Introduction
Discovery Inc. (DISCA, Financial) (DISCK) is a media company that provides TV content in around 220 countries and in 50 different languages worldwide.
The company is well-known for its non-fiction TV shows, broadcasting on Discovery Channel, Food Network and Eurosport, among others.
Discovery's programs are available on various platforms, the most common being linear TV (either cable or satellite) and its recently introduced Direct-to-Consumer (DTC) streaming platform, discovery+.
The company's stock was recently on a roller coaster, (partially) pushed up by speculation and then down by forced selling.
The Archegos meltdown
But what happened exactly with the sharp price runup and subsequent crash? In short, it was mostly due to an enormous short squeeze caused by significant highly-leveraged stakes in the company owned by Archegos Capital Management.
Archegos, a family investment vehicle owned by Bill Hwang (a former stock analyst at hedge fund Tiger Management), recently had to start liquidating huge blocks of shares from its highly leveraged portfolio.
Even if Archegos had around $10 billion in assets invested, it didn't directly own them. Instead, the fund bought complex derivatives like swaps contracts and contracts-for-difference (CFDs), which allowed it to get a five times ($50 billion) exposure to the basket of stocks selected. Using these instruments basically means taking on a lot of leverage, and consequently a lot of risk.
In most cases, Hwang's positions comprised huge stakes in several companies that would have required him to publicly disclose them, if only those positions would have been acquired directly.
When Baidu (BIDU, Financial), one of his (indirect) holdings, started going down, he received margin calls that Archegos was not able to cover, so the banks selling the derivatives to Hwang were forced to sell large blocks of shares at prices significantly lower than market prices (that is the only solution when you can't find enough buyers - and shares - on the other side of the trade).
This is a self-reinforcing mechanism, so the selling intensity continued to accelerate, pushing down the price of virtually all the stocks included in Archegos' portfolio (independently from the fact that they were good or bad investments).
Once the lending banks realized that Mr. Hwang couldn't repay them, they were forced to admit that all this happened because they relaxed their lending practices too much, and some of them also disclosed the maximum loss they were going to take in relation to Archegos' failure. For example, Credit Suisse (CS, Financial), one of the banks involved, disclosed that they were about to take a $4.7 billion charge.
Every time a good company like Discovery is being sold for purely technical reasons, I get interested and try to redo my homework. I have owned Discovery since last year, and enjoyed the recent price rise, but sold it as the stock approached my estimated intrinsic value.
Discovery+
Since then, discovery+ trends showed quite some progress: so the combination of a cheap price and the potential growth represented by the recent subscribers additions, can create the right recipe for future juicy returns.
Discovery+ was launched in the U.S. on Jan. 4. The day after it became also available in most European countries. Here's what CEO David Zaslav recently had to say about the launch of discovery+:
"Key metrics, including subscriber additions, customer engagement, and retention, are exceeding our expectations and demonstrating sustained momentum into the second quarter. We now have 15 million total paying direct-to-consumer subscribers across our global portfolio driven primarily by discovery+."
Paying subscribers have been increasing at a rate of 2 million per month in the last three months and the company already signed additional contracts to extend the reach of the service to consumers who didn't elect to subscribe directly through the website.
Switching to pricing, direct customers can choose between the Ad-Lite version at $5/month or the Ad-Free option for $7/month. The company estimated additional advertising revenues of 4$/month for the former option.
Specifically, Discovery signed a contract with Verizon (VZ, Financial) to offer discovery+ for free to around 50 million existing and new subscribers (both mobile and home internet customers) for a period of time ranging from six to 12 months depending on their contract. Some of these customers are presumably going to renew and subscribe to the service at the end of the free period, even if I expect that the churn rate can be quite high there.
Additionally, discovery+ content has already been available in Ireland and UK since November 2020. The service will be free of charge for all SkyQ customers for 12 months. Here I expect to see a good amount of accounts to turn into actual subscriptions as Discovery's TV shows are quite popular, especially in the United Kingdom.
Back to streaming, Discovery has recently signed agreements with Comcast (CMCSA, Financial) to offer the service on its Xfinity channels and with Amazon (AMZN, Financial) to make it available on their Amazon Prime Video Channels.
While selling discovery+ content as part of a package comes with lower margins, this is a good way to extend its reach and diversify customer categories and geographies.
With all this marketing efforts, one could think that the legacy linear TV would be in decline, but that's not the case: the total share of viewing across the international linear portfolio grew 2% on average in Q1 (it has been growing for seven quarters in a raw).
Financial situation
Total revenues for U.S. networks increased 3% compared to the last year. Adjusted OIBDA (Operating Income before Depreciation & Amortization) decreased by 19%, mostly due to much higher marketing and selling expenses, mainly related to the launch of discovery+.
Total revenues (U.S. + international) increased 4% to $2.8 million from $2.7 one year ago, while net income decreased from $407 million one year ago to $191. Free cash flow decreased from $230 to $179 million.
The decrease in earnings, OIBDA and FCF should not be taken as a permanent shift, as investing heavily in the promotion of discovery+ is the only way to give it the right push and be competitive.
I estimate that the company could (conservatively) not only get back to its around $3 billion of FCF reached in 2019, but produce at least $3.5-4 billion of FCF per year by 2025.
Looking at valuation, I get a price of around $51 per share in case of no FCF growth (in perpetuity) and of $255 if we make the hypothesis that for the next 10 years FCF will grow at the same rate it grew during the last 10 years. The price range is quite large, but when we have such a significant discount related to both the base and growth scenarios we can simply let the company surprise us on the upside (as of today Discovery B shares are selling for $31.03)
Lastly, Discovery has $14.7 billion of non current debt outstanding and around $2 billion in cash, but has no payments left this year and only a total of $581 million to be paid in 2022.
Risks
Even if DTC subscriptions are growing more than expected, it is too early to talk about churn rates, so in order to judge if customer retention is acceptable we would need more data (and more quarters). At the moment we can only make an educated guess and imagine that subscriptions will grow at the same or slightly lower rate for the next few quarters.
Pricing is also a risk, as Discovery is not the only player in the streaming environment. Families are starting to rationalize their expenses by setting a family monthly budget for streaming subscriptions. Families that have a limited budget and prefer watching films and TV series will probably opt for Netflix (NFLX, Financial) or Disney+ (DIS, Financial) and cut discovery+ out. Coming out with the right price is extremely important, so the management should be patient and not try to anticipate price increases if pricing power is not proven.
Another delicate point is choosing what to air on linear TV and what on streaming. The company should try to move to discovery+ only content for which they are sure the customer is really willing to go the extra mile. The risk is that of losing precious advertising revenues on linear TV and not being able to make up for it with streaming subscriptions.
Conclusion
Discovery is trying to transition its non-fiction TV programs content to its higher-margin DTC streaming platform discovery+.
The company's share price has recently been on a roller coaster. High volatility and forced selling due to the Archegos scandal has created a buying opportunity for value investors.
The company's profitability is currently masked by the huge investments needed to launch its DTC (and packaged) offers, but those expenses will come down once the situation will have stabilized. I think the shares provide an adequate margin of safety for the patient investor.
Disclosure: The author own shares of Discovery (DISCK, Financial)
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