US stock investing: Why Discovery Inc shares are a good investment

Long term investors can buy the non-voting shares of Discovery Inc (Ticker: DISCK) with a 2-3 year perspective.US based Discovery is a global media company that owns popular networks like the Discovery Channel, Travel Channel, Animal Planet etc. It is one of the largest pay-TV companies in the world. While currently it derives almost entire revenue from television distribution/subscription and advertising, it announced the global launch of its streaming service ‘discovery+’ in Q4 2020.Since its launch in Q1 of 2021, it has seen nice traction of 15 million subscribers by mid-May.

While the company has had a consistent track record of progress in business performance and execution with 5-year revenue CAGR of 11 percent (upto Covid impacted CY2020) and EPS CAGR of 7 percent, the stock has given CAGR returns of only around 3 per cent in the last half a decade. This significant under-performance versus markets has been due to the ongoing structural shift in the media industry to the streaming business model. Hence, investor preference has shifted to companies such as Netflix since the early part of last decade, and in recent years to Disney, which has seen a rapid growth in streaming business.

Merger with Warner Media

For many years the successful mantra in the television industry used to be ‘content is king’. However, with the advent and development of streaming business model, the new mantra is ‘content+scale is king’.

The key to attract and retain huge volumes of subscribers is not just with high-quality content that will attract subscribers, but also an inexhaustible volume of content that would help to retain them. Structural shift to streaming has resulted in the industry witnessing previously unthinkable M&A such as the acquisition of 21st Century Fox (which also owned STAR India) by Disney in a $70 billion deal a couple of years back.

The need for consolidation was also driven by the fact that benefits of streaming business are more back end loaded; require higher investments in early years but is more profitable in long run as it benefits from economies of scale and better margins due to elimination of distribution fees paid to cable, and dth.

While a potential merger involving Discovery was viewed only as a matter of time, the company and telecom major AT&T surprised industry and market participants in May by announcing a merger of Discovery with the media conglomerate Warner Media (formerly The Time Warner Company, currently owned fully by AT&T) in a mega deal that values the combined company at an enterprise value of $130 billion and equity value of around $80 billion.

The deal is expected to be completed by middle of next year and the new company (NewCo) – Warner Bros Discovery, will have one of the deepest content libraries in the world. Their current annual content spend is $20 billion, exceeding Netflix’s current annual content spend guidance by around $3 billion. Shareholders of Discovery will own 29 per cent of the new company, while AT&T shareholders will own 71 per cent.

Buying rationale

The merger will position Warner Bros Discovery to be a very formidable player given its volume of content and also an excellent blend of unscripted programming (non fiction shows from Discovery) and scripted programming of Warner Media (like Warner Bros, HBO, TNT) .

Despite being a large merger, the integration risks are minimal considering the excellent track record of Discovery in past M&As. The successful large M&A of Disney and 21st Century Fox further indicate the challenges may not be signifcant. Also while AT&T shareholders will own 71 per cent of the NewCo, the fact that it will be headed by the current CEO of Discovery - David Zaslav, is a strong validation of the the past track record of management of Discovery and ability to successfully execute the merger.

Post merger the company is targeting adjusted EBITDA of around $14 billion in FY23. Given Discovery’s stake in the NewCo at 29 per cent, it is now trading at an EV/EBITDA (FY23) of around 7-8 times. Peers Netflix and Disney trade at approx. 19x and 22x FY23 EBITDA respectively.

While FY23 estimates are relatively more into the future than current year estimates, given the merger will result in significant synergy benefits of around $3 billion dollars (21 per cent of FY23 EBITDA) even on a conservative basis as per Discovery management, taking post merger estimate is a more appropriate way to value the company.

Since the higher multiples assigned to Netflix and Disney is mainly due to their success in streaming business, it is evident that currently markets are not giving much value to the streaming business prospects of Warner Bros Discovery. This is where the opportunity exists in Discovery as the NewCo with scale and content quality would be very well positioned to gain significant traction in the global streaming business.