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Morningstar | DISCK Updated Forecasts and Estimates from 12 Oct 2018

Discovery reported a mixed second quarter as revenue and EBITDA came in line with consensus expectations, but adjusted EPS fell below Street projections due to higher-than-expected D&A and net interest expense. Management remains focused on integrating the Scripps acquisition which closed in the first quarter. We are maintaining our narrow economic moat rating and our fair value estimate of $31. Currently trading in 4-star territory, the stock may offer an attractive entry point to those with a longer-term investment horizon and higher risk tolerance.

Overall revenue was up 63% year over year (5% organically and 1% on a pro forma basis) to $2.845 billion. For the U.S. segment, revenue increased 100% (down 1% organically and up 1% on a pro forma basis) to $823 million, driven by growth in both distribution and advertising.  On a pro forma basis, distribution revenue improved by 1% despite a 5% decline in subs. The core networks were only down 3% as the smaller networks continue to suffer from cord-shaving. We continue to believe that the Scripps portfolio has a similar issue to the Discovery channels in that the three large networks (HGTV, Food Network, and Travel Channel) have better success at remaining or gaining carriage in the base packages at traditional and OTT  pay TV  distributors than the more niche channels. Pro forma advertising revenue in the U.S. grew by 1% as better monetization of digital content and slightly better pricing more than offset lower delivery across all of the traditional linear channels. U.S. adjusted EBITDA margin on a pro forma basis fell to 55.2% from 63.7 % a year ago as higher content and marketing costs were partially offset by revenue gains and cost-control improvements.

International revenue on a pro forma basis improved 5% year over year on continued affiliate fee expansion and advertising growth. Distribution revenue expanded by 7% as Europe saw double-digit growth driven by the digital revenue from Eurosport Player. However, Asia continues to suffer from rate declines as the firm’s offerings for the region lack sports content. Despite the revenue growth, adjusted EBITDA margin for the segment improved by 290 basis points to 32.0% as the increased sports rights costs were outweighed by the revenue growth.

Management demonstrated increased confidence in its ability to gain carriage for its networks on the OTT pay TV platforms. Two reasons behind the raised conviction are the improved rating for its main networks and the relative low cost of its channels. Another potential reason is the recent launch of the AT&T Watch skinny bundle that includes eight of Discovery’s channels. While we acknowledge both outcomes as positives for Discovery and its channel offerings, we remain cautious on the ability of the firm’s networks to gain carriage on more of the new OTT players. Of the top four platforms, Discovery’s original core channels are only available on DirecTV Now. We also believe that the AT&T bundle may not be sustainable if the majority of customers are receiving access for free. We are skeptical that the $15 bundle will attract a large number of subscribers given the large number of high-demand networks not in the bundle and the relative small price gap to the $40 bundles that include many more networks.