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June 22, 2010

Update on Discovery Communications Spread Trade

A few months ago I swapped all Northlake client holdings in Discovery Communications voting shares (DISCA) into Discovery Communications non-voting shares. At the time the voting shares were trading at a $4.23 premium to the non-voting shares. Last week, the spread ballooned to almost $7 when it was announced that DISCA would enter the Russell 3000 and DISCK would leave the Russell 3000. Over the past several days, however,, the spread has narrowed rapidly, to $5.47. Here is recap of why I switched to the non-voting shares, what has most recently happened, and why I think Northlake clients can make several extra dollars in the DISCK shares over the next six to twelve months...

In the past few days, a couple of reports have surfaced noting the spread was at its all-time widest point. One write-up appeared on Seeking Alpha from a professional investor. This morning Rich Greenfield of BTIG recommended DISCK as a buy while initiating on DISCA with a neutral, expecting both stocks to move to $42 on the back of strong fundamentals and an expected significant share repurchase to be announced in 2H10 (Rich posts regularly to a great blog for clients of BTIG). Given the spread and the desire of insiders to further increase their economic ownership, the share repurchase will almost certainly focus on the cheaper, non-voting DISCK shares. This point was pushed home last week when John Malone, who controls a third class of super voting shares, volunteered to a group of investors that the spread was too wide and he would advise Discovery management to initiate a share repurchase focused on the non-voting DISCK shares. No doubt the new Wal Street reports were influenced by Malone's comments. All of these reports are narrowing the spread but it still remains close to the highs for the year and well above the average since Discovery came public in September 2008.

DISCA are one vote shares while DISCK are no vote shares. However, two factors mitigate the value of the one vote shares. First, John Malone owns a third class of super voting ten vote shares giving him effective control. Second, Newhouse, a long-time investor and owner of media assets, owns convertible preferred shares into both DISCA and DISCK that contain additional corporate governance rights. The bottom line is that Malone and Newhouse control Discovery making the one vote DISCA shares worth no more than a modest premium to the no vote DISCK shares.

Similar situations exist in other media stocks. Liberty Global, another Malone investment, has LBTYA and LBTYK, which are trading at virtually no spread, thanks in part to an aggressive share repurchase using leverage strategy. Also, Comcast has CMCSK and CMCSA which trade at a spread of around $1 or 6-8%. Finally, News Corporation has two classes, with Rupert Murdoch's voting shares trading at a 14% premium to account for risks surrounding his historic appetite for acquisitions.

Should the spread narrow back to the historical average or to a level more in line with other similar situations, DISCK should close the gap to DISCK by at least several dollars. For Northlake clients, a narrowing spread is a win-win: greater profits if DISCK rises to meet DISCA or downside protection if DISCA falls to meet DISCK.

Keep an eye on the DISCA/DSICK spread on Friday at the close when the Russell rebalancing has the potential to cause it to widen again as DISCA goes in the index and DISCK goes out of the index.

Posted by Steve Birenberg at June 22, 2010 03:04 PM in DISCA