This Undervalued Entertainment Stock Might Not Be the Best Discovery Right Now

We believe that Discovery Communications' broad content appeal, international presence, and near-100% content ownership represent strong competitive advantages for the firm. Last month Discovery reported better-than-expected third-quarter adjusted bottom-line results, but there were several puts and takes within the three-month reporting period, and management lowered guidance for 2014. The stock has moved into four-star territory, but we would wait for a greater margin of safety before investing.

On the domestic side, revenue declined 1.2% to $724 million, as the 3.3% drop in distribution revenue more than offset advertising growth of 1.3%. Management attributed the decrease in distribution to lower digital distribution revenue and the release timing of library content. We're not terribly concerned about this, since digital distribution revenue is booked when the content is delivered and available to customers, leading to quarterly fluctuations based on the timing and volume of content delivery--but it is something that we'll keep an eye on. Advertising growth benefited from the improved pricing environment and higher volumes despite a tough year-over-year comp. Despite the decrease in revenue, U.S. adjusted EBITDA margin improved to 59% from 58% a year ago as operating expense fell amid slightly lower marketing costs.

Excluding the impact of foreign exchange and the Eurosport acquisition, international revenue increased 10% year over year on 14% advertising growth and 8% affiliate fee growth. The company reported that advertising growth was driven by increased volume in Western Europe and higher pricing in Latin America and Nordics, which we view as a good sign.

The Value of Versatile, Universal Content
Discovery owns unique content with a strong universal appeal that transcends cultures and languages. These qualities allow the company to move the content across multiple media platforms and international borders. Discovery, the Learning Channel (TLC), and Animal Planet are the three key domestic cable networks, which should generate decent growth in the mature U.S. market. Hits on the flagship Discovery Channel include "Deadliest Catch," "Shark Week," and "Mythbusters," and the company is constantly tweaking its lineup, adding fresh programming on an annual basis.

The firm owns other cable networks to complement its flagship offering. The Learning Channel and Animal Planet have also carved a niche on basic cable, which gives Discovery three networks that are distributed to about 100 million U.S. cable households. These networks benefit from a dual revenue stream of affiliate fees and advertising dollars. The content shown on domestic networks has strong universal appeal that translates well across cultures and languages. Discovery Channel is the most widely distributed brand in the world, reaching over 200 countries. The company is able to re-edit and update its programming to provide topical versions that can be utilized across international borders.

We believe Discovery is in a solid position to benefit from the growth of pay-TV during the next decade. Discovery wisely established distribution (and at great cost) as pay-TV was in its infancy in overseas markets two decades ago. Each country has a unique market with different regulation, but pay-TV distribution tends to be much more concentrated in foreign countries relative to the U.S. This concentration has made it difficult for Discovery to garner pricing increases for its channels. This concentration also creates a barrier to entry, as it is difficult for cable network peers to establish new channels.

In addition, we expect Discovery to benefit from the emergence of nontraditional content distribution. Companies like Netflix and Amazon are looking to establish business models that offer streaming video on demand, or SVOD, services outside of the current pay-TV ecosystem. Discovery owns the vast majority of its content, so it will benefit from licensing content to these companies.

We believe Discovery's recent acquisitions of ProSieben's SBS Nordic assets and a growing stake in TF1's Eurosport make strategic sense for Discovery given its already-strong presence in Western Europe. Discovery's near-term capital allocation moves are likely to be limited to eventually buying in the full amount of Eurosport and repurchasing shares.

Our Fair Value Estimate Is $38 per Share
Our fair value estimate of $38 per share reflects the two-for-one stock split completed in summer 2014. At this price, Discovery shares would trade at approximately 19 times our 2014 EPS estimate. We expect overall annual revenue growth to average 9% during the next five years, once normalized for the acquisitions of SBS Nordic and Eurosport. The main downside risk to our forecast would be if television advertising weakens materially at any time over our forecast period. We think potential investors should consider the Class C shares (DISCK), which have historically traded at a discount to the A shares (DISCA) despite having the same economic interest.

We're forecasting average annual international sales growth of 14% over the next five years (9% organic annual clip) with the SBS Nordic and Eurosport acquisitions lifting the rate of growth. We project 5% average sales growth in the United States, as there are more growth opportunities outside this mature domestic market. We expect overall EBITDA margins (including stock compensation expense) to average about 42% during the next five years, slightly lower than the 45% average margins posted in the 2010-12 period. The acquisition of SBS Nordic reduces the overall margin profile of the company but will help profit expansion outside the United States.

Digital Rights and International Expansion Bolster Discovery's Wide Moat
We assign Discovery a wide economic moat. As a vertically integrated content company that owns domestic and international channels and much of the content on its channels, Discovery should be able to withstand most potential disruptions to its business models over the next 20 years. While there is plenty of debate regarding the long-term viability of the current pay-television ecosystem, we believe content and channel owners like Discovery are well equipped to adapt to potential changes.

Intangible assets are the most common source of moats for entertainment firms like Discovery. Most often video (television) content is a core asset of an entertainment firm, and in most countries this intellectual property is protected by copyright laws, allowing owners to license it at their discretion. In markets where copyright laws are not enforced, global firms usually choose to do minimal business. With advances in technology, content is distributed in multiple ways and content owners can choose to license programming to multiple distributors and countries.

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The fact that Discovery owns the digital rights to virtually 100% of the content shown on its channels gives the company an additional competitive advantage, as new distributors are willing to pay for dated programming. Monetizing current content and getting incremental cash flow from programming in the vault makes it harder for competitors to encroach on its niche.

Pay-television penetration is well below 50% in countries such as Brazil and Australia. Though pay-TV penetration in these countries will probably never approach the 85%-90% level of the United States, we think there is plenty of growth in foreign countries during the next decade. We think having six established channels in a large portion of foreign markets gives Discovery negotiating power with distributors across the globe.

A relevant example of the challenges in establishing an international cable channel presence these days can be seen through Scripps Networks, which has emerged has a strong player in the U.S. cable network market. Scripps has been limited to joint-venture arrangements in other countries, as it started looking for international channel expansion about 20 years after firms like Discovery established channels. Additionally, we think the recent entry of Netflix into some countries, especially in Latin America, will more clearly illustrate the competitive advantages held by entrenched players like Discovery. It owns the channels and the content, and we don't see why any content owner would allow Netflix or other streaming video on demand players to secure quality or current content (similar to Netflix's challenge in the U.S.).

Cost-Cutting and Growing Global Presence Benefit Shareholders
We think Discovery's stewardship of shareholder capital is standard. David Zaslav became president and CEO in 2007. He was hired away from his post as president of NBC Universal Cable by his longtime mentor, Discovery founder (and former chairman) John Hendricks. At Discovery's helm, Zaslav quickly established a reputation as a cost-cutting executive, one example being the shuttering of the firm's underperforming retail stores. Zaslav received about $8 million of compensation in 2008, a reasonable amount in our view, but over the past few years, his total compensation package has ballooned to more than $50 million annually, which could be considered a bit aggressive. Most of Zaslav's minimal share ownership has come through stock option grants.

The board of directors is elected on a staggered basis, and multiple share classes give media magnate John Malone almost 23% of the combined voting power. Malone has a strong track record with media companies and content distribution, so we view his influence as a net positive. Advance/Newhouse controls 26% of the combined voting power. The board consists of 11 directors, seven of whom are considered independent. Since its split from DHC and Advance/Newhouse, we think management has served shareholders well by cutting redundant costs and continuing to push its programming into international markets.