Oprah Winfrey Network Buoys Discovery Communications

By Will Ashworth | December 22, 2011 AAA

Leapfrog Enterprises (NYSE:LF) announced on December 14 that it is partnering with Discovery Communications' (Nasdaq:DISCA) education division to produce digital content for the tremendously successful LeapPad Explorer tablet computer for children four through nine. The learning apps created by the partnership will retail for between $5-$10 and are available at the LeapFrog App Center. Retailers can't keep the tablets in stock this Christmas so it's a winning arrangement for both companies and just one of the many reasons to own Discovery's stock. (For related reading, see 5 Most Profitable Toys Of Past Christmases.)

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Oprah Winfrey Network
When you're a billionaire like Oprah Winfrey it's inevitable that you're going to have your detractors. It's no surprise then that the mediocre results achieved by Oprah's network (OWN, which is 50% owned by Discovery) in its first 11 months have brought a heap of criticism. While the network averages just 136,000 viewers, an 8% decrease in viewership from predecessor Discovery Health, Discovery's management don't appear concerned about the slow start and they shouldn't be. Oprah should have been the CEO from the start. How can anyone but Oprah run a network with her name on the door? That would have been like Merv Griffin or Dick Clark leaving the details to someone else.

The Hollywood Reporter makes a big deal of its poor start suggesting Discovery is going to pull the plug on its $254 million investment as of the end of September, an amount much higher than its original commitment of $189 million. That argument simply doesn't fly. Ted Turner took five years to turn a profit at CNN, now owned by Time Warner (NYSE:TWX); Oprah's network is just completing its first year in operation and just the fifth month with Oprah at the helm. In four years, I'm confident Discovery will have gotten its investment back and then some. In the meantime, it's accruing 7% interest on its money until every dollar is repaid.

Some have suggested that Oprah pick up half any new capital required to fund the network's future development. It's a nice thought but she didn't become a billionaire for nothing. Discovery understands the situation and will continue to remain patient. Oprah's own weekly prime-time interview show begins January 1 and that should get a few more viewers tuning in. She knows better than most it is all about entertaining the audience.

Profitability
Discovery expects revenues in 2011 of $4.2 billion and net income of $1 billion with revenues and net income increasing 10.5% and 53.3% year-over-year respectively. In the first nine months of the year, free cash flow increased 72.6% to $718 million. With free cash flow approximately equal to net income, it will likely be about $1 billion for all of 2011, which translates into a free cash flow yield of 6.3%. That yield is about the same as Time Warner and considerably lower than Viacom (Nasdaq:VIA). However, over the long haul, the gap between Discovery and Viacom may be shrinking. In the past three years, Discovery's grown free cash flow from $467 million in 2008 to over $1 billion in 2011. Once the Oprah Winfrey Network gains traction and cable companies actually start paying carrier fees, that number will accelerate pretty quickly. (To learn more, read Free Cash Flow: Free, But Not Always Easy.)

Diversification
Discovery's strength is its combination of fully distributed channels like Discovery, TLC and Animal Planet combined with emerging channels like OWN and the Hub, a 50/50 joint venture with Hasbro (Nasdaq:HAS), catering to children ages 2-11. Internationally, the third quarter saw its subscriber base increase by 10%, resulting in double-digit affiliate revenue growth combined with increased viewership and advertising growth. TLC International surpassed its 2011 goal of being in 100 million homes. The company has a great blend of American and international revenue providing multiple streams of income including advertising, distribution and merchandising. The more networks it's able to develop over time that can generate all three types of revenue, the more profitable it will be. It's going to take time but the payoff is tremendous.

The Bottom Line
A $10,000 investment in Discovery in 2005 is worth $25,000 today. I imagine if you roll over the $25,000, it will easily be worth $62,500 in another six years.

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At the time of writing, Will Ashworth did not own shares in any of the companies mentioned in this article.

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