Discovery: (Another) Deleveraging Play

by The Compound Investor

A large portion of recent articles have been devoted to what you could call ‘deleveraging plays’. By that I mean stocks which can probably generate solid shareholder returns simply by paying down debt. Some good examples include the likes of Anheuser-Busch InBev, Molson Coors, AT&T and Kraft Heinz. There is one more I’d like to add to that list: media stock Discovery (DISCA). This is the umbrella company responsible for well-known pay-TV assets like the Discovery Channel and TLC. Following its acquisition of Scripps Networks Interactive, we can add the likes of Travel Channel, HGTV and Food Network too.

Discovery has quite a lot in common with the other four stocks I just mentioned. Firstly, it owns very well-known brands that are dominant in the media content space. Only Disney, Fox and Comcast came out ahead of the combined Discovery/Scripps in terms of ratings share. More importantly, it is a bona fide profit machine. Even after eliminating the costs of producing programming, the business of selling channels to TV providers, plus advertising slots, is a cash spinner. I mean, Discovery converts somewhere in the region of 20% of its revenue into surplus cash each year.

Secondly, the stock looks very cheap. As it stands we are looking at an EV/EBITDA ratio of around 8 on a trailing-twelve-month basis. That is the kind of valuation that implies relatively little downside unless earnings fall off a cliff. And if analyst forecasts are anything to go on, that shouldn’t be a worry.

Interest Bill

On the downside, Discovery has previously struggled for organic growth. It also has a fair bit of debt sitting on its balance sheet. We are looking at roughly $17b worth of net debt versus annual profit of around $2b. Granted, that low-growth/high-debt combination can be worrisome, but at the same time it can throw up some good opportunities from reducing the interest bill. The most important thing is to have an underlying business that throws off plenty of excess cash. That isn’t an issue here given that company guidance points to $3b worth of free cash flow next year.

At the moment, the company is paying something like $750m per year in annual interest on its debt. That works out to around 95¢ per share, and quite a large figure when you consider estimates for 2019 earnings clock in around $3.50 per share. Imagine slashing that interest bill – with the difference then flowing straight to the pre-tax profit line.

The good news is that the path to achieving that is very straightforward because Discovery doesn’t pay a dividend. The only thing it has done in recent times is buy back its own stock and acquire other businesses. Further acquisitions aren’t likely to be on the table for a while for obvious reasons, which leaves just two outlets for Discovery’s surplus cash generation: net debt reduction and stock buybacks. Both will obviously act as a tailwind to EPS growth. Based on its current share price of $27.70, the stock sports a forward price-earnings ratio of just 8. If you don’t mind the lack of dividend income then it has got to be worth a closer look.

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