One company that has always interested me, and which I have owned in the past, is Discovery Inc. (DISCK, Financial). The investment thesis here is pretty simple. The firm, which owns a range of broadcasts properties, focuses on producing low-cost content, which it can then present to consumers along with advertising. Over the past couple of years, the strategy has evolved to encompass different revenue streams, but the overall principle remains the same.
Unlike other companies like Netflix (NFLX, Financial) and Disney (DIS, Financial), Discovery does not commission a lot of big-budget blockbusters. It focuses on producing mass-market content, which can be quickly and easily produced and then sold.
Discovery's strategy
Under the stewardship of CEO David Zaslav, the company has been pursuing bolt-on acquisitions to build scale in the increasingly competitive streaming market. In the company's latest deal, AT&T's (T, Financial) WarnerMedia and Discovery are merging to form a media behemoth, although this transaction is not yet complete.
One of the reasons I have always been attracted to this company is its free cash flow generation. Discovery's business model means it is highly cash generative. It does not have to spend significant amounts of money on producing content. Therefore, profit margins and cash margins are relatively high.
What's more, every time the company produces a program, it creates a reusable asset. There is no reason why it cannot repeat the same program year after year for a decade, generating new revenues every time. This is another quality that makes the company attractive from an investment perspective.
For 2020, Discovery's free cash flow per share amounted to $3.48, down from $4.37 in 2019, but still up significantly from the $1.82 reported in 2015.
Free cash flow per share has grown at a compound annual rate of nearly 14% since 2015. Based on the figure reported for 2020, the stock is trading at a free cash flow yield of 15%. That appears incredibly cheap.
Why is the stock so cheap in such a buoyant market? A free cash flow yield of 15% is incredibly rare in this market, suggesting there is something either very wrong with the business, or it is challenging for investors to understand how the company may grow over the next five to 10 years.
I think it is a combination of both of these factors. There are two things that really stand out about Discovery which make me uneasy.
Discovery's issues
The first is the group's leverage. Historically, the company has had a high level of leverage. This is not unusual because Discovery is part of the John Malone empire. Virtually every single company under the Malone umbrella has a high level of debt as he made the bulk of his fortune by leveraging telecommunication companies to the hilt and using the funds for share repurchases or acquisitions. The strategy has worked incredibly well for Malone at least. It is less clear if the strategy has worked well for all of his shareholders.
At the same time, Discovery's CEO is one of the highest-paid in the U.S. In seven of the past 10 years, he has earned more than the CEO of Disney, and he was recently awarded a pay package of cash and options totaling $190 million.
I do not have an issue with high levels of CEO compensation if the CEO is worth it. In this case, I think that's questionable. Over the past 10 years, Discovery's C class of shares have returned 2.2% per annum, underperforming the wider entertainment industry by 16.5% per year. In comparison, shares in Disney have returned nearly 20% per annum over the past decade. Given this, it doesn't seem to make sense for Discovery's CEO to be better-paid compared to Disney's.
Another factor to consider is the large number of outstanding share options. Discovery's 10-Q for the third quarter shows the company had 506 million basic shares and 663 million diluted shares outstanding. With such a high level of dilution possible, it is challenging to understand how much the shares could be worth. The additional dilution could also be an overhang on the stock.
All in all, Discovery looks cheap, but it might be cheap for good reason.
