Discovery suffers from a gap between its 13 share of

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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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