Judging by the stock's 20% dip this year, investors aren't optimistic about Discovery Communications' (DISCK +0.00%) business as we approach the third-quarter earnings report due out on Tuesday, Nov. 3.
Image source: Discovery.
It's not hard to see why the bears are in charge right now. Discovery is highly dependent on TV advertising, and the prospects for that industry are sinking as consumers shift away from expensive cable package subscriptions.
Discovery isn't the only company that's smarting from this change. Disney's stock recently plummeted by 21% after the entertainment giant talked of falling subscription numbers for its ESPN channel. In an August conference call, CEO Bob Iger talked about how technology was "disrupting the media business" and "putting pressure on the multichannel ecosystem." Yet Disney thinks its portfolio of TV channels is well-positioned to thrive in this new environment.
But how about Discovery? This week's quarterly results will help answer that key question.
The soft U.S. advertising market
Discovery gets over half of its revenue from advertising, which is why it is worrisome that the segment has been flat through the first two quarters of 2015. The company has so far managed to pick up that slack by collecting higher distribution fees. Its collection of widely popular shows has given it leverage to raise the prices it charges cable providers by a hefty 13% so far this year.
But investors will want to look for growth in the advertising business as well. And, more specifically, that growth would ideally come from higher delivery, meaning improved ratings, and not just increased ad prices.
Image source: Discovery.
The good news is that, as of three months ago, management was optimistic about its U.S. business. "We have seen advertising market momentum pick up across all of our channels, so far in Q3, as we continue to benefit from ratings outperformance driven by the flagship Discovery Channel," CEO David Zaslav said in the second-quarter conference call. We'll find out Tuesday whether those positive early trends continued through the entire third quarter.
Rising international profitability
While the U.S. business is highly profitable even at tiny rates of growth, Discovery's international segment isn't yet generating big profits. And that's true despite recent market share and audience gains. The company climbed to a 6% share of all global viewers last quarter, led by strong pay-TV growth in India, Mexico, and Brazil, and broadcast growth in the U.K., Germany, and Italy. The Eurosport business, which Discovery now owns outright, is already making large sales and profit contributions, which should only grow as it deepens sports coverage with events like the Olympic Games.
Discovery hopes to leverage its global network in part by turning popular U.S. shows like Gold Rush and Fast N' Loud into international hits. That should help the division's profitability eventually rise from the current 30% margin toward the stellar domestic margin of 57%. And in the meantime, it helps that the international business, with its healthy outlook for advertising gains, accounts for half of Discovery's revenue right now.
The right time for a push into digital distribution?
Finally, management might have some interesting things to say about the prospect of bypassing the advertising market entirely by selling content directly to consumers. Zazlav's remarks on the topic in August echoed the bullish ones made by Iger, who said ESPN could thrive in an on demand, app-centric TV world. "The idea of going directly to the consumer is something we have every opportunity to do ... We have super fan groups. And we will be in a position if we want to, at any moment to start picking off some of those super fan groups," Zazlav said.
Management suggested such a move might not make sense over the next couple of years since distribution agreements have locked in much of Discovery's revenue over that time period. But the pace of technological change is speeding up in the media world. And so executives will need to constantly update their thinking on how Discovery can best respond to the disruption.
