« May Model Signals Still Favor Small Cap and Growth | Main | News Corporation Earnings Preview: Is This The Bottom? »

May 04, 2009

Another Positive Surprise at Discovery Communications

Discovery Communications (DISCA/DISCK) reported its third consecutive positive earnings surprise. The shares are responding, up 8% in early trading on Monday. DISCA shares are now at their highest price since early September 2008 and up 21% since the day before the market crash began.

In 1Q09, DISCA produced an across the board positive surprise with revenues, adjusted EBITDA, and EPS all coming in ahead of analyst expectations. Revenue growth was 2% despite severe currency headwinds and the sharp global downturn in advertising. Adjusted EBITDA grew 9% as cost controls were once again superb, especially in international operations.

Management raised the low end of its guidance range for the year. Commentary on advertising trends indicated some modest deceleration in 2Q but still industry leading numbers with domestic growth forecast at flat to very slightly down against a tough +10% comp from 2Q08. International advertising growth for 2Q should be in the mid-to-high single digits in local currency. As a comparison, domestic ad growth in 1Q09 was 2% and international ad growth in local currency was 7% (although excluding the UK, international growth was 13%).

DISCA continues to easily outperform its peers. Last week Viacom (VIA) reported domestic ad growth of -9% and indicated that 2Q would be similar. Time Warner (TWX) reported domestic ad growth of very slightly negative and forecast a mid-single digit decline in 2Q. DISCA is benefitting from strong ratings performance which is helping ad sales and also reducing "make goods" or free ads given to advertisers when ratings fall short.

The last three quarters have revealed all the benefits of DISCA's business model. The company enjoys the dual revenue stream associated with cable networks that is allowing affiliate fees to rise in upper single digits or higher. Strong ratings are helping ad sales. International growth is being fueled by DISCA's focus on non-fiction programming that translates well abroad and is also cheaper to produce. These core fundamentals are supported by a superior operating management that is exceptionally good on cost controls and has a strategic vision for growth and enhancing shareholder value.

The balance remains somewhat leveraged at 2.8 times debt to EBITDA. $600 million in debt comes due within in a year. However, the influx of $300 million from the Hasbro deal and $500 million plus in projected free cash flow leaves little worry about or the amortization schedule.

The stock is getting back to a relatively normal valuation for media stocks but upside remains for four reasons. First, growth rates should remain superior at the core networks including Discovery, TLC, and Animal Planet. Second, rebranding and relaunch of networks is just starting with initial success at Investigation Discovery and Planet Green. Third, international growth opportunities remain robust. Finally, well thought out deals with third parties, such as the Oprah Winfrey Network and last week's announcement with Hasbro for a relaunch of Discovery Kids, offer great hidden value potential.

Takeover potential also supports DISCA shares as cable networks should continue to consolidate with potential buyers in DirecTV (DTV), Comcast (CMCSA), and Time Warner. A merger with Scripps Interactive (SNI) also could make sense.

Upside to the mid-$20s is plausible especially if the economy stabilizes and improves and domestic advertising growth resumes late in 2009 and accelerates in 2010.

Disclosure: DISCA and TWX are widely held by clients of Northlake Capital Management, LLC including Steve Birenberg's personal accounts.

Posted by Steve Birenberg at May 4, 2009 10:25 AM in DISCA