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Portfolio Activity Q4 2019 Thumbnail

Portfolio Activity Q4 2019

By: Jeffrey Malcom, CFA

Last quarter we eliminated remaining positions of Bank of New York (BK) to provide funds for a new holding, Discovery Communications (DISCA).  

The company operates cable networks including The Discovery Channel, Food Network, Cooking Channel, TLC, HGTV, Oprah Winfrey Network, Animal Planet, Motor Trend, and Eurosport Player.  The company’s networks are widely carried across the US and internationally, with its flagship Discovery Channel available in over 220 countries to 340 million subscribers.  Domestically, Discovery’s networks lead in viewership among women aged 25-54 with 25% market share, an important demographic group that appeals to advertisers.  The company makes money by selling advertising and from per-subscriber fees paid by cable companies that include Discovery’s channels in their bundles.

 

Cable subscribers have been declining for the past several years, leading investors to take a dim view of Discovery’s prospects, and the shares have become abnormally inexpensive relative to profits.  Buying here implies that we believe the company has the pieces it needs to navigate a changing landscape, specifically, content and subscribers.

CONTENT: Discovery generates 8,000 hours of new content per year, and has the second largest share of U.S. TV viewing behind NBC Universal, with the leading presence among women. Ultimately, good content that commands an audience should find its way into future products.

Domestically, Discovery’s networks lead in viewership among women aged 25-54 with 25% market share.

The spending bonanza in the industry at the moment illustrates just how much demand there is for quality content. For example, Netflix spent $14.6 billion in 2019 developing its own movies and shows, whereas Disney paid $71 billion to add Fox Corp’s assets in advance of its Disney+ streaming service debut.  Meanwhile, deep pocketed companies (especially Apple) are waiting in the wings with streaming services that are light on content.  

SUBSCRIBERS: As cable companies come under pressure, they are increasingly looking to trim costs by renegotiating lower fees to content providers.  At the same time however, they are loath to drop channels that could accelerate subscriber losses as customers bolt for competitors.  Discovery significantly bolstered its market position when it purchased Scripps Networks in 2018.   The purchase added popular networks including HGTV, Cooking Channel and Food Network, solidifying Discovery’s leading position among women viewers, its value to advertisers, and importance within most cable bundles.

Discovery is also proactively looking to develop its own direct relationships with consumers.  The company has begun direct-to-consumer services, bringing in ex-Amazon management to lead the effort.  The company is taking a segmented approach, creating direct-to-consumer products that are focused on three areas: sports, lifestyle and factual content.  While this direct to consumer effort is nascent, the company has recognized brands, a large audience, content, and management expertise that provides a solid foundation.  

 

In the past three years Discovery has significantly improved its financial position, doubling cash flow and paying down debt on the heels of the Scripps acquisition.  The company now generates cash flow of about $3 billion that will fund growth initiatives and return cash to shareholders via stock buybacks. Despite those financial improvements, the shares are roughly flat over the last five years which argues in favor of their value.  Discovery’s shares currently trade at just 7.5 times estimated 2020 profits, versus 18.4 times for the companies in the S&P 500 Index.  

As the company navigates the trend away from cable bundling fees, continued share repurchases coupled with a stable advertising environment ought to help support earnings per share over the next few years.  Meanwhile, the company's rich cash flow and lower valuation helps make the entire company attractive to any larger competitor looking to bulk up on content.

With fewer bargains generally in the market, the choice is to either pay up for popular stocks or look very deeply at the unloved.  We’ll be watching closely to see which investment thesis plays out for Discovery.  Thanks for your trust and confidence.