Discovery Has Widespread Appeal

Discovery, TLC, and Animal Planet are the three flagship networks for the company in the United States and around the world. Hit programs for the company include Deadliest Catch, Gold Rush, and Street Outlaws on Discovery Channel, along with Counting On and 90 Day Fiance on TLC.

Discovery’s three primary networks have wide distribution in the U.S. and worldwide, each channel reaching over 89 million U.S. cable households and more than 270 million international households. The firm operates eight other channels, including Investigation Discovery and Oprah Winfrey Network, with subscriber bases ranging from 47 million to 85 million households.

The company’s namesake channel is the one of the most widely distributed networks in the world, reaching more than 220 countries and 340 million subscribers. Given its reach, the company is able to repurpose its programming to provide localized versions, as over 50% of the content shown on the international networks is produced for the U.S. networks.

Discovery is leveraged to benefit from increased pay-TV penetration internationally, as it already generates 50% of its revenue and 45% of its EBITDA outside the U.S. The firm established distribution outside the U.S. over two decades ago and now operates in over 220 countries with a cumulative 3 billion-plus viewers. Most television distributors (cable, satellite, and so on) worldwide believe their channel offerings are deep enough and see no need to expand. A new channel could overcome this reluctance by paying for carriage, but the risk inherent in this tactic precludes small firms from employing it. On the other hand, since its networks are among the most widely watched and create a steady stream of affiliate fees and advertising dollars, Discovery can use its existing channels as leverage to gain distribution for new channels.

International Exposure Helps Moat We recently lowered our economic moat rating for Discovery to narrow from wide. Discovery is a vertically integrated content company that owns domestic and international channels and produces most of the nonfiction (or reality) programming that airs on its channels. Even as the media landscape continues to shift, we believe that Discovery's exposure to international markets and content ownership provide a base to help weather any disruptions in the short term. However, we are concerned about Discovery's leverage to negotiate rate increases as distribution platforms mutate. Despite the changes in consumption patterns, pay-TV penetration remains above 80% of households in the U.S. Even without a pay-TV subscription, most cord-cutters still consume video content. While over-the-top offerings such as Netflix NFLX and Amazon Prime AMZN have begun to create their own content, both services require deep libraries to gain and retain subscribers. Given the ongoing demand for content, we believe content creation for cable networks is not a zero-sum game, as high-quality content will always find an outlet. But we still believe that the demand for and shelf life of scripted content will continue to increase at the expense of nonfiction content.

Our framework for evaluating wide moats across our media coverage focuses on four areas: the value of known brands in a changing world, the ability to produce scripted content, limited exposure to U.S. advertising revenue, and increased exposure to international revenue. Via its strong international presence, Discovery passes the final two categories easily. It is deficient in the second category, as Discovery is largely focused on the creation of nonfiction content. Under the first piece of the framework, we believe the company’s main networks would safely be part of any bundle in the near future, despite the channels being highly leveraged to reality programming and its continued relevance. However, we don’t project that the company will have the leverage necessary to break a bundle, unlike some of its peers. While the loss of Discovery could harm the attractiveness of a bundle, we believe that other firms, such as Disney DIS, CBS CBS, Fox FOX, and Time Warner TWX, own channels or a bundle of channels that are more essential to a distributor. The combination of the lack of scripted content and the inability to break the bundle led us to downgrade our moat rating.

The company’s three main networks (Discovery, TLC, and Animal Planet) reach more than 89 million households subscribing to basic cable in the U.S. and more than 270 million viewing international subscribers. A new entrant will encounter two major hurdles to launching a new cable channel with widespread distribution in the U.S. or abroad. First, the cost to create new high-quality content is very high. Discovery spends more than $1.3 billion annually to create more than 2,500 hours of programming. Second, gaining distribution without paying for carriage in many markets for a new company may be nearly impossible, as cable operators have no need for new channels, which only add potential costs down the road. However, Discovery can leverage its existing channels such as Discovery or Animal Planet with carriage to force an operator in the U.S. or around the world to carry a new offering. The company can also rebrand its own channels to better capitalize on changing trends or new opportunities. Over the past six years, Discovery has rebranded seven of its channels, most famously turning Discovery Health into Oprah Winfrey Network.

Discovery’s content has demonstrated widespread appeal that translates across both borders and languages. The company capitalizes on this appeal by editing and updating its content to provide localized versions that can be distributed to its subscribers in more than 200 countries in 45 languages. More than 50% of the programming on the international networks is originally produced for U.S. networks, providing a significant source of margin leverage. Beyond using the content on its own channels worldwide, Discovery can license the same shows to providers of subscription video on demand globally, as the company owns the digital rights to the majority of its content. While the Discovery content does have value within the SVOD world, we still believe original scripted content will generate higher fees and have a longer shelf life.

Changing Consumer Tastes Are a Risk The new business models proliferating in the media sector could diminish Discovery's revenue growth or profitability. Viewership of its programs could fall below expectations, and advertisers could pull back on their spending, both of which could drag on advertising sales growth. Reality or nonfiction TV may fall out of favor completely, causing Discovery's growth to suffer. International tastes may change to no longer appreciate Discovery's American-produced content, forcing the company to source more programming locally and thus hurting margins.

The company’s financial health is adequate. Long-term debt increased to $14.7 billion in September 2017 as a result of the pending Scripps Networks SNI acquisition, and Discovery announced at the time that it was suspending the share-buyback program in favor of quickly decreasing leverage. However, should the acquisition not be approved, the company is more than capable of continuing to return capital to shareholders by restarting the buyback program, given the strength of its balance sheet and healthy cash flow generation.

While the Scripps acquisition would expand Discovery’s reach into a key demographic of upscale females ages 24-54, we believe that management has effectively doubled down on unscripted content during a period of uncertainty about the over-the-top future of the format. We would have preferred that the company search for ways to expand its content offering instead.