The most significant equity investment in Michael Burry's Scion Asset Management portfolio at the end of June was Discovery Communications (DISCK, Financial). The position in the company was worth $25 million at the end of the quarter, giving it an 18% portfolio weight.
Burry is recognized as being one of the most successful value investors of the past few decades, thanks to his laser focus on finding undervalued securities. Let's take a look at why he might be so fond of this free cash flow machine.
Hidden value
Discovery is a bit of an uncovered gem in the media sector. Compared to businesses like Netflix (NFLX, Financial) and Disney (DIS, Financial), the enterprise looks like an ugly duckling. Disney is best known for its big-budget productions, while Netflix is best known for its heavy content spending. It currently spends around $17 billion on content every year. In 2019, Discovery spent $3.3 billion on content. The company spends much less because it focuses on reality TV programs rather than big-budget productions.
What is interesting about this business model is that it leads to significant cash generation. In the second quarter of the year, the group generated $757 million of free cash flow. Netflix generated free cash flow of around $500 million in the first half of 2021, despite generating approximately $14 billion of revenues compared to Discovery's $6 billion.
Discovery is also in the process of merging with WarnerMedia. The combined group will have a content budget of $20 billion per year. Discovery's CEO David Zaslav believes this will allow him to create a global streaming giant with as many as 400 million streaming subscribers, up from the approximately 100 million subscribers that the two companies have today.
The deal to merge the two companies will create a content powerhouse. Discovery under Zaslav has become a lean operation. It has been optimized to increase cash generation and output. I think he will use the same playbook as the WarnerMedia acquisition. As such, when the deal is completed towards the end of 2022, the company could be a force to be reckoned with in the streaming market.
There's more to this trade than the upcoming merger. The cable cowboy John Malone is the ultimate owner of Discovery, and like many of his companies, the group has a complex share structure. There are three shares classes: the K shares (DISKA), A shares (DISCA, Financial) and B shares (DISCB, Financial). Malone owns 95% of the thinly traded B shares. These shares have 10 votes each. The A shares have one vote each and the K shares are the non-voting class.
Under the terms of the merger, all three share classes will be converged into one, with the traditional one share one vote structure when it completes. However, despite this structure, the non-voting shares are trading at a discount of around $2 to the voting shares.
It is possible Burry could see an opportunity here. Not only could there be an opportunity for arbitrage as the deal reaches its conclusion, but the enlarged company could achieve substantial growth in the years following as it leverages its position in the global media landscape and builds its subscriber base.
I should also note that the company has been an active purchaser of its own shares in the past when it has available cash to do so.
This is only speculation as to why Burry owns such a significant position in the stock. It would appear there are a couple of reasons why he could be interested in this media sector opportunity, in my view.
