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Morningstar | Discovery Starts 2019 With Stronger 1Q Than Expected; Smaller Nets Continue to Lose Subs

Discovery reported a better-than-expected start to 2019 as first-quarter revenue was in line with consensus expectations and EBITDA beat the Street projections. As previously projected by management, ad sales outside the United States fell 6% year over year on a pro forma basis due to a tough comparison versus the Olympics in Europe last year and a pullback in spending in certain markets like Mexico (reduced government ad expenditures). We are maintaining our narrow economic moat rating and $32 fair value estimate.

Overall revenue was up 17% year over year (down 5% on a pro forma basis due to the sale of the education business) to $2.7 billion. For the U.S. networks segment, revenue increased 49% (up 3% on a pro forma basis) to $1.8 billion, driven by growth in distribution and advertising. On a pro forma basis, distribution revenue was up 4% despite a 4% decline in subscribers as the firm continues to lose subscribers, mostly at its smaller networks. While affiliate fee rate growth offset the loss in subscribers again this quarter, the firm will need to continue to win and hold onto carriage at over-the-top pay-television distributors for its core networks to offset the decline of the smaller networks. The recent deal with YouTube TV was a great win for the firm but will mostly be offset by the loss of carriage at DirecTV Now. Pro forma advertising revenue in the U.S. grew 4% as better monetization of digital content and better pricing more than offset lower ratings and subscribers across the linear channels. Adjusted EBITDA margin for the segment on a pro forma basis improved to 61% from 54% as the firm lowered operating expenses by 12% due to merger synergies.

International revenue on a pro forma basis was down 7% year over year as continued affiliate fee expansion was more than offset by the expected lower advertising revenue and the lack of Olympics sublicensing revenue versus a year ago. Distribution revenue expanded by 1% on a pro forma basis as growth in Europe and Latin America continued to offset the rate declines in Asia. Management continues to point to the PGA deal as the big potential driver of growth in Asia, particularly in Japan and South Korea. Adjusted EBITDA margin for the firm on a pro forma basis improved to 43% from 33% as the firm continues to reap the cost-reduction benefits from the merger.

Discovery has now met its target of lowering leverage to below 3.5 times debt/adjusted EBITDA from over 4.7 times after the Scripps acquisition. With the leverage ratio now within the target range of 3.0-3.5 times, management updated its capital-allocation strategy by announcing a $1 billion stock-repurchase authorization. The company also reaffirmed its three priorities of reinvesting in the business, strategic M&A, and share buybacks. As we discussed last quarter, we expect the firm to continue to reinvest in the business and we do not see any natural large-scale M&A targets for Discovery in the U.S. in the near term. We expect that Discovery will probably focus on smaller acquisitions in the near future, focused on firms with international exposure and digital distribution technology.