Discovery (DISCA) has not done much since I covered it earlier this year. The stock is up circa 20% in that time, though it has badly lagged the wider market. I have the S&P 500 gaining around 55% since that piece was published back in March. On the plus side, the company has largely proved the defensive business I thought it would. The market still hates it, but deep value plays are totally unloved right now anyway. Better to write about Tesla stock, maybe.
In all seriousness, I will persevere with the money-spinning dogs like Discovery. After all, the owner of cable-TV channels such as the Food Network, Discovery Channel and TLC has still made plenty of cash this year. That is because a big chunk of its sales come from the affiliate fees that pay-TV providers pay in order to carry its channels. So, while the business of selling ad-slots may have struggled for obvious reasons, the company has largely done okay.
To put some numbers on things let’s take a look at recent financial results. The company generated revenue of $2.54B over its 2Q20, an 11% drop after taking into account foreign currency movements. This was largely a result of a collapse in advertising revenue, particularly in its international operations. Advertising sales outside of the United States collapsed by almost 40% in the second quarter compared to the same point last year. In contrast, domestic non-advertising revenue actually rose by around $50M year-on-year.
Even in a choppy advertising market the company has made a bunch of money this year. Adjusted profit for the first half of FY20 stands at around the $1.65 per share mark. Discovery generated $1.1B worth of free cash flow over the same timeframe, a 1% increase on the year-ago period. Throwing off ample cash is what this company does. I have cumulative free cash flow generation at $4.2B over the last six quarters.
The firm’s cash generating ability is central to my optimism here. That is because organic growth is not easy to come by in this industry. The old pay-TV model is supposedly a dead man walking, so buying the owner of a bunch of pay-TV channels in the expectation of meaningful growth is probably not the smartest idea in the world, right? If Discovery stock wasn’t so cheap I’d be inclined to say yes. As it happens, it occupies a sweet spot whereby it can provide ample returns by throwing cash at shareholders. The company does not like paying dividends, probably for tax reasons, so this typically takes the form of stock buybacks. Share repurchases took a pause in the first quarter due to COVID-19, though they should resume this quarter.
The upshot of the above is that most cash flow ended up reducing the debt load last quarter. That is no bad thing, as the firm ended the second quarter with $13.6B worth of debt net of cash. The bloated balance sheet is largely a result of its acquisition of Scripps Networks Interactive back in FY18. Discovery ended that year with a net debt load of $15.8B.
The stock closed the week at just under the $22.90 mark. Here’s the thing: this is a business that throws off circa $3B in annual free cash flow, or $4.45 per share on a fully diluted basis. That figure includes a small fortune paid out to service its debt too, with the company spending $680M on interest last year. This is not really a big deal; on the contrary, it represents an easy profit source as net debt is continually reduced.
Now, the vast majority of its outstanding $15.3B in gross debt is not due until FY24 onward. I think we are talking around $10B, by which point the underlying business will have generated more than that by way of cumulative surplus cash. Anyway, let’s go with a complete debt reduction strategy. This is low-returning and not really realistic but bear with me.
On the basis of the above, it seems entirely possible that Discovery could eliminate its net debt position within four years. Its current enterprise value – the sum of its market-cap and net debt – stands at around $29B. That figure is equivalent to around 9.5x its annual free cash flow generation. If Discovery were to eliminate its net debt while retaining a 9.5% free cash flow yield, its share price would need to rise to $43. That is how cheap the stock is right now. I remain optimistic that the shares will provide a good return over the next few years.
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