Swapping Discovery Share Classes

On March 1st, all Northlake client positions in Discovery Communications voting shares (DISCA) were swapped to Discovery Communications non-voting shares (DISCK) on a dollar for dollar basis.

DISCA shares were added to the S&P 500 as of the close of trading on February 26th. The non-voting DISCK shares are not being added to the S&P. Several other companies with multiple classes of stock also have only their voting shares in the S&P 500.

The addition of DISCA to the S&P 500 caused the shares to spike relative to DISCK as index funds had to buy DISCA. What had been about a $3 premium expanded to over $4. The swap was completed at $4.23.

An added wrinkle in Discovery's share structure is that a third class of high voting shares (10 votes per share) exists and are completely controlled by insiders. As a result, the one vote per share "A" shares offer little value over the no vote "K" shares. After all, the A shares can't override the wishes of the insiders. All other aspects of the A and K shares are equal so there really is no reason for the A shares to trade at a significant premium.

I think the premium should be less than $2. It was headed steadily in that direction prior to the S&P move, having fallen from $4.50 since December. Other similar situations in News Corporation (NWS/NWSA), Comcast (CMCSK/CMCSA) and Liberty Global (LBTYK/LBTYA) all have spreads of less than $1 or less than 10% on a percentage basis.

Disclosure: DISCK is widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts. The Entermedia Funds are net long DISCK, NWSA, CMCSK, LBTYK, and LBTYA. Pair trades on NWS/NWSA and DISCA/DISCK are held in the Entermedia Funds. Steve Birenberg is co-manager of the Entermedia Funds, owns a portion of the Funds' investment management company, and has personal monies invested in the Funds.

Discovery Leading the Advertising Recovery

Discovery Communications (DISCA) reported another good quarter, making it five in a row since the company went public in September 2009. The upside was not as big this quarter than prior quarters but that is due to factors beyond management control: higher expectations and analyst estimates and a still tough environment for advertising sales. What is in management's control continues to perform as well or better than any peer media company. Ratings are good, channel upgrades are on target and creating value, and cost controls remain strict.

DISCA shares are up 90% since Northlake's initial purchase in mid-September 2008 on the first day of the market crash. I still think upside remains but it will take more help from an economic and advertising recovery to drive future gains. I expect continued strong operating performance and support from merger activity at other cable networks to combine with an ad rebound and take the shares to the mid-$30s in 2010.

In 3Q09, DSICA reported revenues of $854 million, EBITDA of $364 million, and EPS of 22 cents. Revenues were slightly ahead of estimates and EBITDA was a significant positive surprise. The upside did not flow through to EPS, which fell short of the 27 cent estimate solely do a large non-cash charge related to stock-based compensation.

DISCA's fundamental drivers are advertising sales and affiliate fees. Domestic ad sales rose an industry leading 5%, better than expectations for a 1% gain. DISCA is converting outstanding ratings into ad sales. International ad sales were up 9% in local currency, at the high end of guidance, although foreign currency translation led to a reported figure of -22%.

The news on affiliate fees was equally positive with domestic fees rising 10% after adjusting for the deconsolidation of Discovery Kids (now part of a joint venture with Hasbro)). International fees rose 5%, again pressured by currency translation.

The company raised its EBITDA guidance but was only cautiously optimistic about 4Q and early 2010 ad sales. I think management is playing it safe due to the uncertain economy and the high amount ad sales taking place very close to airing. This theme was repeated throughout 3Q media conference calls. The trend of improving ad sales is obvious and established but like much in the economy the situation is fragile. I think DISCA management captured it well when they said "difficult pricing prevents full monetization of ratings" and "the environment is "improving but challenging." I suspect that when DISCA reports 4Q in early February it will be another positive quarter.

For 2010, I think revenue growth can be in the high single digits with slightly more margin expansion leading to low double digit EBITDA growth. The company does face two headwinds in 2010. The rebranding of Discovery Health to the Oprah Winfrey Network will cost $20 million in EBITDA and the sale of Travel Channel will cost DISCA an attractive ad sales contract that proves 1-2% of EBITDA. Nevertheless, as noted, I think another good year of industry leading financial and operational performance is on tap.

Disclosure: DISCA is widely owned by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.

Discovery Communication Reports Another Positive Surprise

Discovery Communications reported another positive surprise, making it three straight quarters. Revenue matched expectations but superb performance on costs allowed EBITDA to come at $381 million vs. analyst estimates ranging from $341 million to $356 million. EPS were in line after adjusting for one-time but would have been higher if not for a high tax rate and non-cash stock based compensation.

The operating performance was even better than it appears as the company took an $11 million write-off on German programming and foreign exchange again pressured results. Excluding forex, revenues rose 3% and EBITDA rose 17%, a truly outstanding performance given the economic and advertising environment and far better than its peers.

Domestic advertising rose 2% in the second quarter, the only media company so far to be in positive territory and about 700 basis points better than the industry average. Strong ratings, good branding, and excellent management are driving the performance.

Discovery raised guidance for EBITDA slightly even as it eliminated the contribution of Discovery Kids network, which is now part of a joint venture with Hasbro.

The shares are trading off slightly this morning in a weak market following in the footsteps of last week's action in media stocks that reported decent to good results. Yesterday, DISCA shares spiked into the close to finish at a 52 week high – yes, that is correct, the stock is above its price prior to the September 2008 crash, 50% above , in fact.

While estimates have firmed from last fall, most of the advance in the shares is due to expansion of the shares valuation as investors grow more confident in the company's long-term growth and reward the stock for the amazing financial results it has produced through the worst recession ever for media. My stretch target for the stock had been the upper $20s. With the stock approaching that level but for now, I am comfortable holding the shares given the outstanding relative operating momentum and management team.

Disclosure: DISCA is widely held by clients of Northlake Capital Management including in Steve Birenberg's personal accounts.

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.

Discovery Communications in Value Enhancing JV Ahead of 1Q Earnings Report

Ahead of its 1Q09 earnings report on Monday, Discovery Communications announced a joint venture and re-branding of its Discovery Kids Network. A 50/50 joint venture with Hasbro will lead a re-naming and re-programming of the U.S. network. Kids will continue to operate as is in international markets

According to SNL Kagan, Kids currently reaches 63.4 subscribers and produced $83 million in revenue and $32 million in EBITDA in 2008. Advertising represents 47% of revenue. Affiliate fees run 6 cents per month but are set to bump to 7 cents in 2011. Anthony DiClemente of Barclays believes EBTIDA in 2008 was in the range of $10-20 million.

Under the terms of the deal Hasbro will contribute $300 million in cash and Hasbro.com. In addition, Hasbro is going to make a separate investment to establish a creative team. Programming will draw on current Kids content but mostly be geared to Hasbro brands including G.I. Joe and Transformers both of which will be movie theaters this summer.

It is probably fair to assume virtually all of the $300 million investment is for cable network. This implies a $600 million value. DISCA's current 100% share is worth around $350-400 million if Kagan estimates are correct but just $96-$130 million if Barclay's cash flow forecast is accurate.

As a result, receiving $300 million in cash for 50% of the network looks like a very good deal for DISCA.

1Q09 Earnings Due Monday

I expect a strong earnings report from DISCA on Monday. The last two quarters were positive surprises and greeted warmly by investors. DISCA shares are 15% above their pre-crash levels, a truly extraordinary performance for any stock but especially one so tightly tied to advertising trends.

Key to Monday's report will be advertising trends, which will clearly decelerate from 2H08. If domestic and local currency international advertising remains in a positive territory it will be very good news.

I also look for further upside in margins which have been expanding greatly under the current management team and ticked up a level since the company restructured last September from a tracking stock to an asset-based company.

DISCA shares are trading at a well deserved premium to other TV advertising sensitive companies. Additional upside surprises are probably necessary to kick the stock up another 20%. I think that is a distinct possibility.

The shares are also supported by takeover potential as the company would be a superb fit with any of the big entertainment conglomerates.

Trimming Discovery Communications

Discovery Communications (DISCA) has been one Northlake's best performing stocks. The stock was purchased in mid-September prior to the market crash at $16.50. Today, I trimmed the position across most client accounts at $17.83. Pretty amazing that any stock, let alone a media stock, is above its pre-crash level. With most all other holdings down sharply since the DISCA purchase, the position size had swelled to north of 4% in many accounts. Obviously, I still like DISCA as I did not sell the entire position. However, I still see the market and advertising environment as fragile so I want to avoid concentrated positions. DISCA has less margin for error due to its well-earned premium multiple of earnings and cash flow. 1Q earnings are due later this month and I do not think there will be a disappointment. The last two quarters were positive surprises. The key metric will be domestic advertising advertising growth. Expectations are for flat growth (that is excellent compared to -5% to -10% for most media companies). Here's hoping that my sale proves wrong so Northlake clients make more money on their remaining DISCA positions.

Discovery Communications Catches a Downgrade

I'll bet you would be shocked to learn that there is a media stock trading above its mid-September, pre-crash levels. It's true. Discovery Communications (DISCA) is up about 5% thanks to a restructuring from a tracking stock to a regular stock, two positive quarterly earnings surprises, strong ratings for its TV networks, and still positive domestic advertising growth.

In typical Wall Street fashion, the recent strength in the stock was met by a downgrade today as Natexis went form buy to neutral after the stock reached its price target of $18. I've been thinking the stock could be getting a bit ahead of itself so the downgrade is not surprising. I don't think the stock will get abused as management is sending signals that 1Q went pretty well via press releases. Nevertheless, I am looking to trim the stock as the relative strength has caused my position size in percentage terms to balloon. For those non-money managers out there most professional closely monitor position size and cut back at certain thresholds.

Discovery Communicaitons Provides Some Good News

I finally got something right. Discovery Communications (DISCA) reported another positive surprise (EBITDA +23%, margins +700 basis points) and provided upbeat 2009 guidance. The stock responded by jumping 15%, leaving it within 10% of its mid-September, pre-crash level.

4Q08 benefited from continued strength in domestic and international advertising, ongoing growth in domestic and international distribution fees, and great cost control. Guidance for 2009 suggests these trends will continue with the macroeconomic headwinds taking growth rates to flat to up low single digits excluding investment in the start-up Oprah Winfrey Network. In this environment, especially for media stocks, the guidance is stellar.

DISCA management is doing a great job of managing the business and managing street expectations. If the company can hold on through the downturn it is poised to come out the other side in really good shape. A nice aspect to the DISCA story is that right now results are being driven on a global basis by the well established networks (Discovery, TLC, and Animal Planet) but the potential for phase 2 and phase 3 exists as new sets of networks are rebranded and monetized. DISCA is already having success with Science Channel and Investigation Discovery. Down the road similar value could be created from the Oprah Winfrey Network or currently morose nets like FitTV, Discovery Kids, and Military Channel.

DISCA's results also bode well for other cable network heavy stocks including Time Warner (TWX), Viacom (VIA), and Scripps Interactive (SNI). DISCA is the best story but the cushion of distribution fee growth and relatively strong advertising spending makes cable networks one of the only investable themes in media.

Why You Should Own Discovery Communications

Discovery Communications (DISCA) is one of the world's largest providers of cable networks, with projected 2008 revenue in excess of $3.4 billion. The company operates over 100 channels around the world in more than 170 countries reaching 1.5 billion subscribers. In the U.S., its best-known networks are Discovery Channel, TLC and Animal Planet.

DISCA is currently trading at $13.45. The 52-week high was $28.35 on Dec. 13, 2007. The 52-week low occurred on Oct. 24, 2008, at $10.02. The current market cap is $5.7 billion. Debt totals $3.9 billion. At year-end, cash should be over $300 million. DISCA should produce north of $500 million in free cash flow in 2009. Assuming flat 2009 EBITDA, net debt to EBITDA at Dec. 31, 2009, would be about 2.4 times, indicating the DISCA is not heavily leveraged. The debt currently consists of bank facilities, so some refinancing exists.

The consensus earnings-per-share estimate for 2008 is $1.09. For 2009 the estimate is $1.12. At $13.45, the price-to-earnings ratio for 2008 and 2009 is about 12.4. Media stocks commonly trade on EBITDA multiples. On the basis of my 2008 estimate, DISCA is trading at 7.1 times earnings. For 2009, the EBITDA multiple is 6.3 times. On both P/E and EBITDA, DISCA trades at a premium to the big four entertainment companies (Viacom (VIA.B) , Time Warner (TWX) , Disney (DIS) and News Corp. (NWS) ).

Why You Should Own DISCA for the Short Term

DISCA has the best earnings momentum among major media stocks. Recently reported third-quarter results were a significant positive surprise. DISCA raised its guidance for 2008. That is right, in the midst of all the gloom, DISCA just reported a good old-fashioned "beat and raise" quarter. As a result, analyst estimates for 2008 and 2009 have risen over the past 30 days. This relative strength in DISCA's earnings profile is the best reason to own the stock today.

DISCA shares have responded to its earnings performance. The stock is down about 20% since mid-September, easily outperforming the market and massively outperforming other media stocks, many of which are down 50% to 80%. The relative performance of the shares leaves the technical status of the stock in fairly strong position.

DISCA has less exposure to advertising than most other media stocks (40% of projected 2009 revenue) and affiliate fees, its largest revenue stream, representing 48% of revenue, will grow to contractual increases in both subscriber counts and monthly subscriber fees. In addition, DISCA's advertising revenue is somewhat insulated by a growing subscriber base internationally, solid ratings at its U.S. networks, and below-average pricing on its international advertising inventory.

Finally, in both the near term and long term, DISCA's operating income growth is being driven mostly by margin expansion at its international networks, which are significantly less profitable than its U.S. networks despite more synergies than any other cable network provider.

Why You Should Own DISCA for the Long-Term

DISCA's competitive advantage is its focus on nonfiction programming. Nonfiction programming provides the company with three distinct advantages. First, it looks great in high definition. Second, it is often narrated, allowing it to be easily used regardless of the spoken language of the viewer. Third, it is cheaper to develop and create.

Rising margins are driving DISCA's long-term financial performance. Margin expansion is coming mostly from abroad, where the 34% margin in 2008 pales next to the 53% margin for the company's U.S. networks. Because of the advantages of nonfiction programming, management should be able to increase margins steadily and independent of a weak advertising environment.

Margins should also benefit in the U.S. as certain channels are rebranded with the hope that ratings will improve. Planet Green, Investigation Discovery and the Oprah Winfrey Network are three examples of newly branded networks that offer upside, given that they are widely distributed (over 50 million households) but are producing no profits.

Finally, DISCA is an attractive acquisition for any of the major media companies. The dual revenue stream of subscriber fees and advertising make the cable network business attractive. Each of the big four entertainment companies would like to expand in cable networks. Several of these companies will be flush with cash when the credit markets normalize. Cable networks acquisitions historically have been at premium EBITDA multiples, providing upside of 50% to 100% if DISCA were to be sold in the near future.

What Could Go Wrong

DISCA trades at a premium to its peers and has had positive earnings momentum. A negative surprise would cause the stock to take a very hard hit. DISCA is also vulnerable to negative sentiment and further downgrades in advertising growth. The rebranding of channels could fail. Non-U.S. revenue is significant leaving the company's financial results vulnerable to currency fluctuations.

My Position

I am long DISCA for my clients and in my personal accounts. I started buying my position in mid-September at $16.50. My most recent trades came in mid-October, when I averaged down for selected clients between $11 and $12.

The Bottom Line

DISCA has positive earnings momentum and lower estimate risk than most other media stocks. Operating income growth is under a greater degree of management control, since it is driven by margins more than revenues. The stock acts well, indicating an underlying bid that would make DISCA shares a leader if media stocks come back into favor. A takeover bid provides downside support.

New Buy: Discovery Communications

After many months of monitoring and researching, I finally got long Discovery Communications in Northlake client accounts on Friday. The shares are temporarily trading under the tickers DISAD (voting) and DISCK (non-voting). In twenty days DISAD will revert to DISCA. There is also an illiquid class of super voting DISCB shares. New DISAD/DISCA shares no longer include the company's ownership of Ascent Media (ASCM) which was spun out to DISAD/DISCA shareholders as of last Wednesday night.

The reason I finally jumped in is because of unusual trading in the DISAD shares on Thursday. DISAD shares were not included the Russell 1000. Instead, DISCK shares are in the Russell. On Thursday, despite the huge rally DISAD shares fell at the close when everything else rallied.

My thinking in the very short-term is that if you add back $1.60 to DISDAD, to compensate for the Thursday spin-off of Ascent Media, at my $16.50 purchase price you really get an $18.10 price for DISAD or LESS than it closed at on Wednesday by about 2%. Since Wednesday the closest comparables Viacom (VIAB) and Scripps Interactive (SNI) are up 10% and 6%. Other media stocks are up similar amounts. Thus, DISAD got a lot cheaper vs. the group. The only good argument against DISAD shares on a relative basis to other media stocks is that it is expensive. I think I can now say it WAS expensive.

At Friday’s close of $17.29, if you add back the $1.60, you are just back to $19 or up 4% the last two days. Thus, I think you could get a further catch up move this week. While I like DISAD long-term due to my relative bullishness on cable networks, if the shares popped quickly to $19-20, I'd likely take the profit.

Beyond the short-term pricing inefficiency, several other things should work in favor of DISAD over the next few months....

....First, the completion of the recap creating a pure play operating company may open up the shares to more investors. Second, completion of the recap may lead analysts to reiterate buy ratings, or maybe even upgrade. Third, DISAD will begin holding conference calls with quarterly earnings. Thus far, no calls have been held. Obviously, I think DISAD has a good story to tell so increased exposure should support the stock.

There two primary risks in DISAD shares: slowing national ad growth and acquisitions. Thus far, national TV advertising has held up surprisingly well. However, at media industry conferences sponsored by Merrill Lynch and Goldman Sachs in the last few weeks several companies indicated some initial signs of slowing. Should this slowing accelerate, even the relatively good competitive position of cable networks will be penalized by Wall Street. On the acquisition front, I think it is possible that DISAD would be a buyer, especially given the insider control by John Malone and Advance Newhouse. Some investors may be hoping that DISAD is sold to a larger entertainment conglomerate.