The media business in general is one I really like. Pay TV-delivered channels enjoy a dual source of revenue in affiliate fees (paid by cable and satellite companies to carry their channels), and traditional over-the-air advertising spots. Affiliate fees are very reliable revenues, negotiated in multi-year contracts and stable even through economic downturns, while advertising revenues offer growth opportunity in economic booms. Also, despite the shake-up in distribution over the last decade, great content always wins, giving the networks that own their own shows an excellent opportunity to further monetize through Internet channels like Netflix or mobile apps.
Discovery has a lot of really nice attributes that make it one of the highest quality media companies in the MFI screens right now. But the key question is: is the price right? Let's take a look.Giving You The Business
Discovery owns and operates a variety of popular pay TV networks including the Discovery Channel, TLC, Animal Planet, Science Channel, Velocity, and Investigation Discovery (NYSE:ID). The company also owns a 50% stake in Oprah Winfrey's OWN channel, as well as The Hub, a children's channel joint venture with Hasbro (HAS). Some of Discovery's most popular shows include Shark Week, Mythbusters, Man vs. Wild, and a personal favorite, How Its Made.
Discovery reports in 3 business units: U.S. Networks, International Networks, and Education and Other, the last of which is just 3% of revenue and consists of the firm's online educational tools for schools. The company's revenue breakdown is pretty easy to remember. It is roughly a 50/50 split between U.S. and International, and a 50/50 split between distribution and advertising!What Makes Discovery Better Than Its Peers?
Unlike many of its competitors, Discovery has a robust international operation, with a presence in close to 200 countries and 35 languages. The firm's content transcends cultures and is easily modified to fit local markets. This gives Discovery greater growth potential than predominantly U.S. networks. Discovery has kept expanding its international presence, recently acquiring SBS Nordic and Eurosport. The company grew its international business over 25% in 2014, and with pay TV's penetration rates overseas far below that of the U.S., it has very attractive organic growth potential for many years. I estimate the company should be able to grow revenues and profits at 8-10% over the next few years.
Another advantage is that Discovery owns essentially all of its content. This is in stark contrast to the company we looked at earlier this week, Crown Media (CRWN), which uses mostly third party programming. Ownership of content gives Discovery an opportunity to monetize their entire catalog through new distribution sources, such as Amazon or Netflix.
Of course, as previously mentioned, the media business model is an attractive one. Discovery generates substantial and stable cash flows, even through economic downturns. Management has reduced share count by an average of 5% per year over the last 5 years, adding substantial value for shareholders. Put that together with earnings growth, and shareholders could conceivably expect 10-15% earnings per share growth. That's not bad at all.The Risks
Like many of its peers, Discovery has suffered weak performance in the U.S. recently. U.S. revenues were flat last quarter, with stagnant ratings driving weak ad growth and limited distribution gains. I believe U.S. growth will continue to be difficult as distributors push back on affiliate fee growth and consumers continue to migrate to new sources of entertainment.
Overall, I see the biggest investment risk as simply valuation. At just a 7.1% earnings yield, Discovery is not particularly cheap by any measure, let alone as a Magic Formula stock. Honestly, I'm not sure how it is being screened at its current price! Traditionally this has been a highly valued stock, with a 5-year average earnings yield of 6.5% - so the stock may be slightly undervalued. But by no means is it deep value.Conclusion and A Quick Tip
Assuming 8-10% earnings growth and 3-5% share buybacks, I estimate Discovery's stock worth about $37 per share. With the class A shares at $32.30, that represents almost 15% upside. Not bad, but certainly not a margin of safety to qualify this as a Top Buy candidate.
Here's a quick tip for those who like the stock. The class C shares (NASDAQ:DISCK) have identical economic interest in the company, but trade at a 5% discount to the class A (DISCA) shares. The only difference is that the class A shares have one vote while class C shares carry none. For most investors, voting power is virtually meaningless (this is a $21 billion dollar company), so the discount to the C shares is an enticing advantage.