Discovery Is a Cash Flow Machine. Here's Why.

Shares of many legacy media stocks have suffered over the past few years, because of the rise of streaming and the acceleration of cord-cutting. That includes the likes of Discovery (DISC.A) (DISC.B) (DISCK), which is the market leader in unscripted content. But is all the pessimism warranted?

Discovery made a major acquisition with Scripps Networks Interactive in early 2018 for $14.6 billion. That consolidated most of media's leading unscripted brands under Discovery, from the Discovery Channel to The Learning Channel to OWN, along with Scripps' HGTV and The Food Network, among many others.

Beyond this, Discovery has also become a big player in European sports through its Eurosport channel, which it acquired in 2015 and will broadcast the Olympics this summer. In addition, Discovery has been building out GOLFTV, a direct-to-consumer over-the-top offering for golf fanatics, featuring PGA Tour content outside the U.S., along with lessons from Tiger Woods, and content from Golf Digest magazine.

Discovery's content portfolio may not be the most glamorous when compared with award-winning premier scripted content at some competitors. However, looking at its bottom line, Discovery appears to be one of the best cash flow machines in media, if not the best. Here's why Discovery is so profitable, and why the stock is so insanely cheap right now.

Discovery is minting money. Image source: Getty Images.

Unscripted is more efficient

Unscripted content is what makes Discovery different. Last year, Netflix (NFLX 0.94%) executives revealed that the costs for top shows had inflated by 30% in 2019 as big media conglomerates and tech giants all scrambled to get into the streaming game.

While the cost of top scripted shows has skyrocketed recently, Discovery management estimates its content costs are only one-tenth that of its scripted competitors.  Not only does that save a tremendous amount of money, but it also affords Discovery the ability to own all of its content. That's in contrast to the large streaming giants, which, despite spending tens of billions of dollars, often have to "rent" content from other studios to fill in their gaps.

In addition, Discovery's content translates extremely well overseas, as Discovery has translated its content into 50 languages across 220 countries and territories around the world. Therefore, Discovery's recipe for cash flow is low content costs, which it can then distribute over a very large customer base.

Hugely profitable and cheap to boot

Adding to this highly profitable model has been $800 million in synergies realized from the Scripps merger, making the first full year after the merger a good one for the combined company: 

Data source: Discovery Inc. fourth quarter filings. OIBDA = operating income before depreciation and amortization. 

Discovery printed profits while growing its business last year, converting a stunning 28% of its revenue into free cash flow. Consider that while Discovery made $3.1 billion in positive free cash flow, Netflix had a $3.3 billion negative cash burn in 2019.

What's even more remarkable is Discovery's current valuation. Today, Discovery's market capitalization is just $13.3 billion as of this writing. That means the stock is trading at just 4.3 times its free cash flow, putting the stock firmly in value stock territory. 

Of course, Discovery also has a not-insignificant $15.5 billion in short- and long-term debt. Still, the combined $29.1 billion in enterprise value is less than 15 times last year's net income and less than 10 times last year's free cash flow number. Discovery has also been paying down its Scripps acquisition debt for the past two years, bringing its leverage ratio down from 4.8 times adjusted OIBDA to just 3, the low end of management's target.

Now that management feels good about the company's debt levels, it recently turned to share repurchases to take advantage of the discounted shares. Discovery just recently completed a $1 billion share repurchase program, before reauthorizing another $2 billion repurchase program in February. At these levels, that could retire an enormous 15% of shares outstanding. 

What gives?

With such a shockingly low valuation, some may ask what is going on with Discovery's stock. Clearly, investors are skeptical that Discovery can maintain these economics in a world of cord-cutting. However, Discovery management isn't standing idly by. First, Discovery's content is some of the cheapest content in cable, with less than 5% of cable affiliate revenue, despite getting about 20% of the ratings. So it should be able to generate a fair amount of affiliate and advertising revenue even as subscribers slowly decline.

Second, Discovery is investing heavily in its direct-to-consumer offerings and will be ramping those investments to $600 million this year, double last year's $300 million investment. While a lot of that will be going to its branded channels, Discovery is also launching local-content Hulu-like bundles in Europe as well.

Management disclosed that it earned about $700 million in direct-to-consumer revenue in 2019, which it sees growing to $1 billion in 2020, good for over 40% growth and close to 10% of revenue. Overall, management guided for mid-single-digit revenue growth for the whole company in 2020.

One believer is director and media mogul John Malone, who owns about 21% of Discovery voting shares. In December, Malone purchased another $75 million Discovery C shares at just over $28. And if Malone, who is one of the best media investors of all time, thought Discovery was screamingly cheap at $28, investors can buy Discovery C shares at an even cheaper $25 today. Amid this market sell-off, Discovery belongs on any value investor's buy list.