to net income was not significant in the quarter as the OIBDA generated was mostly offset by higher purchase accounting amortization associated with the acquisition. The purchase price allocation, the amortizable trade names, distribution contracts, broadcast licenses and other assets will result in additional amortization expense in 2014 of about $33 million and $51 million of Eurosport amortization anticipated for 2015.

Total company adjusted net income produced a more relevant metric from a comparability and valuation perspective as it excludes the impact from noncash amortization of acquired intangible assets was $405 million for the second quarter of this year, a 22% improvement versus the $333 million from the second quarter of 2013.

Earnings per diluted share of the second quarter was $1.09, 33% above the second quarter a year ago while adjusted earnings per diluted share was $1.16, a 27% improvement versus 2Q 2013.

Looking at the last 12 months, adjusted net income increased 29% to $1.3 billion, while adjusted earnings per diluted share increased 35% to $3.52.

Free cash flow in the second quarter of $202 million declined by $109 million versus a year ago as the strong operating performance was more than offset by higher tax payments resulting from the expiration of the accelerated content cost recovery under Section 181.

Over the last 12 months, free cash flow increased by 9% to $1.2 billion due to the stronger operating performance, partially offset by the higher cash tax payments and content investments.

Content spending during the second quarter, excluding Eurosport, increased by only mid-single-digits, even as we continue to drive market share growth across the globe.

Before I move on to the divisional results, I do want to highlight that while not part of our operating free cash flow, OWN continues to increase its cash flow generation and repaid Discovery $20 million in the second quarter.

Turning now to the operating units. The U.S. Networks continue to perform well in the second quarter. On a reported basis, total domestic revenue was down 2%. That was due entirely to the licensing revenue we recognized a year ago as we extended our Netflix agreement.

While the licensing revenue is lumpy, given that they recognize upon delivery of the content, we are still recognizing cash flow in the current year from our existing Netflix agreement. Organically, domestic revenues were up 4%, excluding the impact of licensing revenues, with advertising and distribution growth partially offset by $7 million decline in other revenues.

As I mentioned last quarter, our U.S. Networks have increased their programming being shared with their International Networks, rather than selling to third parties. So as a result, we are now generating lower content licensing sales. We anticipate a similar trend in other revenues for the remainder of this year.

Domestic advertising revenues increased 5% in the quarter as the stable pricing environment and higher delivery across the majority of our younger networks more than offset anticipated headwinds from the cancellation of our Everest Live event and the sale of the HowStuffWorks platform.

Looking ahead to the third quarter, given the relatively stable current ad market trends, the scatter pricing up high-single to low-double digits from last year's upfront negotiations, we anticipate ad sales growth will at least be in the mid-single digit range, even with the sale of HowStuffWorks, as well as a difficult comparison to the 12% ad sales growth we generated in the third quarter a year ago.

Distribution revenue increased 6% in the second quarter excluding licensing revenue, as we recognized the higher rates we were able to secure during the latest round of affiliate negotiations.

Please note that while the organic growth rate for affiliate revenue will continue to be in the same range through the remainder of the year, the reported affiliate growth will continue to be impacted by both the additional licensing revenue we recognized in the third and fourth quarters of 2013, as well as any new licensing deals we may complete during the remainder of this year.

Looking at the cost side. Domestic operating expenses declined 4% from the second quarter of 2013, primarily due to higher content cost a year ago associated with the licensing deal with Netflix. Last year's second quarter also included programming and marketing costs associated with broadcasting Skywire Live on Discovery.

Domestic adjusted OIBDA declined 1% on a reported basis versus last year's second quarter, but increased 8%, excluding the impact of licensing agreements with margin expanding fully 200 basis points versus the second quarter a year ago.

Turning now to our international operations. The reported results include the impact of Eurosport, but for comparability purposes, my following international comments refer to the results excluding this acquisition. Additionally, now that we have fully cycled through the acquisition of the SBS Nordic assets, we will, today, and going forward, be discussing them as part of our overall organic base business.

The International segments continue deliver very strong momentum across our global operations this past quarter. With revenues expanding 15%, led by 18% advertising and 10% affiliate growth. Excluding the impact of exchange rates, total revenue growth is 14%, with ad revenue increasing 17% and affiliate revenue remaining at 10%. The 17% advertising growth was broad based, with double-digit increases across nearly every region led by Western Europe, primarily from the continued success of our free-to-air initiatives in Italy, Spain and the U.K, Latin America from increased volumes across the region and CEEMEA from both Poland and Africa. The quarter did also include an additional 8 days of results from the SBS Nordic businesses given the April 9 close a year ago, but the international business still delivered solid double-digit ad growth despite a greater than expected negative impacts from the World Cup. On the affiliates front, the 10% affiliate revenue increase in the quarter, excluding currency, was driven primarily by subscriber growth, especially in Latin America from the continued expansion of pay-television in Brazil and Mexico and in Central and Eastern Europe, from additional subs in Russia and new launches in Turkey and the Middle East. Note that the affiliate growth would have been in the high-single digits, excluding the additional 8 days associated with the SBS close timing a year ago.

Turning to the international cost side. Operating expenses were up 13% in the second quarter, excluding currency, primarily driven by higher content amortization and increased personnel costs as we further expand our global footprint. The additional cost also reflect the inclusion of 8 extra days in the SBS Nordic business, as well as its higher costs through the acquisition of the Raw Production Studio in the U.K.

The International segment delivered 15% adjusted OIBDA growth in the second quarter, excluding foreign currency, as our International team continue to significantly grow revenues, while thoughtfully investing in long-term growth initiatives.

Very importantly, now that we have fully cycled through the acquisition of the SBS Nordic business, we expanded International organic margin by 50 basis points, including SBS, but excluding Eurosport and currency fluctuations.

Now focusing on our overall finance position. With a strong balance sheet and sustained financial and operational momentum and given our gross leverage targets and long-range free cash flow per share growth assumptions, we had the opportunity to both continue returning capital to shareholders and investing in our global businesses. This past quarter, Discovery repurchased over $500 million of stock and we anticipate returning more capital to shareholders through our buybacks in 2014, and we did in 2013. Since we began buying back shares towards the end of 2010, we have spent over $5.2 billion buying back shares, reducing the outstanding share count by over 102 million shares, or 24%.

Before I update our guidance for 2014, please note that current expectations include preliminary purchase accounting adjustments associated with the Eurosport transaction, which may change when it's finalized. We will update you on our next call, if they change materially.

Currently, we continue to be encouraged by the sustained momentum across our business portfolio and the robust ad sales trends in many of our global markets. We remain on track to hit our original expectations in 2014, but are narrowing the guidance ranges to reflect the delayed close of the Eurosport transaction, foreign currency headwinds versus our original expectations, the less robust U.S. ad sales environment and higher corporate costs associated with accelerated stock compensation and professional fees. Therefore, for the full year 2014, we now expect total revenues to be between $6.45 billion and $6.525 billion, adjusted OIBDA to be between $2.6 billion and $2.65 billion, net income to be between $1.225 billion and $1.275 billion, and adjusted net income of $1.34 billion to $1.4 billion. This is the first time that we've ever guided adjusted net income and we will continue to do so into the future as this critical profit metric best underscores the true bottom line operating performance of the company.

And thank you for your time this morning. And now Dave and I will be happy to answer any questions you may have.

Question-and-Answer Session

Operator

[Operator Instructions] Your first question comes from the line of Todd Juenger from Sanford Bernstein.

Todd Juenger - Sanford C. Bernstein & Co., LLC., Research Division

David, thanks for your comments and the opening remarks around Eurosport and a lot of the stuff that you guys have been doing over in Europe. I wonder if you could expand on that a little and just think of it longer-term, when you put all of that together, Eurosport, SBS, All3Media, other things that you may be contemplating on there, what ultimately are you trying to build in Europe for Discovery? What sort of presence do you hope to have there over time? And any, sort of, indications of what sort of growth that implies if you're successful?

David M. Zaslav

Thanks, Todd. Well, first, our International business has never been stronger. Last year, we became the #1 pay-TV media company in the world, but more importantly, we have more channels in more countries than other any other media company. And we started to populate those channels with better content, stronger brands and we're growing market share over the last few years, 20%. So a lot of the growth we're seeing in Western Europe is that the cost of getting local internationally, most of that cost has been borne already over the last 7 or 8 years. We have local teams throughout all of Eastern and Western Europe, Latin America and Asia. And our content is getting stronger. So even in a flat market, which is what the advertising market is like or even down in some of Eastern -- Western Europe, particularly Western Europe, we're able to grow mid-teens, high-teens, early 20s, and that really is about the fact that our content is resonating. What Eurosport does is it just adds more must-have content to pick up between 1 and 4 channels in 70 countries that we're already in and to have all that IP and to be able to bring that to the advertising market and bring it to the distribution market with almost no additional cost, we think is really valuable. As important is the fact that we own all of that IP. And it allows us to talk to partners about sharing content, about joint bidding for content and many of those partners will be distributors that we already have 8, 10, 12 channels with. So we have found a lot of players in Eastern and Western Europe that are looking for -- to align around sports, which is very attractive for us when we can package up all of our other channels and leadership. But for us, Eastern and Western Europe is a very important market where we're finding great success but Latin America is probably our strongest market right now. We have Discovery Kids, which is the #1 cable network in Brazil, not the #1 kids' network, but the #1 cable network. We also got early to the market with Discovery Home & Health down in Latin America. We have Discovery. We have TLC. We have Animal Planet, Science. We have 5 of the top 20 channels in Latin America. And we're getting a lot of organic growth down there, and we're seeing big, big growth in India. So I would say, our International business has never been stronger. Our leadership position has never been as advanced and it's one of the reasons why I'm spending more than half of my time outside the U.S. and one of the key elements of that is, how do we take our portfolio and make sure we have more must-have content? In Latin America, it's Kids, together with Discovery and women's programming and then Eastern and Western Europe, it's our men's and women's programming, together with sports. And that's key for us, how do we continue to build our IP. But our international business right now, it's just accelerating.

Todd Juenger - Sanford C. Bernstein & Co., LLC., Research Division

A very quick follow-up, if you don't mind. Andy, on the international revenue line, there was a nice growth in the other component, which looks like it was attributed to [indiscernible] studios. Maybe that was Raw or was that something else? Anything you can tell us about what that is and whether it will recur, it would be great.

Andrew C. Warren

Sure, a big driver of that, Todd, is the Eurosport licensing. Some of the contents that they have rights to, they sell off some of the rights that they can't utilize fully. So you'll see that kind of be a sustained level of growth as we annualize the Eurosport acquisition.

Operator

Your next question comes from the line of David Bank from RBC Capital Markets.

David Bank - RBC Capital Markets, LLC, Research Division

So a question about the domestic side and particularly on advertising. I guess, some -- I think Andy gave us some pretty healthy pricing in some sense as a sense of the domestic ad market. But your slight guidance range narrowing also kind of cited softer advertising. So I guess, how do you reconcile the strong pricing with the kind of tepid tone of the ad market? And what do you think is impacting that market right now? There's been some press that it was a somewhat weak upfront for the cable networks generally, can we get your take on the upfront environment, the upfront process as well?

David M. Zaslav

Sure. Thanks, David. Well, first, let me hit the upfront. For us, the upfront looks like mid-single-digit. We decided to sell less into the upfront market. The volume was not as strong as it was last year. Having said that, the pricing in scatter for the past 2 to 3 years has been strong and the pricing in scatter is strong today. So our view was, given that the pricing was mid-single and that the volume was a little lighter, that we didn't want to sell into it, so we've held more inventory back. And if the scatter market performs similar to what it's done in the last few years, we'll have some significant upside for having that extra inventory. The advertising market in general, it has been good on pricing and a little bit, year-over-year, down on volume. And for us, at least, we've decided to hold our CPMs and not go for that volume. You see some of that in the performance. The other thing is that we've had some tough comps with the Olympics, with the cancellation of Everest and we sold HowStuffWorks, which had some impact. So when you look at the last few quarters, for us, we see it and we think some deceleration of volume, some unusuals that have -- that maybe held us back a few points, but we also think that we left some money on the table. And so, Joe Abruzzese and I and the leadership team have been focusing on how do we really maximize our rating points to get more value. So I think it's those 3 together.

Operator

Your next question comes from the line of Ken Venkateshwar from Barclays.

Kannan Venkateshwar - Barclays Capital, Research Division

Just a couple of questions. The first is, when you look into your tax rate, I mean, are there strategic options for you now that your revenues are more than 50% coming from international market that you could look at, especially in terms of inversions and so on? And secondly, in terms of Eurosport, I mean, what's the kind of cost cadence that we should expect in the -- in terms of soccer? Is that a big priority going forward in terms of acquiring the rights?

David M. Zaslav

Why don't I -- let me do Eurosport and then Andy will talk to the -- where we are in terms of tax and what our opportunities are. Eurosport is a profitable business that has significant growth built in as it is today. They've locked in tennis, winter sports, cycling and track and field, and those are locked in for the next few years. And just by going into local feeds, using the resources of Discovery, we think we could build the brand and we could enhance the performance in a meaningful way. So the question then, since we have between 1 and 4 channels, as we have a very stable and growing asset. What are our options to build it? We will be disciplined. The idea of joint bidding in many of these markets can be very attractive. Often, there are bidders that are -- we have 2 distributors bidding for content, or a distributor bidding for content against a broadcaster. And maybe, in either case, they don't have enough platforms to carry all the content. And so, we've had a lot of conversations where we can align. We can align on a disciplined basis. We could do it where we can get more must-have content, which will enhance our brand, but we could do it in a way that is either has good economic return in the near term or has good economic return and allows us to pick up all of our channels in a particular market and realign our relationship on the distribution side with the distributor. So I think when you see us bidding on assets, you should assume that we're looking at it and we're only going to bid if we think that it will, at the very least, in the medium and long term provide more shareholder value for us. But I would look carefully at where we joint bid, because we have a lot of great distribution partners around the world and many of them are interested in taking advantage of our platforms and our infrastructure and expertise and that could be a real helper to us where we can play sports in a way that's effective. There's no reason -- we don't see any reason to make a big bid to try and build a channel. We already have the channels. So it's really a question of what do we put on it to build the brand and make more value for shareholders and make our overall portfolio stronger.

Andrew C. Warren

Your tax question is a very good one. The one that we agree is the real opportunity for us. It's something that we've been very focused on for the last couple of years. And if you look at the benefit that we've been driving, so far this year, second quarter, our effective tax rate was down 250 basis points. And the theory is really this, as we continue to grow our content investment, more and more of that content is being utilized outside United States, so we're domiciling a lot of that contents in places that not only do we have operations, but also, it is quite frankly, more tax effective. So you'll continue to see that reduction in effective tax rate throughout 2014 and you'll see that accelerating in 2015. So regarding your inversion question, look, for us, we're going to continue to drive our effective tax rate down, as I mentioned, and given our deferred tax rate structures, we should have cash taxes below our effective tax rate, but inversion, really, it comes down to the strategic value of whatever that alignment or acquisition could be. Inversion makes a very good deal better. It doesn't make a bad deal good. And so, for us, it's really all about the overall structure and leveraging the operations we have internationally.

Operator

Your next question comes from the line of Ben Swinburne from Morgan Stanley.

Benjamin Swinburne - Morgan Stanley, Research Division

David, just picking up a little bit more on your M&A strategy and also some comments that John Malone made in the Journal this week about scale and the need or the opportunity for scale. You, over the last 18 months or so, 2 years have, at least, to us, outside have diversified a bit in terms of genre, you've gone a little more vertically integrated with TV production, obviously, sports, some serialized drama probably in SBS. Why not take the opportunity, given the rate environment, to continue to build scale, diversify a bit into other parts of the ecosystem and take advantage of the opportunity you have in front of you today? You guys are one of a few global players with the scale today to sort of continue to take advantage of those things. I realized those have implications potentially for margins and growth rates, which, I think, the market is digesting at the moment. But do you see the opportunity? And is it exciting for you to think about continuing on this path to build Discovery to be a meaningfully larger company in different kinds of businesses maybe than you were in 4 or 5 years ago?

David M. Zaslav

Thanks, Ben. Well, first and foremost, we have a great organic growth story that's intact and accelerating outside the U.S., and inside the U.S., we see growth, and we look at what we've done over the last year and we think we can do better. Our brands are still strong. We're growing market share here in the U.S. and we think we can do -- we could even lean harder into the ad sales market and do even better. So we think the organic growth story is very compelling for us and there's a lot of kind of easy fruit in a lot of these markets like India, Brazil, Mexico, Eastern Europe, where we have 10, 11, 12 channels and subscribers are growing significantly and more and more viewers are moving to cable and advertisers. We want to catch those, so there's a significant piece of our organic business that we're just very well positioned on. Having said that, because we have infrastructure everywhere in the world, local teams selling and programming, we're able to very quickly look at what's out there and the idea of getting bigger in a way that we can grow faster or pick up IP and have more scale for our negotiations with advertisers and distributors is attractive, but it's all a matter of price. In the last 18 months, we've done some acquisitions, but we've done acquisitions that we think are really in line with our business. With SBS, it's 30% sub fees. A lot of IP, got us a lot of scale in the market. We have a fair amount of synergy. We continue to take advantage of that. Eurosport, which really just comes on top of our infrastructure. So we will look, but again, when you see -- when you take a look at scale, one of the most important things we did was we went from 4% of viewership on cable in the last 7 years to 12%. The fact that we now have 14 channels and many of those channels are channels that people are spending time with in affinity groups that they love, having OWN work, having ID that didn't exist, be the #2 channel in daytime and in late night and then the #4 channel for women overall. That 12% scale is very important today. At this consolidation here in the U.S., if we had 4% scale, that would be a real issue for us. Outside the U.S., the fact that we have 6 broadcast networks and 6 cable networks in Italy gives us -- we're the third largest player and the largest outside media company in Italy and the biggest media company in Eastern and Western Europe in terms of pay-TV, that's important. And so we do want to get bigger in Brazil. We want to get bigger in Mexico. We want to get bigger in Europe and Asia. But we need to do it on a disciplined basis and when we see our businesses growing over 20%, 18%, 19%, 20%, 22%, you can accumulate a lot of growth in a short period of time by just staying in the course and doing what you're doing. So we're looking, we certainly have a great team and great synergy and a lot of momentum, but we feel comfortable that if they aren't the right assets, that we can continue to scale up as is.

Benjamin Swinburne - Morgan Stanley, Research Division

That's helpful. And does Sky Europe factor into that at all? Do you sort of starting to see Europe move up a bit in the consolidation sort of path the U.S. has?

David M. Zaslav

Yes, we've had a very good relationship with Sky, Jeremy Darroch. In most cases, we sell our advertising in markets around the world. In the U.K., Sky sells our advertising. So they're the biggest distributor and they sell our advertising. We have 15 channels in the U.K. We have a very strong relationship with Jeremy. We've been very effective and, I think, very symbiotic with SKY Italia, with Sky Deutscheland. We also have a good relationship with Foxtel in Australia. So I think part of this is building relationships, and those relationships are often built on how long you've been in the market, how important your content is to the viewers. And so, I think, we are in that relationship with News Corp. by having a lot of channels, important content that matters and it allows us to partner up. So I think, there's no question consolidation raises issues. The fact that we have significant scale in those markets, I think, is very helpful to us.

Andrew C. Warren

And Ben, from a purely financial operating perspective on your acquisition question, 2Q is an important proof point for us. When we entered the license with SBS, you look at the overall margin profile, the company up 100 basis points, International up 50 basis points. It really showed and demonstrated that kind of the command control that we talked about that we're going to be able to grow margin off the new base when you leverage, as David said, our infrastructure, our ability to grow both the top line and leverage our cost base.

Operator

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

Jessica Reif Cohen - BofA Merrill Lynch, Research Division

You mentioned earlier in the call that there's a CPM gap on the newer channels, so I'm just wondering if you could give us a range of what you think it is in the U.S., as well as, I think, you said it was outside the U.S. as well, that you feel like you're not really monetizing to the full potential.

David M. Zaslav

Sure. Thanks, Jessica. In the U.S., it's quite meaningful. I think it's going to take us another 2 to 3 years to, at least -- well, on ID and we've been at it for 2 years on ID, to get our fair share on CPM. The bad news is that it's taking a long time. The good news is that we're making significant progress. We really started a very slow base. I don't think anybody expected that we'd be aggregating these kind of female audiences with the length of view and the scale of what ID has become. So we're now starting to sell it, really, as a must-have product. We're #2 in daytime, #2 in late night but it's going to take time. The good news about that is there's some built-in growth, same thing with Destination America. And as we look at some of our growing networks, that's going to provide real growth to us. So if the market CPMs are lower, you should expect to see as those channels grow, higher growth from us. Outside the U.S., it's even bigger. Because we just rolled out TLC 18 months ago into almost 190 countries. ID, we've rolled into about 150 countries in the last year and we're going to roll it out to another 50 in the next 12 months, and we're getting accelerated viewership on those 2 channels in a meaningful way. One of the real advantages we have outside the U.S. is that you go into France and you put on a TV, you go into Italy and you put the TV on, it's just a much less competitive environment. So as we launch -- you launch a channel here in the U.S., you're 1 of 200 or 220. If you launch a channel in Russia, in the Ukraine, in Italy, you're 1 of 50, 1 of 40, 1 of 60. And also, gestationally, the pay-TV market is more like it was 7, 8 years ago, maybe 10 years ago in the U.S. So younger viewers are watching more of cable, advertisers are starting to move over. So we see a bigger gap. Finally, I would say that the -- when you look at the U.S., subscribers are flat, viewership is flat. So it's a pretty tough market. The one wind at our back in cable is that there is still a meaningful CPM differential between broadcast and cable. And it's becoming less and less easy to justify. Primetime is probably the best justification, but when you look at the kind of viewership that we get on, for instance, ID in late night or ID during the day, it's much more difficult to do that. And so, I think, you'll continue to see, over the next couple of years, that gap, not just for us, but for cable versus broadcast come down.

Jessica Reif Cohen - BofA Merrill Lynch, Research Division

And can I -- just a similar question on the affiliate deals. Well, it's not similar, but internationally, how often do these deals come up? And how much of your distribution revenue growth is pure sub growth and how much -- like -- are you starting to see affiliate fees per sub increase? I know we're way behind the U.S. but what kind of increases are you seeing?

David M. Zaslav

Well, it's -- outside the U.S. is a shorter cycle. So it tends to be about 3-year deals. And the deals work differently and we're trying to change that. Most of the growth that you're seeing is actual subscriber growth, not pricing growth and the good news is we're not the only ones trying to change that now. Now there are some markets that have very high growth. We're just getting on that boat and going along with the sub growth is still a hell of a ride. But there are a number of markets that have slowed down, where we're going to take now our scale and we have, whether it's our 10 channels or our 14 channels in the market and really are starting to drive through pricing growth. So I think over the next few years, if we're successful, you'll see more of pricing growth where, historically, it's really just been sub growth.

Operator

Your next question comes from the line of Anthony DiClemente from Nomura.

Anthony J. DiClemente - Nomura Securities Co. Ltd., Research Division

Imply for the trajectory of international growth the number that's apples-to-apples with the 17% growth that you guys put in the release, I was wondering if you could give us that number in the 2Q excluding the unfavorable impact of the World Cup, and so, should we expect that 17% actually reaccelerate, given the impact to the World Cup into the second half? And I have a follow-up.

David M. Zaslav

The World Cup did have an impact on us. Having -- in that 17% was also a few days of -- there was some good stuff in and some bad stuff out. If you took all that away, we would still have been well into the teens even despite World Cup, probably better than that if the World Cup wasn't there. I don't know, Andy?

Andrew C. Warren

That's exactly right, Dave. I mean, the -- when you take out some of those kind of unique items, we were still a teen ad sales growth company internationally and we certainly expect that to continue in the third and fourth quarter. Just really given the whole notion of share of wallet following share of viewership. In many of our key markets, we still see our viewership and our share being much greater than our share of ad sales wallet. So that cycle of catching up will really benefit us, I think, for many years to come.

Anthony J. DiClemente - Nomura Securities Co. Ltd., Research Division

And then David, just -- Liberty Global has been a partner of yours. I wonder if we can get your thoughts on Liberty Global's acquisition of the 7% of ITV? Have you considered partnering with John and with the Liberty Global on that? I mean, it seems to me that it would make sense as part of your free-to-air acquisition strategy on a fundamental level? And then, referring to an earlier question on the tax level, it could've been -- or could be helpful in terms of potential inversion strategy, so I just want to get maybe yours and Andy's thoughts on that particular asset.

David M. Zaslav

Well, we're not going to comment on any specific transactions, but Liberty Global, John and Mike Frees have built a great company and we like working with them. We like working with Rupert and Chase and James and Jeremy on the Sky platform throughout Europe. We see ourselves as partners with all of our major distributors, and we're always looking for opportunities to work with our distributors to create more scale, more distribution revenue, better advertising, CPMs, but that's it.

Operator

Your next question comes from the line of Alexia Quadrani of JPMorgan.

Alexia S. Quadrani - JP Morgan Chase & Co, Research Division

Is there any more color you can provide on the ongoing affiliate negotiations? And do you sort of believe the dynamics may change at all following the closure of the proposed consolidation on the distribution side? And then, just a follow-up on a previous comment you made about the CPM gap and narrowing that gap domestically. I guess, any -- can you continue to see that gap narrow a bit [indiscernible] with light here lately?

David M. Zaslav

On the consolidation here in the U.S., we -- first, it looks like those deals are going to take meaningfully longer than expected. So I think in terms of the timing of the close of those deals, it's looking like it'll be mid to -- at least mid next year, maybe later than that with the number of transactions that need to go through the system and the implications of those very large consolidations. For us, our focus is, we're now almost at 12% viewership on cable. We were at 4%. How do we drive that to 13%, 14%, 15%, how do we make OWN stronger, Discovery, TLC? So certainly consolidation raises meaningful issues. We're still looking at it. We're thinking hard about it, as is all content owners in the business are trying to figure that out. And so we'll continue to do that. On the CPM side, it's -- we're very focused on driving CPM value and we will often hold on price and walk away from business because in the long term, getting the value that we deserve for the quality audience we provide is how we're going to get meaningful growth. And so, you'll probably see us at the front of the line of standing on price. And it does take longer with some of the newer networks and so we've been working with the advertisers and we feel like the more time they spend with Destination America, Velocity, ID, the more they're going to want to come back. But on the volume side, we've walked away from dollars there and we'll continue to.

Operator

Your next question comes from the line of Michael Nathanson from MoffettNathanson.

Michael Nathanson - MoffettNathanson LLC

Let me just ask Andy to -- Andy, firstly, you mentioned and we saw the costs were down in the U.S. this quarter. So we look at the year as a whole, what do you think is the right level of cost growth for the U.S. for the whole year?

Andrew C. Warren

Yes, Michael. We've been very focused as we've talked about the cost structures and driving productivity and ensuring that we can sustain a level of profit and free cash flow growth and part of that comes from just managing our costs as aggressively as we can. So I think for the year, we expect kind of a mid-single-digit cost growth for the U.S. net. We've talked about kind of on the content side, the amort kind of being in the mid to high and on the SG&A side, kind of being low to mid. We have, in the last several quarters, only increased content spend growth kind of mid-single digits, which should certainly help the content amort profile going forward. There will be one meaningful exception to the growth rate, which is the Relinda [ph], another walk that we have in the fourth quarter. We're excited about that and the impact it will have on ratings and the top line, but there surely some meaningful costs associated with that kind of live event.

Michael Nathanson - MoffettNathanson LLC

Okay, I guess, a follow-up on SVOD. Are you assuming SVOD deals second half of the year within your guidance?

Andrew C. Warren

No, we're not. So basically, we are assuming a continuation of the current deals in place, so we're not assuming any large deals. So for the year, approximately $10 million of kind of SVOD revenue from the Netflix deal that we already had previously.

David M. Zaslav

Having said that, we see significant value in our basket of content. We own all of the content we put on our 14 channels, the quality of that content, it continues to get better. The characters, the storytelling, the diversity of audiences. So we think that content is very valuable in -- on all platforms, including SVOD. As do the SVOD providers, and we're in discussions with all of them and if we feel that whether it's over the next few months or longer, we will have some SVOD relationships that are benefit -- that are mutually beneficial.

Andrew C. Warren

We have time for one last question, operator.

Operator

Your next question comes from the line of John Janedis from Jefferies.

John Janedis - Jefferies LLC, Research Division

David, you talked about tripling your viewership share. Since last quarter's call, there's been a concern about TV ratings broadly. Can you talk about the weakness? Do you think it's an air pocket on the content side of the business, a change in viewership habits, a timing issue or something else?

David M. Zaslav

I think viewership on cable is pretty stable. It's not a great story in the U.S., it's flat. People are spending more time watching TV in general, that's what the data says. On the other hand, when you add it all up, it's basically flat. So it's -- you have to -- you need better content. We're focusing on -- instead of just more content, having it -- be stronger, better characters, better story, more on brand, but the U.S. market is a bit of a challenge. But the good news is we have very good, creative team. Over the last few years, we've been able to grow. As you look at the first half of the year, I think cable in general, outside of us, is down about 5. But we're up about 1. So outside the U.S., we're up almost 20. So the -- it's not easy pickings here. And it's -- most of the share that you get, if we gain share, somebody else loses share. Having said that, the fact that when we own our content, there are a lot more buyers for it, now there a number of players in the over-the-top space that want to acquire our content, there's SVOD and mobile domestically in around the world that are becoming more and more interested in content. And so, I think, the ability to grow in a big way here in the U.S., aside from new channels, which is where a lot of our growth is coming from, is definitely not as easy as it used to be.

Craig Felenstein

Thank you, everyone, for joining us. If you have any follow-up questions, please let us know.

Operator

Ladies and gentlemen, that concludes the call. Thank you for your participation. You may now disconnect and have a great day.

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Source: Discovery Communications' (DISCA) CEO David Zaslav on Q2 2014 Results - Earnings Call Transcript
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