$DISCA Discovering a Merger Arbitrage

Since the COVID-19 pandemic began, we have shifted every aspect of our lives online. The movement to online/at-home streaming has been immense, and binge-watching has become commonplace. We have seen the continued rise of Netflix and Disney+, now amassing a combined 400mn in paying subscribers. The market has attributed higher multiples to both companies on the basis of this growth, and with the launch of Discovery+, I believe it is time Discovery Inc. (DISCA) caught up.

Discovery Inc. is a media and streaming company, providing content across various distribution platforms in 50 languages and 220 countries. It operates in two segments, U.S. Networks, and International Networks. The company owns and operates various television networks under the Discovery Channel, Animal Planet, Discovery Kids, the Oprah Winfrey Network, Eurosport, among many others.Its content spans every genre, and the company also operates production studios that develop and produce content. It provides content through various distribution platforms comprising pay-television, free-to-air and broadcast television, apps, content licensing agreements, and direct-to-consumer (D2C) subscriptions, on almost any platform (phone, console, etc).

As mentioned above, revenue is split between US and International Networks. 60% of the top line comes from the US, and 40% is from international networks. However, when taking these two regions as a whole, Discovery’s revenue split is roughly 50/50 between advertising and distribution. Advertising is its legacy business and forms a stable revenue source across its TV channels and sporting events. For example, the company aired the Tokyo 2020 summer Olympics reaching 372mn people in Europe alone. Distribution revenue comes in the form of fees paid by 3rd parties to use their content (content licensing arrangements), for example, Sky paying Discovery to air Gold Rush.

Previously Discovery had leased out content to its rivals to be aired on their platforms for a fee. However, under the company’s new business model, it is ending these contracts and pulling all its content onto one platform, Discovery+. This is the second part of the company’s distribution revenue, accounting for subscribers to Discovery+, which was launched in January 2021. This is classified as a Direct-to-consumer (D2C) aspect of the business and it is set to expand rapidly, with higher margins, more assured revenue, and a bigger moat around the business.

Discovery+ is a subscription streaming service, much like Netflix. It has the largest content library out of any streaming service, with over 55,000 episodes and 1000hrs of Discovery’s own content. It is available on all major platforms (Amazon fire TV, Smart TVs, etc) and across all devices. The company also has deals with Vodafone and Sky to expand further into the UK and Europe and has a partnership with Verizon in the US, offering a 12-month Discovery+ subscription on certain Verizon plans. This creates sticky demand for its product once customers are acquired.

Paying subscribers have grown from 15mn to 20mn between Q1 and Q3 of 2021 (its first nine months since launch) and subscribers pay between $4.99 and $6.99 per month. This has only been rolled out in the US. Discovery+ is also being launched in Canada, Europe, Latin America, and parts of Asia. The subscription growth could be exponential.

Notably, the company also owns a small venture capital firm investing in solar and other renewable energy projects, as well as investments in other media companies and Formula E – the world’s only electric vehicle Formula-1 racing competition.

There are now 1bn streaming subscribers around the world, boosted for obvious reasons during the last year and a half. But the growth is only starting. The global video streaming market size is expected to reach $224bn by 2028, expanding at a 21% growth rate per year. With the improvements in WIFI and the rise of 5G, on-demand streaming and subscription services will continue to expand. Also, the creation of the metaverse, which is still in its early stage, should help boost the experience for customers. Furthermore, as smartphone affordability rises and infrastructure improves in emerging markets (benefitting Airtel Africa also), Discovery, with a presence already in all corners of the world, will be able to take market share in these regions. The opportunity is huge.

Before diving into the business’ prospects, I thought I would address the crazy price chart first. Archegos capital was a hedge fund managed by Bill Hwang. Instead of buying shares as we do, Bill’s fund bought total return swaps (a derivative) for companies he wanted to own. These total return swaps were essentially leveraged bets on the stock price going up. This leveraged bet meant if Bill was correct, and the stock went up 30% for example, Archegos may make five times that, i.e. 150%. This is great when stocks are going up, but when Bill is wrong, and the stock drops 30%, Bill could lose 150% (more than his initial investment). One of Bill’s positions, ViacomCBS, unfortunately did not go up. Long story short, because Archegos Capital had a leveraged bet on ViacomCBS to go up, and it didn’t, the hedge fund imploded, losing roughly $20bn in two days. Archegos bought these total return swaps from several different banks and therefore was leveraged beyond belief. When the hedge fund imploded, many banks were forced to sell multi-million-dollar investments in all of Archegos Capitals positions, one of which was Discovery Inc. This all happened in a matter of days, causing the price of Discovery Inc. to collapse. The reason it exploded upward in the first place was also because of Bill taking out such huge positions in the stock. This rise and fall were beyond the fundamentals of the company at the time.With that aside, let’s discuss the exciting prospects for Discovery Inc. 

Revenue is expected to double by the end of this year compared to 2016 and is up 23% during Q3 2021 compared with Q3 2020. Margins were rising very nicely over the past few years, with EBITDA margins growing from 37% (2016) to 42% (2019). However, this is expected to fall back to 32% by 2022. The primary reason for this is due to Selling, General, and Administration (SG&A) expenses involved in the rollout of Discovery+. This is expected, but I believe this will normalise back to its previous levels over the next few years, as such expenses are normal for any new venture (e.g. increased advertising costs to boost awareness of the new platform). Also, this streaming service should lead to expanding gross margins and growing free cash flow in the future, as much of its content is already owned and created by Discovery. Even with the rollout of Discovery+ and its heightened SG&A costs, the company still generated an 8% free cash flow yield.

The company does have a lot of long-term debt, with a debt-to-equity ratio of 110%. However, more than 80% of this is in the form of senior notes expiring in 2025 or later. It also has enough cash to service these debt repayments into 2025, with 18% still left over. Its balance sheet is solid overall. Discovery is planning to merge with WarnerMedia in mid-2022, but due to Discovery’s high debt level, alongside the additional debt taken on through the merger, the market views this as a significant barrier to cash flow growth for the merged business. In my opinion, this is mistaken, as I explain below.

Aside from the expanding margins and growing revenue that Discovery will realise through its launch of Discovery+, its merger with Warner Media is another exciting catalyst for the business.

The planned merger, agreed in May 2021, will combine WarnerMedia (sold by AT&T) with Discovery to create a global entertainment company called Warner Bros Discovery (WSB). This will create the largest content library in the world, with 200,000hrs of programmes and over 100 channels. There is huge intellectual property and brand awareness through Warner Media’s shows, such as Harry Potter, Looney Tunes, and Game of Thrones. It will also include Major League Baseball, the PGA tour, and other huge channels, as you can see in the graphic above.

Warner Media owns HBO and Time Warner. HBO currently boasts 70mn subscribers. However, I believe the platform has been dreadfully underutilised by AT&T, hence the reason it is selling this segment and focusing on 4/5G services. The names Warner owns, as mentioned above, should boast a subscriber base much like that of Netflix or Disney. Netflix is now scrambling to create new content, taking on huge debt levels to produce unique content and continue growing subscriber numbers. However, the merger of Discovery and WarnerMedia means a huge amount of content is already available to users. This is where the opportunity lies. Under better management, with Discovery’s CEO (David Zaslav) taking over as head of the merged company, I believe WBD will compete with the streaming powerhouses previously mentioned. Not only will they compete, but they will not have the huge capital expenditure spend that Netflix has, since they already own the channels and content.

Under the terms of the deal, AT&T gets a combined $43bn in cash and debt, as well as retaining a certain amount of Warner’s debt (as shown above). AT&T’s shareholders then get 71% of WBD’s equity, and 100% of Discovery will be consolidated into WBD in return for a 29% stake. This means buying DISCA shares will give 100% exposure to the new company.

WBD plans to spend $20bn per year on content to increase its appeal to new customers. It is aiming for theatrical (cinema) pictures to be the top of the funnel. This means as the company continues to produce motion pictures for cinema screens, and then transfers these movies to their streaming channels, subscription numbers should continue to grow.

As the share price continues to drop lower, news continues to get better for the merger of Warner Bros and Discovery. The merger was first expected to be completed by mid-2022, but John Malone (a big player in the media space) has stated this may be completed sooner. He also alluded to higher-than-expected synergies. It was first expected that synergies would amount to between $3bn-4bn. Anything above this amount would trickle straight into free cash flow. This comes alongside a 25% growth in revenue for HBO, part of the targeted company, leading to further free cash flow generation. Moreover, leverage (Debt/EBITDA) was expected to be 5x when the merger was announced. This has now been reduced to 4-4.5x. The company has guided that leverage would fall to 3x within two years, but with Discovery’s CEO David Zaslav leading the new company, I expect this to fall below the target. Why? Because David Zaslav has experience deleveraging faster than expected when Discovery acquired Scripps in 2018.

With the projected free cash flow conversion of 60% on EBITDA of $14bn, alongside synergies and leverage coming in better than expected, I believe the market is under-pricing the legacy names and high margin business this merger will bring. Not only will this help to reduce debt quickly, but through its established brand, it will help continue to grow assured subscription revenue to levels that will compete with the leaders in the industry.

On a side note, Discovery currently has multiple share classes. These classes give the shareholder different voting rights or rights to dividends, however, under the merger, all classes will merge into a single share class with 1 vote per share. All preferred stock will be converted into ordinary shares also (creating a 5% dilution).

Discovery is trading almost as cheap as it was during the 2008 financial crisis trading on a Price/Sales (P/S) ratio of 1.2x, and a 12-month forward Price/Earnings (PE) ratio of 7.5x. This comes with an 11% Return on Equity (ROE), a strong balance sheet, and strong prospects through its merger. As I have said, through the implementation and expansion of Discovery+, I believe this company’s margins should grow and higher free cash flows (FCF) should come thereafter. I have no doubt this will be used to reduce debt, buy back stock, or expand operations further, all benefitting shareholders.

In comparison to this, Disney trades on a P/S ratio of 3.3x with a forward PE of 35x, whereas Netflix trades on 8x and 52x the respective metrics. Both companies exhibit poorer margins than Discovery already, and the Discovery+ rollout has only just begun. If on top of this, the merger goes through, the valuation arbitrage is huge.

Looking at Discovery alone, the launch of its streaming business is completely underappreciated. DISCA trades on 7x EV/EBITDA. With the continued growth of this service, I believe it warrants a multiple twice that, giving an implied share price of $50.70. This is without the merger with Warner Bros.

When looking at the merged company, as its margins expand through its D2C streaming business with its huge joint library, there is absolutely no reason why Warner Bros Discovery (WBD) can’t trade at an EV/EBITDA multiple of 20x, aligned with its peer, Disney.  The new company WBD has forecasted $52bn in revenue and $14bn in EBITDA for 2023. Given a 20x EV/EBITDA multiple and a 29% stake attributed to Discovery’s shareholders, its stake in the merged company would be worth around $73bn in Enterprise value. This gives an even larger potential upside for the share price of around $65. This is what I am playing for.

Discovery is an attractively priced business, with a strong balance sheet, two huge catalysts, ran by astute management. This is an attractive business in any macroeconomic environment, and especially the one we currently face. Investors will continue to focus on strong businesses with good free cash flow. Without the merger, Discovery will continue to grow margins and revenue through the launch of Discovery+. With the merger, the joint venture should see monumental growth, and is, in my opinion, one of the most underappreciated opportunities in the market today (alongside Airtel Africa). As I have said previously, I will continue to focus on growth at a reasonable price (GARP), and DISCA is most definitely that.

The biggest risk to the investment case is if management does not execute the strategy. With the recent comments of insiders in the industry (as mentioned above), alongside the astute and experienced management led by David Zaslav, I believe this is highly unlikely. Also, recent news that members of Congress want to block the merger on anti-competition grounds is frankly ridiculous.  The merger will allow WBD to compete with Disney and Netflix, the real monopolies in the streaming business. Further, Discovery’s shares were flat on the day the news broke, showing its insignificance.

Taking Discovery alone (should the merger not go through), the debt is weighing on the companies valuation. With $3.5bn in cash and an EBIT/Interest Expense ratio of 3.7x, the company is very liquid and debt repayment will not be a problem. The major risk here is again if management cannot continue to execute on the growth of Discovery+. They have been able to gain 20mn subscribers in nine months, beating their internal performance metrics, so I trust them to continue to perform. As this creates margin expansion and growing FCF, I would hope management will pay down debt, warranting the market to re-rate the stocks multiple upward.

Should the Warner Bros Discovery merger go through, which seems highly likely, this joint venture will become a powerhouse in the streaming space. With these businesses owning content such as the NBA, Game of Thrones, and Harry Potter, the brand awareness is huge. As the market wakes up to this opportunity, the multiple the market is willing to pay for this company will explode higher. I am adding 6.1% of capital to Discovery Inc A-Class Shares (DISCA) in The Spark’s portfolio at a price of $23.31. Price was taken at close of business on Friday.

Until next time,