The Discovery Inc. Gambit
- Discovery management has successfully built a company.
- The challenge of a large merger like this is managing all the different businesses acquired.
- Large mergers have a less than optimal history.
- Management probably should consider spinning off or selling noncore parts of the acquisition.
- Shareholders need to decide if the potential return is worth the above average risk.
- This idea was discussed in more depth with members of my private investing community, Oil & Gas Value Research. Learn More »
Discovery Inc. (DISCA) has a long and storied growth history. As such, management has earned a well-deserved reputation for excellence. But some of those praises may have gone to the head of management. That could mean that the latest proposed acquisition of the Time-Warner division of AT&T (T) could prove to be more than the company could handle in the future. Nonetheless if the acquisition proves to be a success, it would be a boon for shareholders.
Beginning with AOL (AOL), several companies have been attracted to Time-Warner over the last few decades. None have really been successful. This is probably because Time Warner is far more than movies. So, the acquisition of this group of businesses involves gaining knowledge of various businesses.
Large acquisitions often have a poor history of success. The reason for this is the company acquired is often diversified. The new management assumes they can run the whole thing the way that the acquiring company is run. Many times, that leads to less-than-optimal results.
One possibility of increasing the success of this proposed acquisition would be to spin off everything that is not part of the movie and potential streaming business after the acquisition. Right now, there are no indicated plans to do that. But it may become apparent to the management of Discovery that there is simply too much to learn in new industries to make retaining the whole acquisition impractical.
Nonetheless, the company does have a history of success to get where it now is able to propose the acquisition in the first place.
Source: Seeking Alpha Website November 28, 2021.
Discovery management has built what is now a $16 billion in market value company. Some of us remember when the value was quite a bit less than that. However, it is clear that long term holders really have not been rewarded unless they decided to sell on the spike shown above. So, the challenge to management is to demonstrate how this acquisition is going to change the long-term history shown above.
Clearly the latest price action demonstrates that Mr. Market has some very reasonable doubts about this.
Source: Discovery Inc. Merger Presentation May 2021.
Increasing the riskiness is the debt ratio shown. Now to some extent that debt ratio overstates the risk because it will have the previous 12 months of history for earnings combined with the total debt. The ratio should improve just by reporting combined company results because it takes a full 12 months for the top number of the debt ratio to fully reflect the actual financial performance whereas the debt number reflects the actual situation right away.
On the other hand, there are likely to be merger related expenses in the first year that could delay the reporting of the benefits for several months. So, the debt ratio that reflects ongoing business conditions may take even longer to appear. This market is not particularly debt happy at the current time. Therefore, the stock price could swoon or trade in a range until the benefits become apparent.
Nonetheless, the prime business of Discovery is relatively resilient throughout the business cycle. There is of course the risk of a few dud programs or a recession bad enough to impact the company's cash flow and bottom line before the debt is at a satisfactory level. So, this stock, even with its investment grade rating, may only be a satisfactory consideration for the more venturesome investors among us.
Source: Discovery Inc. Merger Presentation May 2021.
The enticing part of the deal is shown above. The company is jumping into a growth area of streaming that management hopes will turn into a long-term cash flow bonanza for shareholders. The sheer number of competitors entering the streaming area is likely to turn this business into a generic item similar to what happened to the business of American Online over time.
More to the point the America Online merger with Time Warner allowed American Online to lose focus on its business with a result that other competitors now dominate the search engine business. Alphabet Inc. (GOOG) (GOOGL) is a prime example of what often happens to companies like America Online when they venture too far from their core business.
Therefore, the challenge will be to turn all those combined assets into more cash flow per share than was the case before the merger without losing the competitive focus in any area. That is a real tall order in any large merger.
On the plus side, there are a lot of assets to be gained and combined here. The business is to some extent guided by hits. If too many of those assets end up with a miss, it could sour the market on the company's prospects. On the other hand, a large enough hit movie could make future comparisons difficult.
The market likes a steady stream of growth comparisons. The diversification shown above may provide a steady diet of market desirables. But there is the risk of lumpy growth or even a cyclical nature if the company becomes too dependent upon just a few of the assets shown above.
In the long term, streaming is likely to become a necessary subsidiary for a lot of these companies. What has not happened is a way for the consumer to access this media in one combined place rather than a dozen or more separate subscriptions. Some sort of combined entity where everyone contributes for a price may well happen in the future.
Netflix (NFLX) tried for a long time to have a lot in the library by purchasing the right to rent others' movies for a profit. But plans fell apart when "everyone" saw how much profit they could make on their own. It is likely that in the future, some sort of the original Netflix model should make a resurgence. Too much competition should dry up profits enough for these companies to allow another company to deal with streaming. Currently, though, it's too early to tell with certainty what the survivor model will look like.
In the meantime, this merger offers Discovery shareholders a fair amount of potential return combined with the above average risk of a large combination. In the longer term, management will need to keep looking for new growth avenues as this avenue appears to be filling up at a good pace. Repayment of debt on schedule will be an important first step. In fact, that repayment would remove a fair amount of financial risk from this deal.
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