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July 31, 2013

Messy Quarter But Core Growth At Discovery Warrants Patience

Discovery Communications (DISCK) shares have traded off 5% since reporting June quarter earnings. The underlying organic growth rates were largely in line with estimates but accounting adjustments related to the company’s acquisitions in Europe earlier this year led to a reduction in net income guidance for the year and miss on reported EPS for the quarter. It is too soon to get a read on how the acquisitions will work out. They are designed to sustain the company’s growth as it enters new territories and expands the programming and channel genres it offers. The stock sold off mostly because expectations were so high. DISCK shares trade at the highest valuation among its cable TV network peers leaving little room for error. I think it makes sense to show a little patience as ultimately investors should re-focus on the company’s superior near-term and long-term growth.

This growth was evident in the just reported quarter. Adjusting for acquisitions, advertising grew 10% domestically and 21% abroad. Affiliate fees grew 5% domestically and 14% in international markets. Management suggested domestic ad growth could strengthen in the current quarter and surprisingly offered positive comments on fourth quarter ad growth. Strong ratings are a key driver of management confidence. Affiliate fee growth should pick up a little after decelerating slightly. Timing and phasing of renewals makes this line item a little trick to predict but there is little doubt growth will pick up as ratings and additional TV Everywhere rights support higher fees.

The 20% growth abroad even before the acquisitions in Europe is what really sets DISCK apart from its peers. Other network companies have similar growth but DISCK is getting almost half its revenue and 40% of its EBITDA from high growth international markets.

DISCK also has more upside from upgrading its domestic networks. The Oprah Winfrey Network is finally turning into a contributor after years of losses. Other networks like Investigation Discovery have moved from small or mid-tier contributors to full-fledged, large growth drivers.

After the pullback, DISCK shares trade about 19 times 2014 estimates. Most peers trade more like 15 times. DISCK’s growth drivers, including very aggressive share buybacks, should drive 20-30% EPS growth for the next several years, well ahead of the peers so the premium makes sense. 2015 EPS could easily exceed $5 so if the multiple just holds, which it should given the growth rate, the shares can work to $100. Those numbers explain my call for patience.

DISCK is widely held by clients of Northlake Capital Management, LLC, including in Steve Birenberg’s personal accounts. Steve is sole proprietor of Northlake, a registered investment advisor. Northlake’s regulatory filings can be found at www.sec.gov. DISCK is a net long position in the Entermedia Funds. Entermedia is a long/short equity hedge fund focused on media, entertainment, leisure, consumer retail, communications, and related technologies. Steve is portfolio manager of Entermedia, owns a controlling stake in Entermedia’s investment management company, and has personal monies invested in the funds.

Posted by Steve Birenberg at July 31, 2013 12:41 PM in DISCA