Key points

Strong start to the year with a positive outlook on Affiliate Fees, Advertising and cost growth

Discovery reported 1Q16 Adj. OIBDA of $577mm vs our/consensus $553mm, a beat of 4%. Domestic Affiliate Fee growth of +8% y/y topped consensus +5% and drove the beat and should remain at ~+7% for the year. Domestic Ad growth of +7% was also strong, and with deceleration in cost growth in H2 (following a rise in 2Q) the company has an improved outlook for its earnings. Adj. EPS and FCF growth guidance (at constant currency) goes from 'up low double-digits/up low teens' to 'up at least high teens', and DISCA now expects constant currency margin expansion.

Restructuring ahoy!

Discovery announced a cost savings plan aimed at more efficient operations with personnel adjustments, restructuring and budget re-allocations towards digital. The program should be completed by 3Q16 and includes $40-$60mm of upfront costs, but should generate annual run-rate savings of ~2x cost. We think some benefit should accrue in late 2016.

FX helping estimates too

In addition to the organic guidance raise, DISCA numbers will benefit from a weaker US dollar. The headwind to sales and EBITDA comes down, while Adj. EPS goes from a modest FX headwind to a $0.01-0.05 tailwind. There's a lot of moving parts that are detailed in our note, but the main result is that 2016E consensus EBITDA should move up by around 5% reported (3% constant currency) while Adj. EPS should move up by 7% (4% constant currency). 2017E estimates should benefit from organic growth + the circa $100m+ in run-rate savings from restructuring.

Gas pedal

With revenue/EBITDA/EPS estimates and/or guidance moving up organically, FX helping and cash deployment continuing we like all the cylinders in the DISCA engine. Management is also embracing OTT both domestically and internationally. All of this supports our target multiple of 16.5x CY16/17 P/E and 11.2x EV/EBITDA. Our 2016/17E EPS goes from $1.91/$2.18 to $2.04/$2.31. As a result, we raise our target price to $36, and reiterate our Outperform rating.

Valuation

We value all of our Media stocks on a sum-of-the-parts basis with target multiples applied to the EBITDA of the business components. Given the low visibility of various Media earnings streams and potential for lumpy outcomes (SVOD and syndication sales, and program writedowns), we think a blend of current year and next year estimates is most appropriate. We currently value Media stocks on 50%/50% CY16/17 estimates.

For DISCA, we estimate $2.6bn in CY16/17 EBITDA. This is nearly entirely from cable networks where we use an 11.2x EV/EBITDA multiple. This is a 20% premium to the peer group cable nets, given the high margins and international growth. After a very small contribution from Education, we derive an enterprise value of $29bn, which implies 11.2x EV/EBITDA—a 7% premium to the blended multiples of our Media coverage. After deducting minorities and net debt, and adding equity method investments, we derive an equity value of $22bn. Applying our year-ending CY16E share count, our target price for DISCA is $36 resulting in an ETR of 30% and an Outperform rating. Our target implies 16.5x CY16E/17E P/E on 15% average EPS growth, though EPS growth would be high-teens excluding FX.

Price target impediments

Several factors could impede achievement of our price target and rating.

The loss of carriage agreements presents risk. Discovery's businesses depend heavily on the carriage of the company's cable channels on pay TV operators. A loss of these carriage agreements could adversely affect affiliate revenue, which composes a substantial portion of the company's total revenue.

A decline in advertising expenditures could materially affect DISCA's operating results. Discovery's business has significant exposure to advertising. An adverse change or decline in overall advertising expenditures could negatively affect many of the company's business units.

Much of Discovery's business is based on consumer preferences for content, which can be difficult to predict. TV content caters to preferences and demographics. While we think Discovery's content has broad appeal, its ability to grow is in part based on delivering content that resonates with consumer preferences, which can change rapidly. An unexpected shift in these preferences could affect Discovery's operating results and, therefore, our price target and rating.

International markets offer growth but can be significantly affected by currency movements. Discovery generates about half of its revenue overseas, typically generating revenue through distribution fees paid in local currency. These revenues are translated back to DISCA's reported USD results, so currency movements can have a significant impact on reported earnings. Discovery's adjusted EPS does not exclude the impact of foreign currency movements.

All values in USD unless otherwise noted.

Priced as of prior trading day's market close, EST (unless otherwise stated).

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