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2017 - DJIA: 24,719.22 FRIDAY, JUNE 8, 2018 1934 - DJIA: 104.04 JUNE 7 DJIA 25,241.41 UP 95.02

Good Morning. This is the Market Digest for Friday, June 8, 2018, with analysis of the financial markets and comments on International Flavors & Fragrances Inc., Apple Inc., and Discovery Inc.

IN THIS ISSUE: * Change in Rating: International Flavors & Fragrances Inc.: Downgrading to HOLD on lofty acquisition price (John Staszak) * Growth Stock: Apple Inc.: Low-key WWDC; $1 trillion market cap approaching (Jim Kelleher) * Value Stock: Discovery Inc.: Moving forward with Scripps Networks integration (Joseph Bonner)

MARKET REVIEW: Stocks finished mixed on Thursday amid continued trade tensions as investors looked ahead to the G7 summit meeting this weekend. Energy and Telecom stocks rose strongly, while Technology and Materials finished lower. On the employment front, the Labor Department said that first-time unemployment claims fell by 1,000 to 222,000 for the week ended June 2, above the Bloomberg consensus forecast of 220,000. The Dow rose 0.38%, the S&P fell 0.07%, and the Nasdaq fell 0.70%. Crude oil traded near $66 per barrel, while gold fell slightly to trade near $1301 per ounce.

INTERNATIONAL FLAVORS & FRAGRANCES INC. (NYSE: IFF, $126.22) ...... HOLD IFF: Downgrading to HOLD on lofty acquisition price * IFF has announced plans to boost revenue by making $500 million to $1 billion of new acquisitions by the end of 2020. We are concerned that it may overpay for this growth. * In particular, we believe that the company is overpaying for its recently announced acquisition of Frutarom, a $7.1 billion purchase that will not contribute to 2018 earnings and that will provide only a modest boost in 2019. * We are reducing our 2018 EPS estimate from $6.26 to $6.20 and our 2019 estimate from $6.80 to $6.70 based on our expectations for gross margin pressure and a higher share count following the Frutarom acquisition. * IFF appears fairly valued at 19.9-times our 2018 EPS estimate, compared to a five-year historical average range of 9-25. We believe that this valuation adequately reflects the company’s current growth prospects, as well as the modest benefits and high price of the Frutarom acquisition. ANALYSIS INVESTMENT THESIS We are lowering our rating on International Flavors & Fragrances Inc. (NYSE: IFF) to HOLD from BUY. We have a favorable view of the company’s innovative products, as well as of its efforts to increase sales despite the slow growth of many of its large consumer goods customers. However, IFF has announced plans to boost revenue by making $500 million to $1 billion of new acquisitions by the end of 2020, and we are concerned that it may overpay for this growth. In particular, we believe that the company is overpaying for its recently announced acquisition of Frutarom, a $7.1 billion purchase that will not contribute to 2018 earnings and that will provide only a modest boost in 2019. We believe the company’s long-term outlook is brighter, based on expectations for strong sales and earnings growth and emerging market expansion. As such, our long-term rating remains BUY. RECENT DEVELOPMENTS On May 7, IFF reported 1Q18 net sales of $931 million, up 12% from the prior year and $16 million above consensus. In local currency, net sales were up 7%, driven by growth in both Flavors and Fragrances. Adjusted EPS rose to $1.69 from $1.52 last year, topping the consensus estimate by $0.11. The share count declined slightly, to 79.1 million.

A R G U S R E S E A R C H C O M P A N Y • 6 1 B R O A D W- A1 Y- • N E W Y O R K , N. Y. 1 0 0 0 6 • ( 2 1 2 ) 4 2 5 - 7 5 0 0 LONDON SALES & MARKETING OFFICE TEL 011-44-207-256-8383 / FAX 011-44-207-256-8363 MARKET DIGEST

The first-quarter gross margin decreased 20 basis points year-over-year, to 43.6%, reflecting a 13% increase in the cost of goods sold. Operating income rose from $130 million to $175 million and topped the consensus estimate of $168 million. Driven by a 12% decrease in selling and administrative expense and lower restructuring costs, the operating margin rose 310 basis points, to 18.8%. In the Flavors segment, sales rose 11% to $449 million and accounted for 48% of revenue. Sales were nearly $3 million above consensus. Currency-neutral revenue growth of 6% was driven by strong sales of Savory, Beverage and Sweet products. This marked the 49th consecutive quarter of local-currency revenue growth in the Flavors segment. In the Fragrance segment, sales rose 14% to $482 million and contributed 52% of 1Q revenue. Sales topped the consensus estimate of $468 million. Currency-neutral revenue rose 8%, benefiting from double-digit growth in all regions. Segment operating profit increased from $78 million to $93 million and came in $10 million above consensus. On May 7, IFF agreed to pay $7.1 billion to acquire Frutarom, a flavors, savory solutions and natural ingredients company. Under the terms of the transaction, IFF will assume Frutarom’s net debt and Frutarom shareholders will receive $71.19 in cash and just under a quarter share of IFF stock for each of their shares. We estimate that IFF will issue an additional 17 million shares to fund part of the transaction. Management expects to achieve $145 million in annual cost synergies within three years. The deal has been approved by both companies’ boards and is expected to close in 6-9 months. IFF expects the acquisition to be accretive to earnings in 2019. The deal values Frutarom at 21.5-times the consensus EBITDA estimate prior to the announcement, well above the multiple of 15 that we think is reasonable. EARNINGS & GROWTH ANALYSIS In 2018, management expects organic revenue to increase 6.0%-8.0%. It also projects organic adjusted operating profit growth of 6.5%-8.5% and adjusted EPS growth of 5.5%-7.5%. It expects currency headwinds to reduce reported sales by 300 basis points. We expect sales to grow nearly 6% this year to $3.6 billion. However, we look for higher input prices to reduce the full- year gross margin by 60 basis points. We are reducing our 2018 EPS estimate from $6.26 to $6.20 and our 2019 estimate from $6.80 to $6.70 based on our expectations for gross margin pressure and a higher share count following the Frutarom acquisition. As noted above, we are concerned that IFF may be overpaying for Frutarom. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on IFF is Medium. The company ended 1Q18 with $305 million in cash on hand, down from $368 million at the end of 2017. Long-term debt rose to $1.7 billion from $1.6 billion at the end of 2017, and the long-term debt/ capital ratio decreased to 48.5% from 49.1%. The improvement in the long-term debt/capital ratio reflected higher shareholders’ equity. In October 2017, the company raised its quarterly dividend by 7.8% to $0.69 per share, or $2.76 annually, for a yield of about 2.2%. Our dividend estimates are $2.81 for 2018 and $3.00 for 2019. MANAGEMENT & RISKS Major risks for IFF include raw material cost inflation, changing consumer trends, and increased competition. The company purchases more than 10,000 different raw materials from all over the world, including oils, extracts and concentrates derived from fruits, vegetables, flowers, woods and animal products. While IFF requires high volumes of many different ingredients, it is usually able to source products from a range of countries and can look for alternatives when the price of a particular ingredient is high. Another concern is exchange rate volatility, as IFF generates 75% of its sales from international markets. COMPANY DESCRIPTION International Flavors & Fragrances Inc., based in New York, is a leading developer and manufacturer of commercial flavors and fragrances. These ingredients are used in a wide variety of consumer products, including fine fragrances and toiletries, soaps, detergents, food, and beverages. The company has sales, manufacturing and R&D facilities in 32 countries, and distributes its products through its own sales force in North America, Europe, the Asia Pacific region, Latin America, and India. Over 70% of its revenue is generated outside the U.S.

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INDUSTRY Our rating on the Consumer Discretionary sector is Over-Weight. The sector has shown solid market momentum, reflecting investor expectations for strong durable goods demand in the wake of tax cuts. At the same time, Consumer Discretionary stocks have been out of favor for multiple quarters, and appear undervalued relative to peers. The sector accounts for 12.9% of the S&P 500. We think investors should consider allocating 13%-14% of their diversified portfolios to the group. Over the past five years, the weighting has ranged from 8% to 13%. The sector is outperforming thus far in 2018, with a gain of 5.5%. It outperformed in 2017, with a gain of 21.2%, but underperformed in 2016, with a gain of 4.3%. Consumer Discretionary earnings are expected to increase 15.5% in 2018 after rising 5.8% in 2017 and 9.4% in 2016. On valuation, the 2018 projected P/E ratio is 20.4, above the market multiple of 16.9. The sector’s debt ratios are high, with an average debt-to-cap ratio of 52%. Yields are below average at 1.0%. VALUATION IFF appears fairly valued at 19.9-times our 2018 EPS estimate, compared to a five-year historical average range of 9- 25. We believe that this valuation adequately reflects the company’s current growth prospects, as well as the modest benefits and high price of the Frutarom acquisition. As such, we are lowering our rating to HOLD. On June 7, HOLD-rated IFF closed at $126.22, up $0.62. (John Staszak, CFA, 6/7/18)

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APPLE INC. (NGS: AAPL, $193.46) ...... BUY AAPL: Low-key WWDC; $1 trillion market cap approaching * Apple’s 2018 worldwide developers’ conference (WWDC) highlighted upgrades to iOS and Mac OS, an app to time-out application usage, and new tools to enhance data privacy. * Although iOS and Mac OS will remain separate, the company has enhanced interoperability through an app that operates in either operating system. * WWDC will likely be a minor stock driver, though every bit helps as AAPL pushes toward a $1 trillion market cap. Apple is about $5 below the $198 level, which should be high enough to push the market cap past $1 trillion. * AAPL remains inexpensive relative to the market and to peers, and is particularly attractive based on discounted free cash flow valuation. ANALYSIS INVESTMENT THESIS BUY-rated Apple Inc. (NGS: AAPL) hosted its annual worldwide developers’ conference (WWDC) in June 2018. WWDC 2018 featured no real product announcements and was mainly focused on software enhancements. Apple used the forum to emphasize its commitment to safeguarding the data it captures via its phones, iCloud and other services and products. During the WWDC keynote with Tim Cook, Apple sought to differentiate Apple’s ironclad commitment to data privacy from the slowly evolving policies of other social media platforms and tech giants. Apple also introduced tools for combating mobile device addiction and a grab-bag of features and upgrades for iOS, Mac OS, Apple Watch, and Apple TV. One key question answered during the WWDC keynote was whether Apple would consider making iOS and Mac OS fully interoperable, or even a single operating system. Apple intends to keep the two as separate entities. At the same time, it introduced a new app that will increase the systems’ ability to interact, and promised more to come in OS interoperability in 2019. A share price of $198 should be enough to push Apple above $1 trillion in market capitalization. Share repurchases made in the current fiscal third quarter (not yet reported) may mean that AAPL could require a slightly higher share price to cross above that mark. WWDC will likely be a minor stock driver, but every bit helps. Fiscal 2Q18 results gave a strong boost to the stock price, based on what appear to be sustainable positives. These included a stunning quarter from the services business, a highly favorable mix and ASP for the iPhone, and the usual April increase in shareholder return. Investors went into the fiscal 2Q18 report less concerned about results and more concerned about guidance. On that score, Apple did not disappoint, guiding for mid-teens annual revenue growth that was also slightly above consensus. AAPL remain inexpensive compared with the market and peers, and is particularly attractive based on discounted free cash flow valuation. We believe that Apple’s positives are not fully reflected in the share price. We are reiterating our BUY rating and raising our target to $225 from $210. RECENT DEVELOPMENTS AAPL is up 15% year-to-date in 2018, while the peer group of computing, storage & information-processing companies in Argus coverage is up 12%. AAPL rose 46% in 2017; the peer group was up 18%. AAPL rose 10% in 2016, slightly lagging the 12% gain for the peer group. In 2015, AAPL fell 5%, its first down year in a decade, while the peer group declined 16%. AAPL shares rose 38% in 2014, ahead of the peer group’s 16% gain and 11% capital appreciation for the S&P 500. Apple is still trading higher in the afterglow of its well-received fiscal 2Q18 report. From $168 on 5/1/18 just prior to the report, AAPL has advanced 15% to the $193 range. That gives the company a market cap of about $950 billion. A share price of $198 may be enough to push Apple above $1 trillion in market capitalization; however, based on share buybacks, AAPL could require a slightly higher share price to cross above that mark. Apple hosted its annual worldwide developers conference (WWDC) in June 2018, though the event barely registered in the stock price. The convention did reveal some meaningful software developments, even though few if any had real “wow” factor. Investors have long speculated on the possibility that iOS, the operating system for iPhone and iPad, might become interoperable with, or even subsumed into, Mac OS, the operating system for Apple’s PCs. Few expect one OS to subsume the other, but better interoperability would be a logical goal for Apple as it tries to nudge iPhone owners with Wintel PCs to migrate to Apple Mac PCs. At WWDC, Apple announced a project in which a single app would be able to run on both iOS and Mac OS. This is a toe-in-the-water of interoperability, when some investors and Apple acolytes were hoping for full immersion. Still, CEO Cook did suggest that the company would take further steps to integrate the two operating systems.

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For the new Mac OS, called “Mojave,” Apple introduced dark mode, which will automatically adjust screen brightness to the time of day and/or room ambience. For the new iOS iteration, iOS 12, Apple focused on performance improvements. The company claims that some apps opened in iOS 12 will launch twice as fast as they launched under the predecessor OS. The new iOS will now also support FaceTime calls with up to 32 participants, enabling families, enterprises, and affinity groups to easily initiate and conduct conference calls. Apple also announced a new iOS app for augmented reality (AR). For the developer community, Apple introduced ARKit2, a code library and tool kit to facilitate the development of AR and VR apps. Apple noted that 20 million developers are writing for its community, and that it would like to see an enhanced focus on AR app development. Apple also introduced tools for combating mobile device addiction. A new feature in iOS 12, called Screen Time, will let users (and, presumably, their disapproving parents) manage the amount of time they spend on specific apps. Apple demonstrated a time shut-down of a session on Instagram. The irony of a shutdown on an app owned by frenemy Facebook was not lost on the crowd. Siri, launched with such great fanfare years ago, has been cast into Alexa’s formidable shadow. Apple called Siri the world’s most-used digital assistant; although Alexa’s user base is smaller, the Amazon-based voice app has been gaining voice- assistant share while Siri has lost ground. Given that Siri is limited to iOS devices, over time Siri risks falling behind Alexa in usage. To keep its edge, Apple is giving Siri some overdue upgrades. These include user shortcuts and other measures designed to create a more satisfying user experience. Calling Dick Tracey: the new Watch OS software upgrade will accommodate a walkie-talkie app. In the grab-bag of other developments, Apple TV will support Dolby Atmos, considered one of the best surround-sound formats currently available. Apple TV is also adding content from Charter. And the photos app will include more intuitive search features. CEO Cook used the forum of WWDC to emphasize that customer data privacy was now a top concern at Apple. In our view, Apple sought to differentiate its commitment to customer data privacy from the slowly evolving policies of other social media platforms and tech giants, who are still dancing around the topic. Craig Federighi, Apple’s SVP for software engineering, stated that, “private data should remain private.” Apple has previously criticized Facebook and others for capturing user data that it then monetizes. Among new tools designed to thwart data capture, Apple’s Safari browser will now disable tracking software or “cookies.” This feature is now part of Safari default mode. Advertising-reliant companies such as Alphabet (Google) and Facebook embed cookies in websites to track users’ online shopping, browsing and other activity. When a pop-up appears asking to allow these cookies, Safari will alert the user that their data may be at risk. Generally, this will reduce these companies’ ability to track and exploit the preferences of Apple device owners and users. While Apple positions its move as a noble defense of users’ privacy, the cookie-deflecting feature will also likely prompt some Android owners to switch to Apple devices. Apple is a bit of a reformed sinner in this area, given earlier strategies such as a data-sharing partnership with Facebook. WWDC will likely be a minor stock driver as Apple pushes toward a $1 trillion market cap, but every bit helps. Although AAPL has made a big move since its 2Q18 report, we continue to see value in the shares, given multiple growth and margin expansion drivers across this increasingly global enterprise. These include exceptional growth in the services business, favorable mix and ASPs that are driving iPhone revenue growth, and an unmatched capital allocation program that has brought in a new class of investors. EARNINGS & GROWTH ANALYSIS For fiscal 2Q18 (calendar 1Q18), Apple posted revenue of $61.14 billion, up 4% year-over-year but down 31% sequentially from the peak holiday quarter for this increasingly seasonal company. Revenue was within management’s $60-$62 billion guidance range and matched the consensus forecast. The 2Q18 GAAP gross margin of 38.3% was trimmed sequentially from 38.4% in 1Q18 and compressed further from 38.9% a year earlier. The GAAP operating margin narrowed sequentially to 26.08% in 2Q18 from 29.8% in 1Q18 on reduced volume leverage, and was down from 26.7% a year earlier. GAAP earnings totaled $2.73 per diluted share, up 30% year-over-year but down $1.16 sequentially from the peak holiday quarter of fiscal 1Q18 (calendar 4Q17). Fiscal 2Q18 EPS was $0.09 above the consensus call of $2.70. For all of FY17, revenue of $229.26 billion rose 6% from $215.6 billion in FY16. Apple earned $9.19 per share for the year, up 10% from $8.28 in FY16.

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For fiscal 3Q18, the company’s weakest quarter, Apple forecast revenue of $51.5-$53.5 billion, which at the guidance midpoint would be up 18% annually; the midpoint also exceeded consensus. Apple modeled a gross margin of 38.0%-38.5%; operating costs of $7.7-$7.8 billion; interest income of $400 million; and a tax rate of 14.5%. On that basis, Apple appears primed to earn $2.25-$2.30, which was also better than the prereporting consensus and indicates 30%-plus annual growth. Our fiscal 2018 earnings forecast is $11.48 per diluted share. Our fiscal 2019 forecast of $12.81 per diluted share may be conservative, but we are making no changes at this point. With no significant adjustments, events or charges in any period, our GAAP and non-GAAP earnings estimates are identical. Our long-term EPS growth rate forecast for AAPL is 13%. FINANCIAL STRENGTH & DIVIDEND Our financial strength rating on Apple is High, the top of our five-point scale. Cash was $267.2 billion at the end of 2Q18. Cash was $277.0 billion at the end of fiscal 2017, $237.6 billion at the end of fiscal 2016, $206 billion at the end of fiscal 2015, and $155.3 billion at the end of fiscal 2014. Debt was $121.8 billion at the close of 2Q18. Debt was $115.7 billion at the end of 4Q17 and $87.0 billion at the end of fiscal 2016. In recent years, Apple has levered up in anticipation of more aggressive capital allocation. Debt was $64.5 billion at the end of fiscal 2015 and $32.3 billion at the end of fiscal 2014. The use of debt gives the company operating flexibility without the need to bring back cash from overseas at onerous tax rates. Cash flow from operations was $63.6 billion in fiscal 2017, $65.8 billion in fiscal 2016, and $81.3 billion in fiscal 2015. Management believes the Tax and Jobs Act will promote a more optimal capital structure. In April 2018, Apple announced a new $100 billion share repurchase authorization. It also boosted its capital return program by $50 billion in both April 2017 and April 2016. Within the new capital allocation program, in April 2018 Apple hiked its quarterly dividend by 16%, to $0.73 per share. In April 2017, Apple hiked its quarterly dividend by 10.5%, to $0.63 per share. Prior hikes include 10% in April 2016, 11% in April 2015, 8% in April 2014, and 15% in April 2013. Apple declared its first quarterly dividend in April 2012. Based on the higher-than-expected dividend hike in April 2018, our dividend forecasts are $2.72 for FY18 and $3.06 for FY19. MANAGEMENT & RISKS Timothy Cook has served as CEO since industry legend Steve Jobs passed away in 2011. Former Apple controller and former Xerox CFO Luca Maestri became CFO in September 2013, succeeding Peter Oppenheimer. Phil Schiller is the head of worldwide marketing, and Jon Ivey is the chief of design. Apple has a deep bench of executive, engineering and marketing talent. We think that it will continue to attract high-quality talent, both from an engineering perspective as well as in the corporate leadership ranks. While investors have criticized Apple for its closed ecosystem, that system does have the effect of prompting consumers to buy iPads and Macs for system compatibility. Even more compelling to brand loyalty are Apple’s services, including iTunes, App Store, and iCloud, as consumers do not want the cost and complexity of pulling their media libraries out of the comfortable arms of Mother Apple. Despite its enormous revenue base, Apple continues to grow phone units and revenue at a double-digit pace. The shares are always at risk from the perception that growth could slow as the law of large numbers catches up with Apple. The company has mitigated that risk, in our view, with very aggressive shareholder return policies, which will likely remain paramount. Despite the company’s growing largesse, we expect institutional investors to continue to demand more aggressive dividend growth and a larger share repurchase plan. COMPANY DESCRIPTION Apple manufactures PCs, MP3 players, smartphones, tablet computers, software and peripherals for a worldwide customer base. Its products include the Macintosh line of desktop and mobile PCs, the iPod MP3 line, the iPhone, the iPad, and various consumer products, including Apple TV. Apple also owns and operates iTunes, the world’s largest vendor of recorded music. Apple derives 40%-45% of its revenue from the Americas, 20%-25% from Europe/MEA, 12%-16% from Asia-Pacific, and 15%-18% from its own retail stores.

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VALUATION AAPL trades at 16.9-times our FY18 EPS forecast and at 15.2-times our FY19 forecast; the two-year average P/E of 16.0 is now above the five-year (FY13-FY17) trailing multiple of 13.6. In a market that has reached record highs, Apple is trading at a slight premium to historical relative multiples. Over the past five years, AAPL has traded at an average 16% discount to the market multiple, or at a relative P/E of 0.84. The stock currently trades at an 8% discount to the market on a two-year-average forward basis, or at a relative P/E of 0.92. Less net cash per share, AAPL trades at an average of 13.6-times GAAP EPS for FY18 and FY19, or at about 80% of the market multiple – at a time when AAPL is poised to deliver 18% two-year average EPS growth and is the largest single component of S&P 500 earnings. AAPL also trades at discounts to the technology hardware peer group on EV/EBITDA and PEGY, and in line or at modest premiums on P/E and price/sales. We believe that a significant premium to peers is justified given Apple’s ability to expand globally and to generate healthy demand for its products in every kind of economy. Our more forward-looking two- and three-stage discounted free cash flow model renders a value north of $320 per share, well above current levels. Our blended fundamental valuation model points to a price above $270. Appreciation to our 12-month target price of $225 (raised from $210), along with the dividend yield of about 1.6%, implies a risk-adjusted total return exceeding our 12-month forecast for the broad market and is thus consistent with a BUY rating. At around $198, Apple would become the first trillion-dollar company, and proximity to that designation may generate momentum of its own. On June 7, BUY-rated AAPL closed at $193.46, down $0.52. (Jim Kelleher, CFA, 6/7/18)

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DISCOVERY INC. (NGM: DISCA, $22.77) ...... HOLD DISCA: Moving forward with Scripps Networks integration * Discovery completed its acquisition of Scripps Networks Interactive on March 6. The merger brought together two cable channel portfolios with strengths in nonfiction, general interest and lifestyle programing as well as in European sports programming. * Along with its 1Q18 results, Discovery raised its synergy target from the Scripps merger to $600 million from an initial $350 million. * We are lowering our 2018 adjusted EPS estimate by a penny to $2.25 and our 2019 forecast to $2.47 from $2.49. * We are maintaining our long-term BUY rating based on the company’s investments in unique sports programming, such as the Olympics, and pursuit of new digital distribution partnerships. ANALYSIS INVESTMENT THESIS We are maintaining our HOLD rating on Discovery Communications Inc. (NGM: DISCA), which is now integrating Scripps Networks in the face of secular cable subscriber headwinds in the U.S. Discovery expects to leverage Scripps’ content across its robust international channels and digital distribution platforms. We think the combination of these two ad-supported pay cable network portfolios, which both specialize in nonfiction programming, is logical, particularly given the slow-to-no- growth conditions in the U.S. basic cable market. However, the merger is unlikely to resolve the problem of audience erosion at Discovery’s legacy U.S. networks. Discovery suffers from a gap between its 13% share of U.S. viewership and its mid-single-digit share of affiliate fees. Management sees closing this gap as a future opportunity; we see it as a tough hill to climb as U.S. audiences continue to fragment. As we expected, the controlling interest of famed cable investor John Malone has led to additional M&A moves for Discovery. RECENT DEVELOPMENTS Discovery reported first-quarter results that missed the consensus EPS estimate by $0.25. First-quarter revenue increased 43% to $2.3 billion, driven by the Scripps Networks Interactive acquisition. Pro forma revenue, excluding consolidations and positive foreign exchange movements, rose 10%. First-quarter adjusted OIBDA increased 16% to $697 million. However, the adjusted OIBDA margin fell to 30% from 37% in 1Q17. Adjusted EPS rose to $0.53 from $0.41. The GAAP loss was $0.01 per share, down from EPS of $0.37 in 1Q17. Adjusted results exclude $226 million or $0.37 per share of restructuring and other charges related to the Scripps Networks acquisition in 1Q18 and charges related to the amortization of intangible assets in both 1Q17 and 1Q18. Discovery completed its acquisition of Scripps Networks Interactive on March 6 in a cash-and-stock transaction. The total transaction value was $14.3 billion, including $11.9 billion in equity value and $2.4 billion in Scripps Networks net debt. Discovery expects the acquisition to be accretive to both adjusted EPS and free cash flow in the first year after the closing, i.e., by March 2019, though adjusted earnings typically exclude merger and integration costs. Discovery initially expected to achieve run-rate cost synergies of $350 million within two years of the closing (March 2020), but has now raised that figure to $600 million. The company booked $56 million in Scripps integration costs in 1Q18 and $241 million in restructuring costs, with about $200 million more to come in 2018. This is well above its originally budgeted $300-$350 million in merger and integration costs. Management has suspended its share repurchase program and intends to devote free cash flow to debt reduction until it hits a target gross leverage ratio of 3.0-3.5, which it expects by the end of 2019 at the latest. Discovery expects to maintain its BBB- investment grade debt rating; however, S&P changed its outlook to negative the day after the deal was announced on July 31, 2017. The Scripps Networks ticker SNI has been retired. We see a certain logic in the combination of these two ad-supported pay cable network portfolios, which both specialize in nonfiction programming. We have thought for some time that Scripps, with its niche networks focused on affluent women, had a stronger position in the U.S. than Discovery, with its more broad-based, male-skewing networks. At the same time, we thought that Discovery had a better position internationally thanks to its European regional and pan-European cable, free-to-air, and sports networks. As such, the combination of Scripps’ strong U.S. business with Discovery’s strong European networks makes some sense. Indeed, Discovery management mentioned its ability to leverage Scripps Networks already broadly internationally

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distributed content (175 countries and 60 unique feeds) through its own extensive distribution channels. Discovery is also looking to the future of video distribution through new over-the-top outlets like Dish’s Sling, short-form digital distribution over channels like YouTube, and mobile over services like Snapchat. However, we see the merger as unlikely to resolve the problem of audience erosion at Discovery’s legacy U.S. networks. Following the merger, management may need to decide which lower-rated networks to pare down, rebrand, or sell off. On June 4, Discovery announced that it would spend $2 billion for the international rights (excluding the U.S.) to the PGA Tour across all platforms for 12 years, beginning in 2019. Discovery intends to monetize the PGA Tour rights through a combination of sublicensing, advertising, affiliate fees, and digital subscription rights. The estimated costs are $50 million in 2019 and 2020, and $100 million in 2021, with further increases in subsequent years. Discovery plans an additional $20-$30 million per year in start-up costs to build out the product, along with a new PGA OTT video streaming service platform, over the first three years of the deal. Discovery completed the sale an 87.5% controlling equity interest in its education business to private equity firm Francisco Partners for $120 million in cash on April 30. Discovery did not incur a loss on the sale. Discovery Education will be run as a separate business under current management. Discovery retains a minority 12.5% equity interest in Discovery Education. EARNINGS & GROWTH ANALYSIS We are lowering our 2018 adjusted EPS estimate by a penny to $2.25 and our 2019 forecast to $2.47 from $2.49. Discovery has a unique portfolio of assets, including owned content that it has steadily diversified from nonfiction programming into sports, children’s and other entertainment-oriented programming. It also has an unmatched international television distribution capability of basic ad-supported cable and free-to-air channels. The company averages 10 channels across 220 markets, reaching three billion subscribers. Of course, the company has also opened up digital channels with its own Discovery GO over-the-top digital streaming and Eurosport Player applications, also including YouTube, and subscription video on-demand with Hulu. With the Scripps Networks acquisition, Discovery has added a strong portfolio of U.S.-based free-cable channels anchored by HGTV and The Food Network. As noted above, management plans to exploit the Scripps Networks intellectual property by leveraging its content across Discovery’s international networks and digital platforms. In 1Q18, U.S. Networks pro forma revenue increased 2% to $4 billion. Segment pro forma revenue growth was driven by 2% growth in both advertising and affiliate revenue. Ad revenue benefited from the growth of Discovery GO, new digital offerings, and higher volumes, partly offset by lower delivery for the linear television channels. The subscriber loss rate at the combined portfolio was 5%, in line with recent trends. Adjusted OIBDA at the U.S. Networks rose 1% in 1Q18. At International Networks, 1Q18 pro forma segment revenue rose 26% in constant currency, driven by 11% advertising growth from the broadcast and digital coverage of the 2018 PyeongChang Winter Olympics. Affiliate revenue rose 9%. Adjusted OIBDA fell 30% in constant currency due to a timing mismatch between expense outlay and revenue recognition from the Olympics coverage. Some revenue will be recognized in the coming quarters. Discovery owns the television rights to the Olympics in Europe, and has leveraged its Eurosport free and pay-television channels as well as its Eurosport Player over-the-top digital streams. Management estimates that 58% of Europeans watched some portion of the Winter Olympics. Management has provided initial cost recognition estimates for its pan-European broadcast rights to four Olympics Games over the next seven years. The 2018, 2020, and 2022 Games will be held in Asia and will include two lower-rated Winter Olympics. Most of the rights recognition will thus take place in 2024 with the Summer Games in Paris. Management currently expects to recognize Discovery’s $1.4 billion in Olympics rights costs as follows: 10% in 1Q18, 30% in 2020, 15% in 2022, and 45% in 2024. In November 2017, Discovery partnered with other cable channel content providers to launch a new U.S. live-television video streaming service called Philo. The service focuses on general entertainment channels and specifically excludes sports programming. In addition to Discovery channels, Philo includes channels from A&E, AMC, Scripps Networks Interactive, and Viacom. Philo is charging $16 per month for a basic tier of 37 channels and $20 per month for a larger 46-channel offering. Philo’s basic offer undercuts many other live streaming services, including SlingTV, DirecTVNow, PlayStation Vue, Hulu Live TV, and YouTube TV, but not Netflix. FINANCIAL STRENGTH & DIVIDEND We rate Discovery’s financial strength as Medium, the midpoint on our five-point scale. Trailing 12-month free cash flow fell 3% to $1.4 billion in 1Q18. S&P gives Discovery a BBB- rating, the lowest rung of investment grade. It lowered its outlook to negative on July 31, 2017 after the announcement of the Scripps Networks acquisition.

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Discovery does not pay a cash dividend. The company discontinued its share repurchase program with the offer to acquire Scripps Networks. We expect management to focus on paying down debt over the next few years. The company almost doubled its debt to $14.8 billion in 2017 in preparation for the Scripps Networks acquisition, and assumed an additional $2.5 billion in debt at the closing. MANAGEMENT & RISKS David Zaslav is the president and CEO of Discovery. He was appointed in January 2007 after serving as the president of NBC Cable from 1999 to 2006. Mr. Zaslav is under contract through December 2019. Founder John Hendricks retired as Discovery’s chairman on May 16, 2014, after 32 years with the company, and has been succeeded by Robert Miron. Mr. Miron has been a company director since September 2008 and previously served as chairman and CEO of Advance/Newhouse Communications and Bright House Networks. Risks associated with Discovery include the challenging nature of the media business, where success requires accurately anticipating the fickle tastes of audiences, both in the U.S. and internationally. Discovery’s programming is heavily weighted toward non-fiction/documentary and reality style programming, which may not be as popular with audiences as scripted series. The development of original entertainment content, which is required for sustained growth, is also an expensive process. Production costs continue to grow in the mid- to high single-digit range, which could pressure margins. With the Scripps Networks acquisition comes integration risk. While Scripps cable networks are similar to Discovery’s in that they are primarily non-fiction based, Scripps’ lifestyle programming targeting women is very different from Discovery’s general audience and more male-oriented content. Discovery’s cable networks, like all producers of creative content, depend on cyclically sensitive advertising spending, which remains a major component of revenue. In addition, the 10 largest cable and satellite operators currently account for 90% of Discovery’s U.S. distribution revenue. Further consolidation among those firms would increase their already considerable bargaining power, which could impact Discovery’s revenues as old distribution agreements expire and new agreements are renegotiated. As the cable market changes with the rise of over-the-top or digitally distributed virtual multi-channel video distributors like Dish’s Sling, Sony’s PlayStation Vue, Hulu and many others, Discovery channels may not be chosen for premier channel packages (or at all), which could seriously impact distribution revenue. Discovery is also more exposed than many peers to European and developing markets due to its aggressive international expansion. These markets could be weaker in the case of Europe or more unstable in the case of emerging economies than the U.S. market, leading to more variable returns. Media audience fragmentation and the secular shift in advertising dollars away from broadcast television and toward digital platforms have magnified the above-mentioned risks. Unfavorable exchange rate movements may also significantly impact the company’s results. COMPANY DESCRIPTION Discovery operates more than 200 television channels, reaching 2.7 billion viewers in more than 220 countries. Its more well-known cable channel brands include the flagship Discovery Channel, TLC, Animal Planet, the joint venture Oprah Winfrey Network (OWN), and the Eurosport pan-European sports channels. Discovery’s channels primarily focus on nonfiction entertainment content. Legendary media investor John Malone effectively controls Discovery with 29% of the voting shares, though Advance/Newhouse Communications also retains a substantial 25% interest. Discovery acquired Scripps Networks on March 6, 2018. Discovery generates more than 50% of its revenue outside the U.S. VALUATION Our valuation methodology is multistage, including peer analysis, a multiple-analysis matrix applied to our proprietary forecasts, and discounted cash flow modeling. DISCA shares have traded between $16 and $28 over the past year, and are currently near the midpoint of that range. The shares are up about 1% year-to-date compared to a 4% increase for the S&P 500 and an 8% decline for the S&P 500 Media Index. DISCA is trading at a trailing EV/EBITDA multiple of 42, well above the peer median of 11. DISCA’s forward enterprise value/EBITDA multiple of 8.4 is 8% below the peer average, less than the 10% average discount over the past two years. We are maintaining our HOLD rating on DISCA. On June 7, HOLD-rated DISCA closed at $22.77, up $0.41. (Joseph Bonner, CFA, 6/7/18)

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