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April 29, 2011

Beat and Raise From Discovery Communications

Discovery Communications reported a strong 1Q11 and increased its full year guidance. Advertising growth picked up from the fourth quarter, aided by improved ratings performance in the US. The guidance increase indicates that there is no slowdown in sight for domestic advertising with the caveat that ratings at key networks (Discovery, TLC, Animal Planet) need to hold at or above year ago levels.

The big story in the quarter was 15% domestic advertising growth (adjusted for the deconsolidation of Discovery Health which is now OWN), an acceleration from 13% growth in the fourth quarter. The overall national TV ad market remained robust from quarter to quarter so the improvement was mostly due to better ratings.

Another major positive in the quarter was acceleration in the pace of share buybacks. Since announcing its share repurchase program last spring, Discovery has been slow to buy back shares. First quarter buybacks picked up and the company announced that repurchase activity accelerated in April. Management clearly stated that the higher pace of buybacks would be sustained; even going so far to say that larger merger and acquisition activity was off the table for now.

One negative in the quarter was yet another increase in funding for OWN, the Oprah Winfrey Network. Management admitted that ratings are below expectations and establishing the network would take longer than initially planned. I think expectations for OWN are now quite low as far as Discovery shares are concerned. Disappointment at OWN is now built into the shares leaving eventual success an upside call option. This is a good situation as betting against Oprah is probably not wise.

On the flip side, growth in subscribers, viewers, and advertising at Investigation Discovery is picking up. There is a chance that ID could become a fourth fully distributed, major cash flow producing network over the next few years. This would drive significant value shareholders.

Another upside for long-term growth and value is the continued expansion of TLC outside the US. Discovery has the best international growth profile of any cable network company thanks to its focus on non-fiction programming and already substantial international footprint.

The latest quarter and guidance confirms near-term strength driven by the domestic advertising, while also increasing visibility of long-term growth due to international and domestic network rebranding. Quarter to quarter ratings volatility remains a risk but overall the latest news indicates Discovery shares are earning their well deserved premium valuation. I see the shares as a core holding for growth oriented investors.

Disclosure: Discovery Communications is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg's personal accounts. Steve is sole proprietor of Northlake Capital Management, an SEC registered investment advisor. Discovery Communications is a net long position 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 April 29, 2011 08:51 AM in DISCA