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Grahamites
Grahamites
Articles (292) 

My Most Humbling Experience

A detailed analysis and reflection of my investment in Discovery Communication

December 21, 2017 | About:

“Experience is what you got when you didn’t get what you wanted.”

- Randy Pausch

Of all the investments I’ve made, Discovery Communications (NASDAQ:DISCA), has been a very excruciating one, but has taught me numerous lessons. Today I’d like to share my humbling experiences with the company since 2014.

In late 2014, I started researching Discovery Communications as a potential investment opportunity because I thought I was familiar with the brand, John Malone owns a lot of the company and the stock has dropped quite a bit from the high of more than $46 a share to around $30 a share. Initial research also showed that Discovery Communications passed two important criteria: having pricing power (I’ll elaborate later) and being a cannibal. I liked what I saw, with moderate enthusiasm. Below were the 11 reasons I liked Discovery back in 2014, from the notes I took then.

1. Universal appeal of content

Discovery’s content has strong universal appeal that translates well across cultures and languages. This means once Discovery created the original programming, it can easily re-edit and dub the program for airing internationally with minimum additional investment.

2. Advantage of scale

  • Cost reductions along the experience and volume curve. The very nature of the business is that if Discovery can get a lot of volume through its joint, it gets better at processing and volume. The per-subscriber cost of its content drops dramatically as Discovery adds more and more international subscribers, while every single new subscriber adds 100% margin revenue. This is an enormous advantage to Discovery.
  • Information advantage  If some wannabe new entrants want to create similar content that Discovery is currently offering to its viewers, they are at great disadvantage because the MVPDs (content providers) and customers know Discovery’s content is likely to provide continuous satisfactions whereas they don’t know whether the new “Joe-on-the-street” will live up to expectations.
  • Advantage of scale from Pavlovian association and social proof – Just like Pavlov’s dog salivates when the bell rings, nerds and curious minds all over the world salivate even more when they think about the joy of watching the Discovery Channel, Discovery Science or Animal Planet. Similarly, if you are new to science or the animal world, you cannot help but find out that all the incumbent hardcore science fellows are watching the Discovery Channel or Discovery Science. You know you cannot go wrong with Discovery’s content.

3. Specialization in niche market

To quote Charlie Munger (Trades, Portfolio), “Just as animals flourish in niches, businesses who specialize in their area get very good because they specialize frequently find good economics that they won’t get any other way.”

Discovery’s three flagship channels – Discovery, TLC and Animal Planet  all have carved a niche on basic cable. The niche markets combined with the patent and copyright, which is another powerful mental model, make it almost impossible for any wannabe new entrant to encroach on Discovery’s niche.

4. Discovery’s channels represents between 12-13% of all viewership on cable but only 4-5% of the economics, whereas many other players would have a percentage of economics multiple times as percentage of viewership.

Therefore, the distributors are very happy with the deals with Discovery, which makes it easier for Discovery when it comes to contract renewals.

5. Vertical integration

Discovery owns virtually 100% of its content and the digital rights to its content. New distributors will be willing to pay for dated programming so Discovery can monetize current content and get incremental revenue from its programs in the vault.

6. Pricing power in the affiliate fees business

Discovery’s contractual relationships with MVPDs call for inflation-based escalators (typically between 3-5%) year over year both internationally and in the U.S. We expect this pricing power to continue because of the unparalleled brands, content and global reach Discovery has built over a long period of time, making its channels essentially “must-carry” for MVPDs.

7. Riding a wave – international subscriber growth

While U.S. subscription volume has flattened, there is still a great deal of untapped potential in the international market. In 2008, the international segment merely accounted for 26% of revenues. As of 2014, the international segment has surpassed the U.S. segment, making up 50% of the company’s consolidated revenues. Management sees double-digit growth in both advertising sales and affiliate fees.

8. Discovery Communication is a cannibal

The company has reduced its diluted shares outstanding by 20% since the start of the share repurchase program as of year to date 2014. Management has indicted a continuation of this trend.

9. Foreseeable lower tax rates

Management has remained focused on lowering both the effective tax rate and cash tax rates by fully utilizing Discovery’s increasing international business mix. To this end, as Discovery continues to grow its foreign assets and content production capabilities in critical international markets, management has guided for a gradual decline in the effective tax rate. This sustained, year-over-year reduction in the tax rate will not only drive net income growth, but also accelerate Discovery’s free cash flow and capital redeployment opportunity growth as well.

10. Margin expansion opportunities

The acquisition of Eurosport was margin dilutive initially by 400 to 500 bps to the international segment due to acquisition-related and integration-related costs. This has lowered Discovery’s international OIBDA margin from above 40% to mid-30%. However, as the integration progresses along and Discovery continues to cut overlapping costs such as distribution cost, etc,, management expects the international segment margin to get back up to 40% within a five-year window.

11. Enormous capital redeployment opportunities in the international market

While the pay-TV market in the U.S. has largely matured, pay-TV penetration is still below 50% in countries such as Brazil, Australia and Italy. There is plenty of growth in the international market and having six established channels in a large portion of foreign markets gives Discovery negotiating power with distributors across the globe. Discovery can also make bolt-on acquisitions in foreign markets.

12. John Malone is a major shareholder

At the time of my initial purchase, I thought I paid a fair price for a wonderful business (18 times trailing 12-month earnings). My DCF calculation, using a 3.5% terminal growth rate and 10% discount rate, resulted in an intrinsic value of between $45 a share and $50 a share depending on other assumptions. Discovery was trading at about $30 a share; it looked like the margin of safety was there.

Since 2014

What happened since 2014 has been very puzzling but more importantly, extremely humbling. Almost all of the above 11 reasons held true (with the exception of margin expansion), but Discovery’s stock, at one point, dropped 50% from my initial purchase price of around $30 a share. I’ve continued to average down over the past three years. As of the most recent closing, I’m still sitting on an approximately 20% paper loss from my average cost of Discovery after almost three years. The opportunity cost has been very high.

I’ve re-evaluated the Discovery situation multiple times over my holding period. In the beginning, I thought it was negative foreign exchange impact that had temporarily impacted the international business. Especially in late 2014 and 2015. For instance, in first quarter 2015, foreign exchange had an astounding 17% impact on Discovery’s International revenue. Without foreign exchange impact, international revenue grew a whopping 26%. And in third quarter 2015, the Brazilian currency alone depreciated 21% during the quarter.

For the full year, Discovery had very strong results and exceeded my expectation both in U.S. and International markets on a constant currency basis. Unfortunately, this otherwise phenomenal performance was tainted by horrific foreign exchange impact – negative 8% on revenue and negative 17% on adjusted EPS. Even with the foreign exchange impact on cash flow, Discovery bought back a ton of shares in 2015.

In 2016, the focus was less on foreign exchange, and it seemed like Discovery’s moat continued to widen. It signed a new long-term comprehensive affiliate deal with Liberty Global. The new multi-year deal will deliver Discovery’s full portfolio of networks to Liberty Global subscribers in 12 European countries and includes new linear distribution for some of Discovery’s key brands. It also includes broad digital distribution on Liberty Global’s horizon platform that will guarantee access to any platform. Discovery announced that it would be making a $100 million investment to change its content and IP mix and help Discovery to grow into a leader in short form and mobile content for the next decade.

Discovery completed a successful renegotiation with AT&T Direct TV with very favorable terms, including the inclusion of all Discovery’s channels on the Direct TV Now skinny bundle. In the U.S., Discovery launched the U.S. direct-to-consumer OTT app GO on Aug. 9 and the early results were promising. Again, Discovery repurchased a significant amount of its own shares during the year.

In 2017 Discovery announced a transformative deal to acquire Scripps Networks (NASDAQ:SNI), which made perfect sense and would make Discovery a much stronger content provider, at least so I thought.

Unfortunately, at the same time, Discovery announced the temporary suspension of the share repurchase program to maintain its credit rating. Later in the year, Discovery also surprised investors with accelerated subscriber losses. As a result, Discovery’s shares went into free fall from the mid-$20s to just over $15 a share. It was fascinating.

If I have to come up with one explanation for why Discovery has been such a bad performer despite the fact that it has made tremendous progress in both its U.S. and international businesses, it was that, like other media companies including Disney (NYSE:DIS), Fox (NASDAQ:FOXA), Viacom (NASDAQ:VIAB) and of course Discovery Communication (NASDAQ:DISCA), Discovery’s battling a tectonic shift. This has created significant and brutal headwinds for almost all media companies. Because most media companies' affiliate fees contracts are locked in for a few years, the impact won’t be obvious in the short term financially, but the U.S linear TV dual-revenue model, which has been so great for the media companies, may be broken in the near future.

There may be an inflection point at which the loss of subscribers becomes so severe that the media companies may lose not only their pricing power but also a significant chunk of their advertising revenue. The big wave is against Discovery Communication, not with it.

What happens with Discovery Communications next? I don’t know. But I completely agree with what John Malone said in a recently CNBC interview. Below are the transcripts provided by CNBC of the parts where they discussed Discovery Communications.

DAVID FABER: So what do you do-- I mean, let's bring it back to a company that you own a significant economic stake in and a larger control stake, Discovery. What do you do if you're Discovery? You do the Scripps deal.

DAVID FABER: you expand domestically, but are you still at that scale disadvantage, or not 'cause you're global?

JOHN MALONE: Well, yes. I think Discovery-- did two things that most other guys in the space didn't do. First of all, they went global, big time. More than half their revenue is offshore. And they're in, I don't know, 1.2 billion households watching their stuff. They have good brand recognition globally. Number two, they're not really in the middle of what I would call the scripted programming food fight, right? Where-- the costs are going through the roof-- where the number of scripted television shows, movies is going through the roof. It's very tough in that space to be financially successful, and particularly up against the guys who are now becoming so large. Discovery's more over here in the non-scripted programming, reality programming, documentary programming-- personality driven. And so David is not seeing his production cost, you know, going through the roof, A. And B, he owns all of his content. He doesn't just license it, he actually creates it, produces it and owns it, all rights in all markets.

DAVID FABER: And it's portable across borders, as he would say, many times.

JOHN MALONE: Correct. So if you look at Scripps-- first of all, big synergy. Second of all-- relatively cheap. Free cash flow engine. You know, if you buy-- post synergies, if you buy-- something that's generating a 12% cash return and you buy it with 3.5% money, right, it's-- it creates a lot of free cash flow, David, you know? And it gives you market power in the U.S., okay, with advertisers 'cause you now have a bigger percentage of the audience. Now, you have this attrition going on as the big bundle-- as people are "Cord cutting." But what they're really doing is going from the big bundle to buying connectivity services and going out and figuring out where else to get their content, right? And so, you know, as that process continues, Discovery needs to make sure they're in every small bundle. They have to make sure that they're in a position to transition to direct consumer platforms. Either their own-- which they would be the core of, or somebody else's. And that process is underway.

DAVID FABER: Is ongoing.

JOHN MALONE: It's an ongoing process. It's underway. And-- o, you know, I would look at the positive of Discovery is in their great position to go direct consumer on a global basis. Outside the U.S., they're in very good shape because you don't have this big bundle coming apart phenomenon, you know? Video in Europe is cheap, much cheaper than it is here. So you don't have that sports pricing pressure in Europe. And where-- even in the U.K., where sports is expensive, it's an a la carte service. It's not bundled in with basics. So you don't have people saying, "Oh, this is getting too expensive." If you don't want the sports, you don't buy the sports.

DAVID FABER: But John, the market has hated this deal. And the stock has just been getting crushed.

JOHN MALONE: David-- most of the money I've made in my life has been when other people don't like what's going on. When things are cheap, that's opportunity. Let me explain a little of short term market phenomenon. First of all-- in this world-- "What have you done for me lately," right? So when you get a whole bunch of investors where are dependent upon the company doing periodic buybacks in large volume and that becomes sort of an addiction and the investor, the guy, the young man who's makin' that decision turns to his boss and says, "We got no downside risk. The company's got a lot of free cash flow and they're soakin' up the stock, so how bad can it get," right?

DAVID FABER: Well, it can get bad 'cause you're not reinvesting in your business and you're buying your stock at highs that you shouldn't be.

JOHN MALONE: That's the long term view. I'm talking about short term mentality, right? So when a company like Discovery that's been on the track of massive stock buybacks with its free cash flow goes out and buys Scripps and part of the deal is we're gonna have to suspend the buybacks for a period of time because we want to borrow the money, it's a 70% debt deal, right, we wanna be able to borrow the money at investment grade rates, (which were very attractive. Sub 4%, long money. If we're gonna do that, and that's important, right-- we don't wanna junk the company. In other words, we don't wanna pay a lot more money for interest going forward. So we stay investment grade. The quid pro quo with the rating agencies is, okay, until your debt ratio drops below 3.5 let's say, you agree that you won't do any more buybacks, right? So all of a sudden, you got the investment community saying, "Oh my God, they're not gonna do any buybacks." Okay. So people who feel like they don't have that support, right--

DAVID FABER: So you don't think it's a function of investors in-- to our conversation about scale, feeling like Scripps simply does not answer that question.

JOHN MALONE: No, no.

DAVID FABER: Scale domestically, and they won't be able to do a direct to consumer offering that really is robust enough?

JOHN MALONE: It depends on how you phrase the question. It gives 'em a great domestic scale, okay? In the historic space, right? It gives 'em personalities, it gives 'em throwaway in the advertising community. It actually gives 'em leverage with their existing historic distributors, right? 'Cause now - well, you got 20% of your viewing audience is watching this stuff, and this stuff is cheap in terms of affiliate fee per eyeball. You know, those are all positive things. And Scripps is one of the cheaper historic services, affiliate fees. You got huge synergies in puttin'gthese companies together. So you're buying something that already has a lot of free cash flow, okay? The synergies are gonna add a lot more free cash flow. If Trump's tax thing gets through, all of a sudden the tax goes down.

DAVID FABER: Right, we'll talk about that.

JOHN MALONE: This thing becomes, on a run rate basis, a cash flow monster. A huge, free cash flow. So they would be able to get back to investment grade leverage quickly, okay? Some people are skeptical.

DAVID FABER: Some are skeptical.

JOHN MALONE: Okay? Now, you also look at it and say, outside the U.S., they grew almost 10% EBITDA this year. I don't see anything negative going on outside the U.S. Inside the U.S., I think they grew 5% this year. Better than any of their peers, right? So I look at it, you know, and to me, it looks cheap.

DAVID FABER: You wouldn't be buying more?

JOHN MALONE: Well, I would possibly buy more.

DAVID FABER: You would?

JOHN MALONE: Okay. Yeah. Now, keep in mind, when you're an insider, you have all these rules and windows.

DAVID FABER: Understood, but you seem to certainly be articulating a point of view that says, "This is a time."

JOHN MALONE: For me, I'm always a long term guy. And I'm gonna bet that Discovery, with its ownership and control of its content, right, will be able to transition to direct consumer platforms in a reasonably efficient way, okay? And if they successfully do that, then they are dirt cheap right now. If--they can partly get there, they're still cheap. So-- and I-- you know, you know David quite well.

DAVID FABER: Yes.

JOHN MALONE: I have a lot of confidence in David and his team. And I think that they will figure this out. And I think Scripps is an important piece of that 'cause I don't think the scale throwaway of Discovery's content alone was sufficient. I think with Scripps, they're much closer to being the gravitational center of the non sports, independent content guys. And so, you know, I think they got a good shot. There is no guarantees in that.

Disclosure: Long DISCK.

About the author:

Grahamites
A global value investor constantly seeking to acquire worldly wisdom. My investment philosophy has been inspired by Warren Buffett, Charlie Munger, Howard Marks, Chuck Akre, Li Lu, Zhang Lei and Peter Lynch.

Rating: 5.0/5 (9 votes)

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Comments

fung9815
Fung9815 - 7 months ago    Report SPAM

It's too soon to call it "humbling". You may be early but you are not wrong. Warren bought Washington Post in 1973 and "humbly" lost 20% on paper in the beginning. It took 3 years for Mr. Market to start recognizing the true value of the Post, and the rest is history.

Anyway, thank you for the article, and more importantly, the idea.

Thomas Macpherson
Thomas Macpherson premium member - 7 months ago

Some of my worst mistakes are when I've gone all in and never looked back. Or put in the timeless worldly wisdom of Admiral Jackie Fisher, when I went "totus porcus". But it's important to remember that Sophocles said, "All men make mistakes, but a good man yields when he knows his course is wrong and repairs the evil. The only sin is pride." In this article you sound a lot more like Sophocles and a helluva lot less like a ripened swine. That's a good thing. Well done my friend. Best - Tom

The Science of Hitting
The Science of Hitting - 7 months ago    Report SPAM

Great article Grahamites. You offer a detailed thesis and a sober update (all sounds accurate to me). If you don't mind sharing, what does this mean for the position in your portfolio? It sounds like you're somewhere between hanging on and selling. Maybe worth another article!

vgm
Vgm - 7 months ago    Report SPAM

Great article, Grahamites. Thanks for sharing your thinking and thesis.

I'd make 2 comments:

First, I don't think the game is over by any means. John Malone's comments are worth their weight in gold in media. He was very clear. You are likely 'just early', a common and frustrating experience for even the best value investors. Malone's observations on the short-termism of the market, compared with his own (money-making) long term view, are crucial.

Second, your article demonstrated you have good and rigorous "process". As Michael Mauboussin often points out, good process doesn't guarantee good outcome, but it's critical to develop it and stick to it.

Thanks for the stimulation.

stephenbaker
Stephenbaker - 7 months ago    Report SPAM

A couple comments from a non-follower of the media space (so take this with a grain of salt): Ever since the AOL/TWX merger, my impression is that media companies have been behind the proverbial 8-ball. It appears to take something really special to move the needle. Discovery offers some nice content (mostly for older folks?) but is there anything really exciting about the company or its offerings? There is really no unique brand here (unlike DIS, for example, which has a long history, name recognition and a variety of profit centers worldwide). Besides, who watches anything for more than a few instants these days? On top of that, the stock does not pay a dividend. Having said all that, at its current price, the stock looks pretty darn appealing.

vgm
Vgm - 7 months ago    Report SPAM

Grahamites - it's not mentioned in your article, and you may have seen it, but John Malone did buy more Discovery shares mid-December, about a month after the interview you quoted from:

https://www.cnbc.com/2017/12/17/liberty-medias-john-malone-puts-his-money-where-his-mouth-is-stockpiles-more-discovery-stock.html

Grahamites
Grahamites premium member - 7 months ago

Fung9815 - Thanks for the encouragement. It might be too soon to call it permanent impairment but it's definitely taking a lot longer than I thought if it's gonna work out eventually. And considering it was not an immaterial position in my portfolio for the past 3 years, the opportunity cost is significant. Good lesson:)

Grahamites
Grahamites premium member - 7 months ago

Tom - You are being too nice my friend:) I've made so many mistakes that the only way I can keep track of them is to write down what I thought when the decision was made. Wholly agree with Sophocles and I still have a lot of sin that I need to get rid of. It's interesting that the more we experience in investing, the less arrogant we become and less pride we have. Thanks for your great comments.

Grahamites
Grahamites premium member - 7 months ago

Science - I'm hanging on to my position at this point and will constantly re-evaluate the position. I think the international part is still a great business and Discovery owns all the content and is the low cost producer in the space. And the content is still universally accepted. There's some downside protection as it's a great acquisition target. But given that all of the above being true for many years and a lot is changing in the media space, I'm not sure whether at this price it's a fat pitch. At $15, it sure was screamingly cheap.

Grahamites
Grahamites premium member - 7 months ago

Vgm - First of all, thanks for the nice words and encouragement. I did see that John Malone bought more Discovery after he said it was cheap. I agree it was dirt cheap when it fell to almost $15 a share. When I first bought Discovery at ~$30, I thought the downside risk was more like $20-23 a share. The market has definitely proved that I was wrong on the downside. I also thought by this point, Discovery's shares should be at high $40 low $50. Maybe I was early but I'm always keenly aware of Howard Mark's reminder - sometimes being too early is indistinguishable from being wrong. I was definitely wrong in the downside assessment and i was definitely wrong in my assessment of how long it would take for the investment to work out. I hope Discovery will work out fine but the biggest lesson here is probably when you have an industry headwind, it might be better to go with the disrupters at a fair price (Google, Facebook, Netflix in this case) than to go with an incumbent at a wonderful price.

Grahamites
Grahamites premium member - 7 months ago

Stephenbaker - Thanks for commenting. I agree that Discovery's content is not must-have for most people, unlike Disney or Fox. They play in niche markets. I hope with Eurosports, their content will be must-have in Europe. And with the SNI acquisition, they sure gained more leverage in the U.S in terms of affiliate fees and advertising fees. But you are definitely right that the brand is not as strong as Disney. I'm ok with Discovery not paying dividend. They shouldn't in my opinion. Buying back shares, acquisition and investing in their own content are better use of capitals for them.

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