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February 14, 2011

OK Quarter and Good Guidance for Discovery Communications

Discovery Communications (DISCK/DISCA) reported 4Q10 results largely inline with expectations. Revenue and EBITDA grew 7% and 16%, respectively. There were a few warts in the report. Domestic advertising came in 100-200 basis points below reduced expectations as ratings weakness in 4Q took a toll. Domestic growth of 13% is still nothing to sneeze at although relative to some peers that saw accelerating growth in 4Q (Disney, Time Warner), DISCK did fall back in the pack somewhat. The other weakness was in international where advertising growth and margins came in under expectations due to tough comps and expense growth to support channel rollouts.

The domestic shortfall looks like it has already cleared up as ratings have rebounded so far in 2011. This should allow advertising to accelerate in 1Q11. In fact, management guidance for 2011 advertising growth appears ahead of the street at about 10%. I think guidance may still be low, especially if ratings hold. The upfront should be very strong and 1Q will grow well ahead of guidance. Comps stiffen as the year goes by, however.

One new issue that came up on the DISCK call and other conference calls from cable network owners is decelerating domestic affiliate fee growth related to declining multichannel subscribers. DISCK management was confident that this situation has stabilized based on its latest numbers. Cable and satellite companies report this week so we should have a better idea. This is something that bears watching, however, as the cable network growth story has been fueled by both affiliate fees and advertising. Losing one leg as advertising comps stiffen due to cyclical issues would not be ideal for longs.

Another issue facing DISCK is a slow start at OWN, Oprah Winfrey's network. DISCK is investing another $50 million, bringing total investment to $239 million. Management is still forecasting breakeven EBITDA in 2011 but poor ratings and increased investment is not a positive sign. The street is likely to give the company the benefit of the doubt until Oprah's broadcast show ends in the fall and more new programming, including Oprah herself, appears on OWN. The buyside is more concerned. I think the network is worth north of DISCK's investment even with the low ratings.

The Hub, the kid's network partnership with Hasbro, is off to a better start. Combined the two networks swing from meaningful losses in 2010 to at least breakeven in 2011, providing a nice boost to growth this year. This is particularly evident in EPS, where management issued guidance well above the street.

One piece of very good news in DISCK's report was acceleration in share buybacks in January and early February. Away from a one-time buyout of part of an insider's holding, DISCK's buyback activity had been disappointing. The increased pace is helping to close the gap between DISCK and DISCA shares as management has been buying the lower priced DISCK shares.

I remain positive on DISCK despite the premium valuation. A superior business model driven by high margin non-fiction programming that easily translates internationally warrants a premium valuation. I can see upside in DISCK shares to the high $40s if ratings hold and the economic recovery continues providing support for domestic advertising.

Disclosure: DISCK is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake, an SEC registered investment advisor. DISCK, TWX, and DIS are net long positions in the Entermedia funds. DISCA and DISCK are a short/long spread trade in the Entermedia Funds. Steve is co-portfolio manager of Entermedia, owns a stake in the Funds' investment management company, and has personal monies invested in the Funds.

Posted by Steve Birenberg at February 14, 2011 10:53 AM in DISCA