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Discovery Communications, Inc. (NASDAQ:DISCA)

1 Q1: HOW ABOUT THEM SYNERGIES? INVESTMENT RESEARCH TEAM BlackVault Investments, LP Outperform – PT: $34.59 t Nima Karamlou, Equity Research We believe Discovery (NYSE: DISCA) is a neglected media story [email protected] +1 (503) 887-0285 whose valuation offers investors an attractive opportunity to gain exposure to the upsides in the Scripps acquisition and the growing international TV market.

Key Points:

Synergy updates are net-net positive Outperform Management raised its synergy estimates from $350MM to Discovery Communications, Inc. $600MM while further noting that reviews have yet to (NASDAQ: DISCA) conclude. All else being equal, modeling the synergy update has tacked on an additional ~$3/share to our PT. We are Media & Entertainment holding our upside forecast tight at ~$750MM, but note that Price Target $34.59 each incremental $100MM in additional synergies adds Share Price as of Latest Close $23.83 ~$1/share to our PT. Implied Upside 49.4% Mkt. Cap, curr. $12,032 Advertising outlook strong 52-Week Range $15.99-$29.92 While DISCA failed to hit our International ad revenue (Olympics) estimate, we saw some of the Olympic boost filter through to CY Ending 2016A 2017A 2018E 2019E International other, which was a direct result of licensing deals. Revenue($) 6,497 6,873 10,413 11,065 We overlooked the miss and revised our downbeat outlook for the US ad market boosting our growth estimates from (1.6%) to OIBDA($) 2,413 2,531 3,913 4,792 +2.1%. We feel confident in management’s guidance for LSD ad EPS($) 1.94 (0.59) 2.58 3.19 growth in US given LSD-MSD guide from our coverage group and the upcoming mid-term election cycle, which will comp well Street EPS($)* 1.94 (0.59) 2.32 2.89 Unless otherwise stated, all metrics are based on BlackVault Investment Research against a weak 2017. model. Revenue and OIBDA figures are in millions. EPS figures are adjusted and do not include one-time items and depreciation and Long-Run is intact amortization. (*) = Street EPS based on FactSet Most importantly, our long-run outlook for the company remains intact; notably, FCF and deal synergies. We have DISCA hitting $3.0B+ in FCF in 2019 and holding steady at ~$3.5B through 2021.

We believe this gives DISCA critical optionality to remain acquisitive, invest in digital initiatives and reinstate its buyback.

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Exhibit 1: Discovery, Inc. Stock Price

Source: FactSet

Base Case – PT: $34.59 Our base case scenario reflects our positive outlook on Discovery-Scripps as we assume affiliate contracts are stabilized at 5.5% step-ups through 2020, and that negotiating leverage post-Scripps allows a rate step-up to 6.0% in CY2021. Meanwhile, we take the conservative position on subscriber trends by assuming sub losses accelerate an additional (0.75%) vs. industry. Internationally, we attribute no growth to subscribers while holding affiliate rate step-ups 1.0% above US averages given Bundesliga and Olympic rights at . All told, our base case looks for the group to do ~$3.9B in OIBDA on ~$10.4B in revenue in CY2018.

Upside Case – PT: $51.41 In our upside case, we assume that sub. losses continue, but 1% less than the base case. Furthermore, we attribute an additional 1% to global ad- growth while modeling an aggressive push by DISCA to close the ad monetization gap driving ~$2.1B+ in incremental ad revenue in CY2021. We also imply lower content spending as a result of overlapping distribution, and content production processes on similar content mixes. For CY2018, our upside case looks for the combined group to hit $4.1B in OIBDA and $10.6B in revenue.

Downside Case – PT: $22.81 Our downside case assumes that both US and international subs drop by 4% and 2% CAGRs through the forecast period. Meanwhile, we assume that content and operational spend will increase by an additional 1%. We further model in 50% less cost synergies, and no ad monetization gap closure. In this mix, DISCA/SNI will trade 1.0x turn lower than our base case at 8.1x vs. 9.0x. For CY2018, our downside case looks for the combined group to do ~$3.8B in OIBDA on ~$10.3B in revenue.

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Business Description & Management Business Description & Management

Company Description Pro Forma 2017 Exposure (%)

Discovery, Inc. is a media company that engages in the Revenue by Geography provision of content across distribution platforms and digital distribution arrangements. It operates through the US 62.3% following segments: US networks and International networks. The US networks segment owns and operates International 37.7% national television networks such as , , and TLC. The international Revenue by Business Line networks segment consists of international television

networks and websites, most notable, Eurosport. The Distribution 42.4% company was founded by John S. Hendricks in September th 17 , 2008. Advertising 53.4%

Management Other 4.1%

Robert J. Miron: Chairman of the Board Revenue & OIBDA by Reported Segment Mr. Robert Miron is a Chairman at Discovery, Inc. He is on 22.2% Int'l Networks the Board of Directors at Crouse Hospital, National Cable 37.9% Satellite Corp., Walter Kaitz Foundation and Syracuse University. Mr. Miron was previously employed as a 77.8% US Networks Chairman by Advance Communication Corp., a Chairman 62.1% by Bright House Networks LLC, a President by Newhouse Broadcasting Corp, and a Secretary & Director by National OIBDA Revenue Cable & Telecommunications Association. He also served on the board at Cable Television Laboratories, Inc. He Source: Company Data, BV Estimates received his undergraduate degree from Syracuse Major Content Networks University. US Networks David M. Zaslav: Board Member, President & Chief 12% of Total P2 + Live + 7 Viewership (2017 PF) Executive Officer Discovery Networks Velocity Discovery Channel TLC Mr. David Zaslav is an Independent Non-Executive Director Investigation Discovery Science (OWN) at Lions Gate Entertainment Corp., an Independent Scripps Networks Director at Sirius XM Holdings, Inc., a President & Chief HGTV International Networks Executive Officer at Discovery Communications Holding LLC Eurosport SBS Nordic and a President, Chief Executive Officer & Director at DMAX Discovery, Inc. He is on the Board of Directors at Scripps TVN Other Assets Networks Interactive, Inc., Lions Gate Entertainment Corp., 42% Group Nine Media $ 159.0 Grupo Televisa SAB, Sirius XM Holdings, Inc., Discovery, 3.4% LGF 120.9 Inc., Cable in the Classroom, National Cable & 50% UKTV 399.0 29% Food Canada 5.6 Telecommunications Association, Sirius XM Radio, Inc., 10% Refinery 29 125.0 Skills for America's Future, The Cable Center, The Mount Source: Company Data, BV Estimates (Stake values are net of taxes) BLACKVAULT INVESTMENTS RESEARCH

Sinai Hospital, The Partnership for New York City, Usc Shoah Foundation, Mount Sinai Medical Center of Florida, Inc. and The Paley Center for Media. Mr. Zaslav was previously employed as a President-Cable & Domestic Television by NBC Universal, Inc., a President-Cable & Domestic Television by NBCUniversal, Inc., an Executive Vice President by National Broadcasting Co., Inc., a President-Domestic TV & New Media Distribution by NBC Universal Cable, Inc., an Adjunct Professor by Fordham University, an Attorney by Leboeuf Lamb Leiby & Macrae, and a Chief Executive Officer by Sound One Corp. He also served on the board at Univision Communications, Inc., The Advertising Council, Inc., TiVo, Inc., Center for Communication and National Geographic Television International. He received his undergraduate degree from State University of New York at Binghamton and a graduate degree from Boston University School of Law.

David C. Leavy: Chief Operations Officer

Mr. David Leavy is a Chief Operations & Communications Officer at Discovery, Inc. He is on the Board of Directors aat Salisbury School. Mr. Leavy was previously employed as a Chief Spokesman & Senior Director of Publica Affairs by the National Security Council. He received a bachelor’s degree from Colby College.

Gunnar Wiedenfels, PhD: Chief Financial Officer

Dr. Gunnar Wiedenfels is a Chief Financial Officer at Discovery, Inc. He is on the Board of Directors at Scripps Networks Interactive, Inc. Dr. Wiedenfels was previously employed as a Chief Financial Officer by ProSiebenSat.1 Media SE. He received his doctorate degree from RWTH Aachen University.

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Recent Updates

Closing in on Upside Synergies As we previously noted, the synergy update is a big positive for Discovery. Management suggested that reviews are still underway; meaning that there could be additional synergy updates. We ran a sensitivity analysis that suggested that each incremental $100MM in synergies adds ~$1/share to our TP. Exhibit 2: Synergy Sensitivity ($MM except per share values)

$ 34.59 $ 200.0 $ 300.0 $ 400.0 $ 500.0 $ 600.0 $ 700.0 $ 800.0 7.3x 30.29 31.37 32.44 33.52 34.59 35.67 36.74 1.07 1.07 1.07 1.07 1.07 1.07 3.5% 3.4% 3.3% 3.2% 3.1% 3.0% Source: BV Investment Research We see synergies as providing a good buffer to margins as DISCA ramps up content and digital spend. In the Q, we saw greater content spending; apart from the Olympics, that led us to push our spending outlook upward. We saw a hit to our margin estimates, but notice that overall, OIBDA margins will remain essentially unchanged from CY2018-CY2021. It appears that the synergies are lending DISCA a “double whammy” by unlocking critical optionality to ramp up investment while limiting the margin impact. Exhibit 3: DISCA DCF Summary

Yes, Populism is Saving the TV Ad Market Combined DISCA - DCF Assumptions Quartlery Cash Flow? Yes After having a second look at our long-run estimates, we have made some Stub Discount: 0.5 Method: Exit Multiple pertinent adjustments to our revenue outlook; particularly advertising and FY2021E WACC 6.9% other. Given the strength of DISCA’s ad revenue growth in Q1, and FY2021 OIBDA 5,278.3 comments out of our media peer group, we are raising our TV advertising Terminal OIBDA Multiple 7.3x Normalized Terminal FCF 2,903.3 outlook. Our revised outlook sees the TV ad market tipping its toes in the Terminal Growth Rate (0.5%) negative during CY2019 and holding steady in CY2020. Our call is buffered Terminal Value 38,531.3 by our bullish tilt toward election ad spending. As the world becomes Sum of PV Stage 1 Cash Flows: $ 12,105.0 increasingly polarized politically, election competition will increase pushing PV of Terminal Value: 31,009.7 Enterprise Value $ 43,114.7 candidates to boost spending. Contrary to most, we don’t think that TV gets left out here as it continues to be a valuable channel to reach a broad Terminal Value % of EV 71.9%

set of voters. Enterprise Value $ 43,114.7 (-) Net Debt (18,442.6) (+/-) Equity Interest 684.5 (+/-) Other Implied Equity Value $ 25,356.5 Diluted Shares Outstanding 733.0 Implied Share Price $ 34.59 Upside/(Downside) 49.4%

Source: Company Data, BV Estimates BLACKVAULT INVESTMENTS RESEARCH

Exhibit 4: BV Estimates vs. Actual ($MM except per share values) 1Q 18 1Q 18A 1Q 18E 1Q 18E 1Q 17A BV Est. Variance ($MM/bps) BV Est. Variance (%) DISCA w/ SNI BV Est. Reported DISCA DISCA w/ SNI DISCA DISCA w/ SNI Revenue 1,838.8 2,307.0 1,722.8 1,613.0 116.0 584.2 6.3% 31.8% Distribution 903.2 1,051.0 934.5 855.0 (31.3) 116.5 (3.5%) 12.9% Advertising 734.2 1,012.0 751 687.0 (16.8) 261.0 (2.3%) 35.5% Other 201.4 244.0 37.3 71.0 164.1 206.7 81.5% 102.6%

Adjusted OIBDA 548.7 641.0 550.0 603.0 (1.3) 91.0 (0.2%) 16.6% % Margin 29.8% 27.8% 31.9% 37.4% -208 bps 206 bps

Operating Income 491.1 432.6 481.2 480.0 9.9 (48.6) 2.0% (9.9%) % Margin 26.7% 18.7% 27.9% 29.8% -122 bps 796 bps

Interest expense - (177.0) (82.5) (91.0) 82.5 (94.5) NM NM Income/(Expense) from Equity investees 22.0 22.0 - (53.0) 22.0 22.0 0.0% 0.0% Other 22.0 22.0 - (67.0) 22.0 22.0 0.0% 0.0% Pre-Tax Income 535.1 299.6 398.7 269.0 136.4 (99.1) 25.5% (18.5%)

Income tax expense (133.8) (112.4) (120.3) (55.0) (13.5) 7.9 10.1% (5.9%) NCI (11.0) (11.0) - (6.0) (11.0) (11.0) 0.0% 0.0% Adj. Net Income 390.4 176.2 278.4 208.0 112.0 (102.2) 28.7% (26.2%) % Margin 21.2% 7.6% 16.2% 12.9% 507 bps 1359 bps

Diluted EPS $ 0.64 $ 0.29 $ 0.48 $ 0.35 $ 0.16 $ (0.19) 25.1% (29.8%) % growth 81.2% (18.2%) 35.7% (15.8%) 4551 bps 9943 bps Source: BV Investment Research

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Exhibit 5: Changes in 2Q 18, CY2018, & CY2019 Estimates ($MM except per share values)

2Q 18E 2018E 2019E 2Q 18E 2Q 18E 2Q 18E 2Q 17A Variance ($MM/bps) Variance (%) 2018E 2018E 2018E 2017A Variance ($MM/bps) Variance (%) 2019E 2019E 2019E 2018E Variance ($MM/bps) Variance (%) BV Est. BV Prior Consensus Reported BV Prior Consensus BV Prior Consensus BV Est. BV Prior Consensus Reported BV Prior Consensus BV Prior Consensus BV Est. BV Prior Consensus BV Est. BV Prior Consensus BV Prior Consensus Revenue 2,733.7 2,747.1 2,748.0 1,745.0 (13.4) (14.3) (0.5%) (0.5%) 10,412.9 9,871.7 10,632.0 6,873.0 541.2 (219.1) 5.5% (2.1%) 11,064.5 10,990.6 11,308.0 10,412.9 73.9 (243.5) 0.7% (2.2%) Distribution 1,140.6 1,171.6 1,117.0 857.0 (31.1) 23.6 (2.7%) 2.1% 4,455.5 4,432.1 4,515.0 3,474.0 23.4 (59.5) 0.5% (1.3%) 4,763.4 4,897.2 4,924.0 4,455.5 (133.8) (160.6) (2.7%) (3.3%) Advertising 1,518.9 1,501.2 1,525.0 805.0 17.7 (6.1) 1.2% (0.4%) 5,457.5 5,146.4 5,637.0 3,072.0 311.1 (179.5) 6.0% (3.2%) 5,781.4 5,750.0 5,972.0 5,457.5 31.4 (190.6) 0.5% (3.2%) Other 74.3 74.3 106.0 83.0 (0.0) (31.7) (0.1%) (29.9%) 499.9 293.2 480.0 327.0 206.7 19.9 70.5% 4.1% 519.7 343.4 412.0 499.9 176.3 107.7 51.3% 26.1%

Adjusted OIBDA 1,151.1 1,227.3 1,192.5 717.0 (76.2) (41.4) (6.2%) (3.5%) 3,912.8 4,016.3 4,101.0 2,531.0 (103.5) (188.2) (2.6%) (4.6%) 4,792.3 4,560.7 4,640.0 3,912.8 231.6 152.3 5.1% 3.3% % Margin 42.1% 44.7% 43.4% 41.1% -257 bps -129 bps 37.6% 40.7% 38.6% 36.8% -311 bps -100 bps 46.0% 46.2% 43.6% 56.9% -18 bps 238 bps

Operating Income 923.7 997.8 840.0 632.0 (74.1) 83.7 (7.4%) 10.0% 3,020.8 3,238.8 2,797.0 708.0 (218.0) 223.8 (6.7%) 8.0% 3,832.8 3,603.5 3,295.0 3,020.8 229.3 537.8 6.4% 16.3% % Margin 33.8% 36.3% 30.6% 36.2% -253 bps 322 bps 29.0% 32.8% 26.3% 10.3% -380 bps 270 bps 36.8% 36.5% 31.0% 44.0% 31 bps 582 bps

Interest expense (176.0) (173.8) (180.0) (91.0) (2.2) 4.0 1.3% (2.2%) (527.9) (604.0) (687.0) (475.0) 76.1 159.1 (12.6%) (23.2%) (711.8) (711.7) (623.0) (527.9) (0.1) (88.8) 0.0% 14.2% Income/(Expense) from Equity investees - - - (42.0) - - NM NM 22.0 - - (211.0) 22.0 22.0 NM NM - - - 22.0 - - NM NM Other - - - (24.0) - - NM NM 22.0 - - (164.0) 22.0 22.0 NM NM - - - 22.0 - - NM NM Pre-Tax Income 747.7 824.0 660.0 475.0 (76.3) 87.7 (9.3%) 13.3% 2,536.9 2,634.8 2,110.0 (142.0) (97.9) 426.9 (3.7%) 20.2% 3,121.1 2,891.8 2,672.0 2,536.9 229.3 449.1 7.9% 16.8%

Income tax expense (186.9) (206.0) (165.0) (93.0) 19.1 (21.9) (9.3%) 13.3% (634.2) (658.7) (416.0) (176.0) 24.5 (218.2) (3.7%) 52.5% (780.3) (722.9) (569.0) (634.2) (57.4) (211.3) 7.9% 37.1% NCI - - - (6.0) - - NM NM (11.0) - - (24.0) (11.0) (11.0) NM NM - - - (11.0) - - NM NM Adj. Net Income 560.8 618.0 495.0 376.0 (57.2) 65.8 (9.3%) 13.3% 1,891.7 1,976.1 1,694.0 (342.0) (84.4) 197.7 (4.3%) 11.7% 2,340.8 2,168.9 2,103.0 1,891.7 171.9 237.8 7.9% 11.3% % Margin 20.5% 22.5% 18.0% 21.5% -198 bps 250 bps 18.2% 20.0% 15.9% (5.0%) -185 bps 223 bps 22.5% 22.0% 19.8% 27.5% 51 bps 270 bps

Diluted EPS $ 0.77 $ 0.84 $ 0.78 $ 0.65 $ (0.07) $ (0.01) (8.9%) (1.9%) $ 2.58 $ 2.70 $ 2.32 $ (0.59) $ (0.12) $ 0.26 (4.4%) 11.2% $ 3.19 $ 2.96 $ 2.32 $ 2.58 $ 0.23 $ 0.87 7.9% 37.6% % growth 17.6% 29.1% 19.9% (1.4%) -1152 bps -230 bps (534.6%) (554.7%) (490.7%) 0.0% 2009 bps -4391 bps 23.7% (598.5%) (490.7%) (66.7%) 62227 bps 51448 bps

Source: Company Data, FactSet, BV Investment Research

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Key Risks and Methodologies

Despite the many possible upside opportunities, risks to the ad-supported cable business remain substantial. Namely: a.) Decline in overall Pay TV subscribers threatens the traditional affiliate business model. b.) Proliferation of digital-supported advertising services cannibalizing TV ad spend. c.) Growing regulatory risks, particularly as it relates to M&A. In such an environment, Discovery’s leverage profile (4.1x Net Debt/ CY 2018 OIBDA) could put the firm into trouble should subscriber declines escalate beyond our downside case.

We value Discovery using a discounted cash flow model that assumes a blended WACC of 6.3%, an EV/OIBDA terminal multiple of 7.3x, and an unlevered FCF CAGR of 0.8% from CY2018 – CY2021.

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Appendix

Exhibit 6: Discovery Communications Income Statement ($MM except per share values)

DISCA Quarterly Projected PF DISCA-SNI Income Statement '17A Q1 18A Q2 18E Q3 18E Q4 18E '18E '19E '20E '21E

Revenue $ 6,873.0 $ 2,307.0 $ 2,733.7 $ 2,512.3 $ 2,859.9 $ 10,412.9 $ 11,064.5 $ 11,620.2 $ 12,443.4 % Growth NM 43.0% 56.7% 52.2% 53.4% 51.5% 6.3% 5.0% 7.1% Distribution 3,474.0 1,051.0 1,139.0 1,124.6 1,136.1 4,450.7 4,750.8 4,974.9 5,217.2 Distribution Synergies - - 1.60 1.60 1.60 4.8 12.6 18.4 27.2 Advertising 3,072.0 1,012.0 1,518.9 1,316.5 1,610.1 5,457.5 5,781.4 6,073.5 5,944.0 Advertising Synergies ------667.9 Other 327.0 244.0 74.3 69.6 112.1 499.9 519.7 553.4 587.1 COGS (2,656.0) (1,060.0) (962.6) (992.3) (1,105.9) (4,120.7) (4,366.6) (4,861.6) (5,038.0) Revenue Synergy COGS - - (0.6) (0.6) (0.6) (1.8) (4.8) (7.5) (285.0) COGS Synergies ------Gross Profit 4,217.0 1,247.0 1,770.5 1,519.4 1,753.5 6,290.3 6,693.1 6,751.1 7,120.4 % Margin 61.4% 54.1% 64.8% 60.5% 61.3% 60.4% 60.5% 58.1% 57.2%

SG&A (1,686.0) (550.0) (563.3) (559.4) (660.8) (2,333.6) (2,350.8) (2,439.3) (2,442.2) SG&A Synergies - (56.0) (56.0) 34.0 34.0 (44.0) 450.0 600.0 600.0 OIBDA 2,531.0 641.0 1,151.1 994.0 1,126.6 3,912.8 4,792.3 4,911.8 5,278.3 % Growth NM 6.3% 60.6% 72.9% 77.1% 54.6% 22.5% 2.5% 7.5% % Margin 36.8% 27.8% 42.1% 39.6% 39.4% 37.6% 43.3% 42.3% 42.4%

D&A (330.0) (96.0) (118.1) (108.4) (128.9) (451.3) (521.8) (526.5) (508.3) Amortization of New Intangibles - (109.4) (109.4) (109.4) (109.4) (437.64) (437.64) (437.64) (437.64) Depreciation from PP&E Write-Up & Other ------Other (1,493.0) (3.0) - - - (3.0) - - - Adj. Operating Income 708.0 432.6 923.7 776.2 888.4 3,020.8 3,832.8 3,947.6 4,332.3 % Growth NM (9.9%) 46.2% 78.4% (206.5%) 326.7% 26.9% 3.0% 9.7% % Margin 10.3% 18.7% 33.8% 30.9% 31.1% 29.0% 34.6% 34.0% 34.8%

Other Income/ (Expense) DISCA standalone Interest expense (475.0) - (82.7) (82.7) (82.7) (248.1) (319.2) (287.8) (247.9) SNI Debt Interest - - (10.5) (10.5) (10.5) (31.4) (76.9) (61.7) (53.3) Interest on New Debt Issued - - (82.8) (82.8) (82.8) (248.4) (315.6) (293.1) (286.2) Amortization of Financing Fees & Other - (177.0) ------Income/(Expense) from Equity investees (211.0) 22.0 - - - 22.0 - - - Other (164.0) 22.0 - - - 22.0 - - - Pre-Tax Income (142.0) 299.6 747.7 600.2 712.4 2,536.9 3,121.1 3,305.1 3,745.0

Income tax expense (176.0) (112.4) (186.9) (150.1) (178.1) (634.2) (780.3) (826.3) (936.3) NCI (24.0) (11.0) - - - (11.0) - - - Adj. Net Income (342.0) 176.2 560.8 450.2 534.3 1,891.7 2,340.8 2,478.8 2,808.8 % Growth NM (15.3%) 49.1% 104.6% (146.8%) (653.1%) 23.7% 5.9% 13.3% % Margin NM NM NM NM NM NM NM NM NM

Basic EPS $ (0.89) $ 0.42 $ 1.04 $ 0.83 $ 0.99 $ 3.50 $ 4.33 $ 4.58 $ 5.19 Diluted EPS $ (0.59) $ 0.29 $ 0.77 $ 0.61 $ 0.73 $ 2.58 $ 3.19 $ 3.38 $ 3.83 % growth (18.2%) 17.6% 59.4% (136.8%) (534.6%) 23.7% 5.9% 13.3%

Source: Company Data, BV Estimates BLACKVAULT INVESTMENTS RESEARCH

Disclosures The information and opinions included in this report were prepared by BlackVault Investments, LP. This document was furnished by BlackVault Investments, LP and does not constitute as an offering of securities.

We are long DISCA.