Down on Discovery

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On the surface, Discovery Holding Co.’s third-quarter results appeared to be another period of stellar operating growth. According to one analyst, though, looks can be deceiving.

Discovery Holding was spun off by Liberty Media Corp. in July, and contains Liberty’s 50% stake in Discovery Communications Inc. and its 100% interest in Ascent Media Group.

According to its third-quarter financial statement, released Nov. 9, DCI reported a 6% increase in operating cash flow to $171 million, with revenue ahead 15% to $639 million. Strong numbers, especially in a weak advertising market.

But in a research report, Fulcrum Global Partners media analyst Rich Greenfield said the cash-flow results are misleading. Back out a $4.5 million benefit for lower launch cost amortization — which, Greenfield wrote, falls directly to the cash-flow line — and $9 million in nonrecurring benefits, including a change in estimates for international music rights accrual, and DCI’s operating cash flow actually declined 2%.

Greenfield, in turn, lowered his cash flow estimates for 2005 and 2006 for DCI ($694 million compared to previous estimate of $723 million in 2005 and $755 million versus $793 million for 2006). He also said that the stock is currently overpriced — it assumes a 12 times cash-flow multiple for Discovery and a 6 times cash-flow multiple for Ascent.

“We have a tough time believing Discovery Communications deserves any more than a 9 [times] 2006 multiple,” he wrote.

Discovery Holdings also lowered its full-year guidance — revenue growth is now expected to be in the low to mid teens, instead of mid-teens increases, while operating cash flow is expected to rise in the low single digits, compared with a previous forecast of low double-digit growth.

Greenfield has opposed DHC from the start, slapping a “sell” rating on the stock when it was first issued earlier this year. He maintains that rating.


DCI spokesman David Leavy said that while Greenfield’s assumptions are not inaccurate, Wall Street is missing the company’s overall strategy.

“We don’t manage the company quarter by quarter,” Leavy said, adding that DCI is making heavy investments in programming and other initiatives. For example, Discovery Education is currently selling a video encyclopedia to schools and will take aim at the home market next year. Short-term cash flow growth will also be impacted by its launch of lifestyles channels around the world and the global rollout of its HDTV service.

Leavy added that the lower launch costs in the quarter are actually a good sign — Discovery is paying less for launch support because it signed long-term deals with distributors.

“That shouldn’t be seen as some sort of artificial growth,” Leavy said. “That’s good news for the business.”

And though he acknowledged Discovery Communications’s $9 million one-time benefit for music rights accruals, he said that, too, must be put into perspective.

“We’re always reviewing, updating and analyzing these expenditures; that’s normal course of business that you would have these changes,” Leavy said. “The number could be a lot larger if we weren’t making all of these investments. This has been a hallmark of the company from day one — we’ve never paid a dividend; every dollar of profit we’ve made we’ve invested back into [the business].”

As an example, Leavy pointed to DCI’s decision to launch digital networks in 1995-96, which impacted cash flow heavily.

“Everybody thought we were crazy,” Leavy said. “Now, any media company out there would kill to have six digital networks holding that valuable shelf space in over 40 million homes.”

Discovery has been hit hard by ratings declines – TLC’s flagship show Trading Spaces dropped precipitously over the past few years after being one of cable’s most-watched shows. And though Discovery Communications has been spending money on developing new programming – it will increase spending 10% to an estimated $500 million on domestic original programming this year — it hasn’t yet benefited from those moves.


Liberty Media chairman John Malone defended the holding company during Liberty’s third-quarter conference call.

Speaking personally and not for DCI management, Malone agreed that Discovery Communications’ ratings had issues related to Trading Spaces — he said that show got TLC to a level of ratings and ad sales that was not sustainable in the short run. He also praised DCI for hiring several talented new programming executives to defend the brand and the identity of the channels and to grow ratings.

He added that DCI’s international division has done well — it grew revenue and operating cash flow by 24% and 15% in the third quarter, but that the domestic networks “needs to get its programming back on track, and I believe it will.”