• Phronimos

mighty mouse

Updated: Jan 8

The Disney + streaming service achieved 10m subs within just days of launch, far exceeding the expectations of analysts. Disney had targeted between 60 and 90m subs in five years, so they’re likely to blow past those numbers. It is really a testament to the astounding power of Disney’s creativity and brand – arguably the most powerful on the planet.

The mighty Disney mouse just Blitzkrieged its streaming wars opponents. The stock was up nearly 8% on the release and is up 34% year-to-date.

A mea culpa is in order. I looked at this earlier this year, but sucked my thumb, despite fully recognizing the remarkable power of Disney’s brand and the value of their content. The share price wasn’t cheap, but wasn’t outrageous either. Given the debt they took on to acquire the 21st Century Fox assets and the guidance for streaming losses over the next several years, I didn’t think this would run away so quickly.

Disney has probably the most compelling “must have” content alongside perhaps HBO. Even more so if you have kids. So if you subscribe to three streaming services, Disney, HBO and Netflix are probably top of the list. For cable cutters, if you go beyond that, plus the cost of a broadband connection, you’re back in the region of $100 per month for your TV. Is it worth it?

And where does that leave the rest of the field? Content is still king, but given the explosion in content investment by the likes of Netflix, Apple and others, the long tail of “so-so” content has seen massive value erosion. The best, “must have” content is incredibly valuable – the rest, worth very little at all. Oddly enough re-runs of Seinfeld and Friends appear to be worth even more given the explosion in choices.

This presents us with a dilemma. We own shares in Discovery. Discovery also has a great brand (although nowhere near as powerful as Disney’s) and it dominates the non-scripted genres of lifestyle, home and garden, food and natural history with channels like TLC, HGTV, Food Network, Animal Planet and Discovery. On the one hand it’s not the high profile, compelling and binge-worthy content like Game of Thrones. On the other hand, it’s cheap to produce and Discovery is the “go to” source for that content for consumers. Given Discovery has a leading 20% share of prime-time female audiences on traditional cable, it is clearly offering something of value.

The problem is traditional cable subs are declining and the streaming wars are probably going to accelerate those declines. That is why the stock is trading on around 8x earnings (adjusted for amortization of acquisition related intangibles, and perhaps even less if they start buying back stock more aggressively), and generating around US$3bn in free cash flow, representing a 14% FCF yield. Advertising and affiliate revenues have continued to grow, albeit modestly.

The shares are unarguably cheap on near term earnings and cash flow.

The risk is that cable subs fall more rapidly and Discovery’s earnings start to decline outright, or the value the market applies to Discovery’s content remains depressed for the foreseeable future - the proverbial value trap.

While it’s always a risky statement to say the market is missing something, it is possible it’s just not paying attention or in a funk about traditional media companies more generally.

For one, Discovery did say on the last earnings call that the contribution to revenue growth from virtual MVPDs (Sling, Hulu, Roku, YouTube TV etc) was starting to become meaningful. They didn’t give a number though. Part of the problem with the transition to digital is actually measuring how much your content is being viewed on non-linear platforms.

Secondly, Discovery is making some moves into the digital era, but it is avoiding head-to-head competition with the streaming giants. It is trying to carve out a few distinct verticals where it can effectively compete; a strategy that seems to have a more reasonable chance of success. There is some precedent for this in the on-line classifieds space, where verticals dedicated to cars, real estate, jobs or hyper-local transactions compete effectively with broad platforms like Craigslist or Gumtree.

For example, Discovery in the process of launching a dedicated natural history streaming channel combining all its own content, plus the entire BBC library of natural history shows. Something for those that love the dulcet tones of David Attenborough.

A new home renovation channel is being launched in partnership with Chip and Joanna Gaines.

They also just launched Food Network Kitchen, dubbed the “Peloton of food”, and if you’re a “foodie” I think there is something interesting there. My mother-in-law promised to overcome her tablet/app phobia if she can do a live cooking class with Nigella Lawson.

There are similar efforts to have dedicated and interactive channels ("view and do" as they call it) in verticals dedicated to golf and cycling. These are sports that don't command the incredibly expensive rights like basketball, baseball or the NFL, but are followed by passionate fans, often with high disposable incomes.

The market also seems to be discounting the fact that Discovery’s OTT streaming joint venture with ProSieben in Germany, “Joyn”, which aggregates a bunch of content from traditional German networks as well as Eurosport (think of an ad-supported German Hulu), already has 4.5m subs, just six months after launch. ProSieben hasn't covered itself in glory lately, but it is available in 45m households across Germany, Austria and Switzerland. Access to high quality local language content is one way to successfully compete with the likes of Netflix, Disney and Amazon. Discovery is doing the same in Poland with Cyfrowy Polsat, combining Discovery’s Polish TVN content with Polsat’s, and open to other networks, to become the streaming home for polish language content.

In the most recent earnings call Discovery’s CEO talked about putting their entire content suite as a stand-alone streaming service. Discovery owns all its IP outright and there are no legal restrictions from existing cable customers to prevent this. I’m not sure if the economics stack up given how crowded the subscription streaming space has become, the technology/infrastructure cost and the cost of getting subscribers' attention. The one thing Discovery doesn't have to worry too much about is the content side of things - it has plenty and new content doesn't cost $5m per episode. A more realistic outlook here might be for Discovery to partner up with other legacy media players (AMC, CBS, Viacom, etc) to build a more comprehensive, competitive streaming bundle.

This makes Discovery an excellent case study in the difficulties of investing in stocks that appear to be cheap. In an industry undergoing once-in-a-generation disruption, a business that appears to offer "value" is probably that way for a very good reason. The risk is that the competitive advantages that the business previously developed are no longer sufficient to protect the returns on capital the business enjoyed in the past, and that earnings and cash flows will not be sustainable over the long term.

As a very famous investor once wrote: "economic terrain that is forever shifting violently is ground on which it is difficult to build a fortress-like business franchise."

At current stock prices investors have concluded that Disney and Netflix are the two certain winners of the new video entertainment landscape. Those same investors have concluded that Discovery and other legacy content providers are facing terminal decline. While it is impossible to say for sure, our view is that reality is unlikely to be so clear cut. At Discovery's share price we see reasonable protection from significant loss given relative stability in its core revenues and its healthy cash flow supporting digital growth initiatives or returns to shareholders. The niche content vertical strategy seems a reasonable path to pursue and industry consolidation doesn't seem an unreasonable expectation either.

Only time will tell.

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