Brisk Ad Sales at Discovery

Oprah Net Becomes Profitable; Affiliate Fees Lag
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Discovery Communications reported strong domestic advertising-sales growth in the second quarter, fielding better-than-expected performance in several financial metrics.

But sluggish affiliate-fee growth had some analysts and investors concerned, which helped drag down the stock.

Discovery reported total revenue of $1.47 billion, up a strong 30% from last year and fueled by a 10% rise in domestic ad sales. Excluding newly acquired businesses — most notably Scandinavian programmer SBS Nordic — international ad sales rose 21% in the period. Consolidated adjusted operating income before depreciation and amortization (OIBDA) was up 23%,to $668 million. Net income for the full company at $300 million was up 2.4% from the previous year but fell short of analysts’ consensus estimates of $329 million.

Domestically, revenue increased 13% in the period to $793 million and adjusted OIBDA rose 11% to $472 million.

While the financial results were slightly behind consensus estimates, Sanford Bernstein media analyst Todd Juenger wrote in a note to clients that the small shortfall shouldn’t matter. But he was most concerned about affiliate-fee performance.

Discovery has said in the past that it expects affiliate-fee revenue to rise as its networks become more popular and ratings increase. With top domestic brands like Discovery Channel, Animal Planet, TLC and Investigation Discovery, the programmer’s 162 networks reach more than 2 billion cumulative subscribers in 223 countries and territories.

“The key question is whether that will accelerate in 2H13 (probably not), and more importantly, FY14 and beyond as more and more distribution renewals take place,” Juenger wrote, adding that while he never expected dramatic affiliate free growth, he at least anticipated it would be greater than 6%.

“Five percent won’t do,” he continued.

But that is what Discovery is planning to deliver, at least for this year.

On a conference call with analysts, Discovery chief financial officer Andrew Warren said the company expects “roughly 5%” affiliate-fee growth for 2013. The programmer expects to negotiate new renewal agreements with about 20% of its distribution partners each year through 2017, he added.

The slower than expected carriage-fee growth, coupled with the financial target misses, helped drive Discovery stock down 4% ($3.41 each) to $81 per share on July 30. While it was a steep decline for the shares, Discovery stock is still up 59% in the past 12 months.

Discovery also revised its year-end guidance on the heels of its second-quarter results, lowering its full year OIBDA guidance to between $1.1 billion and $1.15 billion from the previous target of $1.2 billion to $1.5 billion. The company also expects full-year revenue to come in between $5.55 billion and $5.63 billion, compared to previous forecasts of $5.58 billion to $5.7 billion.

In a research note, Morgan Stanley media analyst Ben Swinburne wrote that although the affiliate-fee miss won’t affect earnings, the fact that it happened in the first year of a multiyear renewal cycle could indicate that pay subscriber weakness is catching up with programmers.

On a high note, Discovery said its Oprah Winfrey Network has become profitable sooner than expected.

OWN, which in its early incarnation was a drag on earnings, has revamped its lineup and significantly increased ratings. Shows from producer Tyler Perry — The Haves and the Have Nots and Love Thy Neighbor — have become bona fide hits and, along with returning series, led to viewership gains of 39% with women aged 25-59 in the second quarter, the biggest increase of any network during the period.

That ratings success is translating into significant ad growth for the channel, and Zaslav said on the call that OWN is now cash-flow positive and starting to pay down Discovery’s investment in the venture. The company had originally expected to reach cash-flow breakeven in the second half.

On the call, Warren said that after those payments, Discovery’s investment in OWN is about $509 million.

TAKEAWAY

Despite better-than-expected performance in several metrics, sluggish affiliate-fee growth was a drag on Discovery stock.

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