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Morningstar | Discovery Reports Mixed 4Q; 1Q International Ad Revenue Expected to Be Down High Single Digits

Discovery posted a mixed end to a busy 2018, as fourth-quarter revenue came in slightly below consensus expectations. While the firm reported flat year-over-year international advertising revenue, management warned that ad sales outside the U.S. are trending down high single digits thus far in 2019 due to a tough comp versus the Olympics in Europe last year and a pullback in spending in certain markets like the U.K. (Brexit) and Mexico (reduced government ad expenditures). This weakness highlights one of the unique challenges investing in Discovery versus other media firms: Its relatively large international revenue share exposes the firm to a multitude of regulatory and political risks from a variety of countries. Despite the negative ad revenue news, we are maintaining our narrow economic moat rating and fair value estimate of $31, as we expect that the weakness will be short term and that growth in other markets will offset the losses.

Overall revenue was up 51% year over year (down 1% on a pro forma basis due to the sale of the education business) to $2.8 billion. For the U.S. networks segment, revenue increased 93% (up 2% on a pro forma basis) to $964 million, driven by growth in both distribution and advertising. On a pro forma basis, distribution revenue was up 1% despite a 4% decline in subs, as the firm continues to lose subscribers, mostly at its smaller networks. While affiliate fee rate growth offset the loss in subs again, the firm will need to continue to win carriage on over-the-top pay-TV distributors for its core networks to offset the decline of the smaller networks. Pro forma advertising revenue in the U.S. grew by 3% as better monetization of digital content and better pricing more than offset lower ratings across the linear channels. Adjusted EBITDA margin for the segment on a pro forma basis improved to 56% from 49% as the firm lowered operating expenses by 4% due to merger synergies and higher content impairment in the same period a year ago.

International revenue, on a pro forma basis, was flat year over year, as continued affiliate fee expansion was offset by lower licensing revenue. Distribution revenue expanded by 2% on a pro forma basis as Europe continued to grow due to digital revenue from Eurosport Player. However, rate declines continued in Asia, as the firm’s offerings for the region lack sports content with local appeal. Management believes the deal with the PGA will help drive growth in Asia, particularly within Japan and South Korea. Adjusted EBITDA margin for the firm improved by over 600 basis points to 42%, as the firm benefited from the merger-related cost reductions.

The firm remains ahead of its schedule for reducing its leverage from the Scripps deal and now expects to be under 3.5 times debt/EBITDA by the end of the first half of 2019. Management promised to update investors on its capital allocation plan in detail after leverage is within the target range of 3.0-3.5. However, the company reaffirmed its previous three priorities of reinvesting in the business, strategic M&A, and share buybacks. While we expect the firm to continue to reinvest in the business, we do not see any natural large-scale M&A targets for Discovery in the U.S. in the near term. We think that an acquisition or merger of equals is more likely. The recently rumored merger of CBS and Discovery made some sense, as the combined firm would have increased leverage with distributors and Discovery could help CBS expand internationally. However, the rumor has already been quashed by Discovery CEO David Zaslav. Additionally, we believe that it is unlikely that Sheri Redstone, the controlling shareholder at CBS, would contemplate a merger of CBS that would not include Viacom. As a result, we expect that Discovery will likely focus on smaller acquisitions in the near future, focused on firms with international exposure and digital distribution technology.