Discovery – The Fire Sale

The Archagos fiasco forced a fire sale in companies such as Discovery (DISCA, DISCK), ViacomCBS (VIAC), GSX Techedu (GSX), Baidu (BIDU), Tencent Music (TME) and others. Forced-selling can produce distortions in the market and create buying opportunities. 

Here’s a chart from last week’s blood bath:

I decided to go quickly over the lot that got beat up. Take note that some of these shares bounced back from their lows.

ViacomCBS (-26%) – They own SpongeBob and recently got into a fight with Judge Judy, so I’m out. The shares had climbed to over $100 in recent weeks, well above the consensus analyst price target of about $60. After the past week’s fire sale, shares traded at around $45.50.

GSX Techedu Inc. (-56%) – MuddyWaters and other short-sellers are after them for fraud. I’m not touching it.

Baidu (BIDU) – The Chinese google. Baidu was part of a group of Chinese stocks that got unloaded. There might be something good there but we are not done with the Chinese government’s interference and the recent SEC action.

Tencent Music (-37%) – This one is intriguing and will require further reading. My hunch tells me that in the long-run it could be a winner but again, because of the CCP’s meddling into big Chinese tech and the SEC I’m staying out for now. 

Discovery (-27%) – My favorite from the fire sale. I bought some. When somebody (Archegos) is dumping shares of a good company at bargain prices, I’m a buyer. When somebody is in a desperate situation, and needs to sell, the buyer is in a good position. Discovery is the one that I’ve looked at on and off over the years. I’m not saying it’s the best one of the group, it’s simply the one I’m more familiar with. It always looked too expensive and they have some headwinds to deal with. The selloff forced me to look at it again. Plus the fact that I was already familiar with the company helped me pull the trigger. DISCA is trading around $41-$42 and is down from $77.27 on March 19, 2020.

Keep in mind this is not a full valuation exercise. I didn’t include the Advance/Newhouse preferred shares. This post is just a quick way for me to chop down some notes on the company.

Discovery didn’t fall off a cliff because of some bad news related to the company. It’s victim of a massive sell-off of shares related to the collapse of a hedge fund. Archegos Capital Management received a margin call and was forced to flood the market of shares.

Discovery themselves put out a press release on Friday during trading hours:

Discovery (Nasdaq: DISCA, DISCB, DISCK) today announced that today’s trading activity is not the result of insider transactions or transactions by Advance/Newhouse Programming Partnership or its affiliates.

The Company issued its outlook for the first quarter of 2021 on February 22, 2021 and provided additional guidance at the Deutsche Bank TMT Conference on March 8, 2021, and is comfortable reaffirming its outlook and the additional guidance. The Company is confident in and pleased with the execution of its strategy, both with respect to its traditional business and the direct to consumer roll out. It looks forward to releasing first-quarter results and hosting its quarterly investor call on May 10, 2021.

Source: 2020 Proxy

We know that the largest shareholder, Advance/Newhouse Programming, is not the seller and it’s reasonable to think it’s not John Malone. Vanguard and BlackRock are ETFs. So we had one guy, through a couple banks, dumping blocks of shares at whatever price to cover his debt. Along the way this probably triggered algorithms to sell too, which further fueled the downward spiral. 

Discovery has three classes of common stock:

• Series A has one vote per share
• Series B has 10 votes per shares
• Series C has no votes.

Discovery is in an out-of-favor industry (cord-cutting), but is able to produce quality content for significantly less than other media companies and has a large subscriber base. Do not underestimate the creator of the 90 Day Fiancé. They bought Scripp (HGTV, Food Network) in 2018 for $15b and the Discovery has been a strong performer over the last couple years.John Malone also owns a good chunk of it and controls a good block of the voting power. If shares don’t rebound, it could be an interesting acquisition target. 

Discovery+ seems to be a hit. It has surpassed 11 million total paying direct-to-consumer subscribers globally and is on pace to be at 12 million by the end of the month. With cord cutting, Discovery+ is the future of the company. There’s an old saying: Adapt or die. Well if you don’t adapt to the digital world you die. 

Streaming is shaping up to be a tough business. The competition is heating up. It will be a war on price and content. Netflix has a first-mover advantage, Disney has content, great brands, sports and families, Amazon has AWS to pump money into Prime, Apple is a juggernaut with 40%+ of the device in people’s hands. AT&T’s HBO has premium content and will be fine. As for CBS/Paramount+, NBC Peacock and the rest I don’t know. Discovery might be a modest success. They have a loyal following with women in above-average-income households. Discovery boasts 3 of the top 4 women’s networks. They also have a good international presence. The trick is trying to find a  balance between growing streaming and not cannibalizing the cable cash cow too much.

However, the economics of streaming require significant scale to turn a profit. We are in the early innings of the streaming era. Disney’s streaming is not profitable yet and I think Netflix recently just turned free cash flow positive. The problem I see with the streamers is they are now on the content & technology treadmill. They need to spend a massive amount on content and technology every year to stay in the game. Discovery has the advantage of creating less expensive content. Where most of the streaming media business has gravitated toward scripted series and movies, Discovery has settled on the unscripted, home, food and travel shows that garnered large audiences but had relatively little high-profile competition in terms of content. Producing Property Brothers, Gold Rush, and the 90 Day Fiance doesn’t break the bank. And they have Shark Week.

Discovery has been a strong buyer of its own shares over the years. In 2020 they repurchased $965M of DISCK stock at an average price of $23.18. Given where the stock trades today this has been highly accretive. Share buybacks are a great idea if the market is failing to recognize the value of a current stock. If shares languish the future buybacks will be highly beneficials.  They also spend some FCF on reimbursing debt.

Discovery uses a metric called adjusted OIBDA – operating income before depreciation and amortization.It’s similar to EBITDA, except with OIBDA, the calculation is started with GAAP net operating income. In EBITDA, the calculation is started with GAAP net income. OIBDA is used to give a clearer picture of the profitability in continuing business activities without taking into consideration the effects of capitalization and tax structure.

Discovery’s market cap after the selloff is approximately $18.5 billion, with trailing free cash flow of $2.34 billion. I’m guessing FCF will be between $2.5b and $3b in the future. To stay on the conservative side, and I’m working with $2.3b. This works out to a FCF yield of 12.6%, or only 7.9x FCF on equity. This is cheap, despite the future opportunity ahead and the quality of the company. Decent companies these days are trading at sub 5% FCF yield. If you were a private acquirer, how much would pay for the whole company? Disney bought Fox for 13x EV/EBITDA. Comcast bought Sky around 16x EBITDA. Discovery could probably attract similar multiples in the event of a sale. The value of the firm is currently $31b, it would have to command a 30%-50% premium to compensate for the selloff and the take-over premium. The market is pitching you a fat pitch.

Now I know that, for the sake of time and simplicity, my FCF calculations are flawed. They are not based on a fully diluted basis. I didn’t include the full conversion of the convertible preferred owned by the Advance/Newhouse interests. So the real FCF per share should be lower. In a take over scenario I would have to use fully diluted numbers. In my head I know what’s going on, but please if you are serious about investing in this company make sure you include them. These back of the napkin numbers are to give me ballpark range.

Discovery is the one of the largest global media providers with over 2 billion cumulative subscribers in over 220 countries. When you buy Discovery, you get a piece of Discovery, TLC, Animal Planet, HGTV and Food Network.

Discovery prints money and has an interesting cost profile. If the price stays low it will be bought out for its great content. Meanwhile share buybacks and debt reimbursement will benefit equity holders.

I didn’t buy this stock to hold forever. It’s more of a trade. I’m buying shares from a good company from a desperate seller. I will probably resell when the mood shifts or when it hits a reasonable valuation. A 12.x FCF (8% fcf yield) multiple would imply a stock price of $57.62, which is 38.8% higher than post bloodbath price of $41.5 a share. Considering the shares peaked at $77, it’s a reasonable outcome.