Discovery Communications (DISCK, DISCA) recently published its full-year results and got approval for the acquisition of Scripps Network Interactive (NYSE:SNI). The stock dropped consistently from April to November, only to recover most of it since. Given this strong recovery and newly reported numbers, I do a new valuation of both entities and give my range of value for the combined company.
Total acquisition cost
Discovery Communications acquired Scripps Network for $12 billion, of which $8.4 billion was in cash and $3.6 billion was in stock, while it assumed $2.7 billion in net debt. For this sum, it acquired primarily US-focused networks, among them HGTV, Food Network and Travel Channel.
Value of Scripps' operations
Scripps is a highly profitable network operator which has grown profitability in recent years. Cash provided by operations minus share-based compensation was roughly $1,015 million in 2017 and showed an increase of 10.9%. This includes interest expense of $93 million and taxes of $342 million. Cash used for additions in property and equipment amounted to $75 million, while significant dividends are paid to non-controlling shareholders, primarily Tribune Media (NYSE:TRCO), which holds a 31.8% share in the Food Network. The dividend to all non-controlling shareholders amounted to $186 million.
This means the total cash flow to shareholders amounted to $754 million, which in 2017 was primarily used to pay down debt.
Many people are concerned about cord-cutting, but some simply refuse to look in a more detailed way at the numbers of individual companies. While some companies like Viacom (NASDAQ:VIAB) and CBS Corp. (NYSE:CBS) are clearly struggling to attract and retain customers, other media companies are performing just fine. While people are all talking about cord-cutting, Scripps was still able to actually increase revenues from distribution and advertising by 6.8% and 3.7% respectively, and its operating income increased.
Synergies
Discovery and Scripps used to be strong competitors because they delivered fairly similar content. Combining similar companies, however, comes with easy realisable synergies. The most obvious synergies come from the use of each other's content to strengthen the quality of all networks. This is especially easy internationally, where Scripps only has a small footprint. Bringing Scripps abroad can yield additional synergies, as Discovery already has operations in most countries. Additional synergies come from a stronger negotiation position with advertisers and network operators. This might allow Discovery to get higher distribution fees, since it is currently paid significantly less per view than the market receives on average. The estimated synergies by Discovery Communications are $350 million annually.
Value Scripps Network Interactive
Discovery paid $15.7 billion in acquisition costs and assumed debt to acquire an existing cash flow stream of $847 million, which is quite expensive, but given the low interest of approximately 4%, the synergies of $350 million and the potential growth of the company, the acquisition already becomes quite attractive at a multiple of 13. The final multiple, however, is even more attractive due to the new tax regulation which could bring in another $200 million, bringing the multiple of 11.2.
Value of Discovery Communications
When looking at the income statement of Discovery Communications for the year, it clearly looks like the company tried to kitchen-sink it. It included an impairment of goodwill amounting to $1.3 billion. While this is obviously not recurring, and therefore not used to calculate the value of Discovery Communications, repeated impairments of goodwill however are important to keep track of because it tells something about the quality of acquisitions.
In addition to the impairment, Discovery reported a $170 million loss on an investment in renewable energy and a $110 million loss on foreign currency and derivatives. If this was not enough, it also had to deal with higher interest expenses and extinguishment of debt cost of $175 million. These costs are incurred in anticipation of the Scripps deal, to ensure that the financing is there when the deal closes. Combined, this resulted in a loss of $313 million for the year, which is pretty horrible compared to the $1.2 billion of profit recorded in 2016.
When you look at the cash flow from operations, however, it becomes clear that the company had quite a decent year. Even with the additional cost of debt, Discovery's operations managed to generate $1.6 billion in cash, an increase of 18% primarily caused by lower taxes.
While cash flow from investment activities with $630 million was more negative than in previous years due to additional investments, it seems to me that Discovery is able to generate $1 billion in free cash flow when deducting share-based compensation.
Balance sheet and market value
Discovery Communications has a significant debt load, which amounts to $14.8 billion. However, it has also raised $7.3 billion in cash and equivalents to pay for the Scripps acquisition. This leads to a net debt position of $7.5 billion, which is actually exactly the same as last year.
The share structure of Discovery is quite complicated, since it consists of multiple shares with more or no voting rights. Discovery has 155.6 million A shares outstanding with one vote, which are currently worth $24.32, which leads to a valuation of $3,784 million; 6.5 million B shares with ten votes per share, which are currently worth $31.15, which leads to a valuation of $202 million; 219.8 million C shares with no vote, currently worth $22.98, which leads to a valuation of $5,051 million. Combined, this leads to a market valuation of roughly $9 billion. This means that the company is still fairly cheap with a market-to-free cash flow multiple of 9. The total enterprise value, thus, is approximately $16.5 billion. Which means the enterprise value-to-free cash flow ($1 billion) + debt expenses ($475 million) is a reasonable 11.8.
Taxes
As everybody might know by now, the corporate tax rate was slashed from 35% to 21%. This is a major benefit to the bottom line of high-tax paying companies.
Scripps paid $342 million, which was 37.9%, due to changes in the value of future tax benefits. In 2016, it had a tax rate of 33.7%, which means the company will definitely benefit significantly from the lower corporate tax rate of 21%. The total tax benefit, including the new, more debt-heavy weighted structure, is around $200M.
Discovery Communications had an artificially low tax rate in 2017 due to the impairment charges. In 2016 and 2015, however, the company had a tax rate of 27% and 33% respectively. Given its international operations, a historic tax rate of 30% on average seems reasonable, which means that the new tax regulation is likely to benefit Discovery to the tune of $150 million.
Combining both tax savings leads to $350 million in annual tax savings which directly benefit shareholders.
Risk
Investments in general, but in common stock specifically, always carry investment risks. In this case, there are three risks which are most prominent:
- M&A risk. While John Malone has a good track record on acquisitions, they always carry the risk that the synergies do not materialise. Both companies might be similar in what they do, but there still is a risk of failure because of cultural differences. In addition, the companies are different in at least one major way. Scripps is more reliant on advertising than Discovery; it only gets slightly more than a quarter of its revenue from distribution, and has advertising as its primary source of revenue. Discovery gets more than 50% of its revenue from distribution, which means that Scripps' revenue might be more volatile due to its dependence on advertising.
- Cord-cutting, while on everyone's mind, might accelerate. While cord-cutting so far is only a US phenomenon, it might spread to other regions or accelerate, leading to lower profits for the combined entity. While Discovery boasts that it gets close to half of its revenue from international markets, this is not the case for its profits, which are 70% US-based. Scripps gets virtually all of its profits from the US market, so accelerated cost-cutting would harm the business as long as a profitable alternative method of distribution is not in existence.
- Competition for non-scripted content might head up. While prices for the production of scripted content have increased so far, competition and cost increases for content produced by Discovery and Scripps has been limited. This, however, should not be taken for granted; large investors in scripted content - like Netflix (NASDAQ:NFLX) - can easily devote more dollars to non-scripted content. An example of this is the Top Gear series, which transferred from the BBC to Amazon (NASDAQ:AMZN).
- Leverage. Discovery is used to having high leverage, and John Malone is a master in financial engineering. Still, while leverage might increase returns in good and normal times, it can be a drag on performance when the situation deteriorates. To see if you are not overpaying for companies with high leverage, it is therefore important to also do a calculation in which you take into account the enterprise value of the company.
Future scenario
Given all the changes for media companies, it is difficult to give clear forecasts for revenue growth. Recent history, however, suggests that both Discovery and Scripps have been able to increase revenues and profits. To me, this shows that it is fairly likely that the combined company is able to increase its cash flows at least with inflation. Production cost containment is also an important pillar for future profitability. Given the merger, I think the negotiating position of the combined company has increased significantly, which might help to contain costs.
Selling content online is a trend that is rapidly growing. The good thing for the company is that it does own all its content and is able to do deals with cable networks and also with Netflix, Facebook (NASDAQ:FB), Amazon, Apple (NASDAQ:AAPL) or Google (GOOG, GOOGL) when the opportunity arises.
Conclusion
Given the strong increase in the share price since I initiated a position, it was time for a review. Without any further growth but with the estimated synergies and tax benefits, the combined company can generate $3 billion in annual free cash flow plus interest expenses. At current prices, the total enterprise valuation is only $32 billion. This means a multiple of 10.7, which is fairly cheap given the high valuations elsewhere in the market. In addition, close to $20 billion of the enterprise value is long-duration, low-interest debt yielding 4%. Thus, $2.2 billion of the spoils will end up in the hands of shareholders with a multiple below 6. This investment, however, is not without risk, since a rapid deterioration of the US TV market without a transition by Discovery to different channels put shareholders' returns at risk.
