A Mixed Signal From Discovery Communications

By Ryan C. Fuhrmann | August 02, 2012 AAA

Media firm Discovery Communications (Nasdaq:DISCA) owns an impressive array of growing cable television channels. This includes the underlying content and programming control. To date, the firm has a great reputation for developing unique and popular content. Overall, Discovery is impressively profitable and there is room for further growth through international expansion and a partnership with a media mogul on one of its newest channels. At the current valuation, a number of larger rivals appear to be more appealing investment candidates, but Discovery and another archrival do offer opportunities for above-average industry growth.

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Recent Results and Outlook
Discovery's second quarter revenues advanced 7% to $1.1 billion. Its U.S.-based networks grew 6% and account for the bulk of sales at 63% and include cable channels such as the namesake Discovery Channel, TLC, Animal Planet, Hub (which is a collaboration with toy firm Hasbro (Nasdaq:HAS)), and OWN: Oprah Winfrey Network, which is a 50/50 partnership with media mogul Oprah Winfrey. Many of these channels are also available internationally through at least 150 network feeds via operational centers such as London, Singapore and Miami, the last of which serves the Latin American market. International sales advanced 10%.

Profits advanced a much healthier 15% to $293 million and represented an extremely healthy net profit margin of close to 26% of sales. The strong top line trends flowed through to the bottom line but Discovery also benefited from a lower reported tax rate, which it explained was due to a reorganization of one of its media assets.

Analysts currently project a similar level of sales growth of 8.5% for the full year to $4.6 billion and profits of $2.75 per share that would represent a slight decline from the $2.80 reported during all of 2011. This worked out to $1.1 billion last year and is right around the $1 billion that Discovery reported in free cash flow.

SEE: Finding Hidden Stock Gems That Analysts Ignore

The Bottom Line
Last year, Discovery logged sales of $4.2 billion and profits of around a billion, meaning that nearly a quarter of sales flow in as excess capital that management can use to buy back shares. Last year it did just that and bought back $1 billion in stock. For the most recent quarter, it bought back $404 million in stock and ended with $1.7 billion in cash on the balance sheet, although debt is currently quite high at $5.2 billion. Borrowings are spread out over many years at relatively favorable interest rates, while net debt is more reasonable at $3.5 billion.

Discovery's business model is lucrative and growing. There is plenty of further growth potential from international expansion and the Oprah Winfrey Network living up to its potential. For the time being, OWN has been a disappointment as viewership is lagging and there are a number of content issues to work out.

The only real drawback to the investment story is the valuation. Discovery currently trades for more than 18 times forward earnings expectations. And given free cash flow is similar to annual net income levels, this is a reasonable proxy for the free cash flow multiple. Rivals including Time Warner (NYSE:TWX) and Viacom (Nasdaq:VIA) (NYSE:VIA.B) trade at more appealing earnings multiples in the low double-digits. They aren't growing as briskly, but have broader entertainment revenues that also have long-term track records of stability and profitability.

Discovery, along with AMC Networks (Nasdaq:AMCX), are two of the fastest growing cable channel operators out there these days, but need to keep growing earnings in the double digits for at least several more years to justify their more lofty valuation levels.

SEE: Reading The Balance Sheet

At the time of writing, Ryan C. Fuhrmann did not own shares in any company mentioned in this article.

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