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November 26, 2008

Why You Should Own Discovery Communications

Discovery Communications (DISCA) is one of the world's largest providers of cable networks, with projected 2008 revenue in excess of $3.4 billion. The company operates over 100 channels around the world in more than 170 countries reaching 1.5 billion subscribers. In the U.S., its best-known networks are Discovery Channel, TLC and Animal Planet.

DISCA is currently trading at $13.45. The 52-week high was $28.35 on Dec. 13, 2007. The 52-week low occurred on Oct. 24, 2008, at $10.02. The current market cap is $5.7 billion. Debt totals $3.9 billion. At year-end, cash should be over $300 million. DISCA should produce north of $500 million in free cash flow in 2009. Assuming flat 2009 EBITDA, net debt to EBITDA at Dec. 31, 2009, would be about 2.4 times, indicating the DISCA is not heavily leveraged. The debt currently consists of bank facilities, so some refinancing exists.

The consensus earnings-per-share estimate for 2008 is $1.09. For 2009 the estimate is $1.12. At $13.45, the price-to-earnings ratio for 2008 and 2009 is about 12.4. Media stocks commonly trade on EBITDA multiples. On the basis of my 2008 estimate, DISCA is trading at 7.1 times earnings. For 2009, the EBITDA multiple is 6.3 times. On both P/E and EBITDA, DISCA trades at a premium to the big four entertainment companies (Viacom (VIA.B) , Time Warner (TWX) , Disney (DIS) and News Corp. (NWS) ).

Why You Should Own DISCA for the Short Term

DISCA has the best earnings momentum among major media stocks. Recently reported third-quarter results were a significant positive surprise. DISCA raised its guidance for 2008. That is right, in the midst of all the gloom, DISCA just reported a good old-fashioned "beat and raise" quarter. As a result, analyst estimates for 2008 and 2009 have risen over the past 30 days. This relative strength in DISCA's earnings profile is the best reason to own the stock today.

DISCA shares have responded to its earnings performance. The stock is down about 20% since mid-September, easily outperforming the market and massively outperforming other media stocks, many of which are down 50% to 80%. The relative performance of the shares leaves the technical status of the stock in fairly strong position.

DISCA has less exposure to advertising than most other media stocks (40% of projected 2009 revenue) and affiliate fees, its largest revenue stream, representing 48% of revenue, will grow to contractual increases in both subscriber counts and monthly subscriber fees. In addition, DISCA's advertising revenue is somewhat insulated by a growing subscriber base internationally, solid ratings at its U.S. networks, and below-average pricing on its international advertising inventory.

Finally, in both the near term and long term, DISCA's operating income growth is being driven mostly by margin expansion at its international networks, which are significantly less profitable than its U.S. networks despite more synergies than any other cable network provider.

Why You Should Own DISCA for the Long-Term

DISCA's competitive advantage is its focus on nonfiction programming. Nonfiction programming provides the company with three distinct advantages. First, it looks great in high definition. Second, it is often narrated, allowing it to be easily used regardless of the spoken language of the viewer. Third, it is cheaper to develop and create.

Rising margins are driving DISCA's long-term financial performance. Margin expansion is coming mostly from abroad, where the 34% margin in 2008 pales next to the 53% margin for the company's U.S. networks. Because of the advantages of nonfiction programming, management should be able to increase margins steadily and independent of a weak advertising environment.

Margins should also benefit in the U.S. as certain channels are rebranded with the hope that ratings will improve. Planet Green, Investigation Discovery and the Oprah Winfrey Network are three examples of newly branded networks that offer upside, given that they are widely distributed (over 50 million households) but are producing no profits.

Finally, DISCA is an attractive acquisition for any of the major media companies. The dual revenue stream of subscriber fees and advertising make the cable network business attractive. Each of the big four entertainment companies would like to expand in cable networks. Several of these companies will be flush with cash when the credit markets normalize. Cable networks acquisitions historically have been at premium EBITDA multiples, providing upside of 50% to 100% if DISCA were to be sold in the near future.

What Could Go Wrong

DISCA trades at a premium to its peers and has had positive earnings momentum. A negative surprise would cause the stock to take a very hard hit. DISCA is also vulnerable to negative sentiment and further downgrades in advertising growth. The rebranding of channels could fail. Non-U.S. revenue is significant leaving the company's financial results vulnerable to currency fluctuations.

My Position

I am long DISCA for my clients and in my personal accounts. I started buying my position in mid-September at $16.50. My most recent trades came in mid-October, when I averaged down for selected clients between $11 and $12.

The Bottom Line

DISCA has positive earnings momentum and lower estimate risk than most other media stocks. Operating income growth is under a greater degree of management control, since it is driven by margins more than revenues. The stock acts well, indicating an underlying bid that would make DISCA shares a leader if media stocks come back into favor. A takeover bid provides downside support.

Posted by Steve Birenberg at November 26, 2008 09:05 AM in DISCA