Fitch Ratings has affirmed Discovery Communications LLC’s Long-Term Issuer Default Rating (IDR) at ‘BBB-‘ and Short-Term IDR at ‘F3’. The Ratings Outlook is Stable.
Discovery’s rating and Stable Outlook reflect Fitch’s expectation that the advertising environment will continue to strengthen during 2021, in line with stronger overall GDP expectations. Given Discovery’s heavy reliance on the advertising market, this should have a positive impact on operating performance and credit metrics. In addition, the company benefits from its leading market position among certain affinity groups due to strong niche brands and its popular and lower cost programming. Finally, Fitch expects Discovery to benefit from the rollout of its steaming service although it is expected to provide a drag on margins over the near-term.
KEY RATING DRIVERS
Improving Advertising Market: Advertising spending in 2020 experienced a significant pull-back followed by gradual improvement to mid-single digit declines during 2H20, in line with Fitch’s expectations. For 2021, Fitch expects the advertising environment will continue improving and show full year growth, roughly in line with existing U.S. and worldwide GDP expectations. The recovery’s trajectory remains highly uncertain, depending on the coronavirus pandemic’s duration. Advertising remains a critical component of Discovery’s business, comprising more than 50% of total revenues placing it near the top of its peer group.
2020 Operating Performance: For the FYE Dec. 31, 2020, Discovery underperformed Fitch’s expectations. While revenues were in line ($10,671 million actual versus Fitch’s $10,716 million estimate), EBITDA margins were below Fitch’s expectations as international underperformance offset U.S. outperformance. Debt levels were higher due to the company’s liability and liquidity management efforts. Liquidity management involved a precautionary revolver draw given the coronavirus’ unknown impact, which was later repaid with bond proceeds. As such, Fitch-calculated leverage was slightly higher than expected (3.9x actual versus 3.7x Fitch), although it remained within Fitch’s sensitivities and is expected to return to the mid-3x during 2021.
Solid FCF Generation: Despite lower than normal FCF margins in 2020 due to the coronavirus’ impact, Fitch anticipates FCF margins to return to the low-20% range over the rating horizon. This is driven by Discovery’s global distribution platform, high operating margins and low capital intensity typically associated with the MVPD programming business. Discovery’s program acquisition costs are significantly lower than most competitive programmers as non-scripted programming has much lower production costs and most of Discovery’s content is produced in-house. Fitch expects Discovery to grow annual FCF to $2.8 billion in 2024 from $2.0 billion in 2020.
Capital Allocation: Discovery’s internal investments focus on the production and acquisition of content for distribution over multiple platforms. Near-term internal investments will be heightened by infrastructure and content buildout requirements for discovery+, its direct-to-consumer (DTC) streaming platform. In 2H20, Discovery reinstated share buybacks after pausing in 1H20 to manage liquidity, given strong liquidity levels and FCF performance. Fitch expects Discovery to continue to use a meaningful portion of FCF for shareholder returns over the rating horizon.
Strong Niche Brands: Discovery focuses on intellectual property appealing to affinity groups, primarily science, discovery, crime, home and food. Performance is driven primarily by six strong core brands: Discovery (86 million U.S. subscribers as of YE 2020), Food Channel (87 million), HGTV (87 million), TLC (85 million), Animal Planet (84 million), Investigation Discovery (ID: 84 million) and Travel (83 million). It also offers additional brands with focused demographic appeal along with a stable of long-term international sports rights, including golf, cycling and the Olympics, capitalizing on its existing broad geographic presence.
Market Position and Leveragability: Discovery is the second-largest U.S. television company in terms of aggregate share and reach, including both linear and digital platforms, and the world’s No. 1 pay-TV company. Its suite of brands delivers almost 20% of all ad-supported linear U.S. aggregate television and nearly 25% of female viewers, with the top four female-skewing U.S. cable networks and an additional two in the top 10. Its content library, one of the world’s largest, includes approximately 60,000 hours of global streaming rights, which is growing by more than 8,000 hours annually.
DTC Content: Discovery launched discovery+ in the U.S. in January 2021 and started its global rollout in the U.K. and Ireland. The platform offers access to more than 55,000 library episodes and more than 50 exclusive original series. It offers a tier with no advertising and a lower priced tier with advertising and does not require an MVPD subscription. Discovery’s combined DTC offerings, including services offered with an MVPD subscription, grew from five million subs at Dec. 31, 2020 to more than 12 million currently. However, Discovery has not disclosed details of each services growth or clarity around the number of discovery+ subscribers provided through its Verizon Wireless relationship.
DTC offerings may prove to be critical components of content aggregators’ long-term viability as MVPDs continue shedding subscribers. Discovery’s late entry into a crowded field could hinder discovery+’s growth prospects based on viewers’ willingness and ability to subscribe to multiple services. In addition, Fitch views scale and content investment as prerequisites for a successful DTC platform, and several competitors are part of larger, better capitalized diversified conglomerates. However, Discovery’s leadership position in lower cost non-scripted programming across several focused affinity groups should prove to be a differentiating factor.
Discovery is well-positioned within its rating, and its leading position in reality-based and documentary programming experienced significant rating improvement during the quarantine period. However, it lacks the size and diversification of The Walt Disney Company (A-/ Negative), NBC Universal Media LLC (A-/Stable) and ViacomCBS Inc. (BBB/Stable), even following the Scripps acquisition. However, Fitch continues to view the acquisition positively as it improved Discovery’s operating metrics, broadened its highly curated and focused programming and solidified Discovery’s industry-leading position with female viewers. In terms of aggregate share and reach, Discovery is the second largest U.S. television company, including both broadcast and cable, and the world’s No. 1 pay-TV company.
–For revenues, in 2021 advertising revenues are expected to show high-single digit improvement as the company cycles through easy comps starting in 2Q21 as the company benefits from a continued recovery in the ad market, offsetting the significant 2Q20 revenue decline. Fitch expects the moderation in sequential revenue declines that began in 3Q20 will continue and revenue growth is expected to turn positive in 2Q21. Distribution revenue growth is expected to ramp up in the US due to contractual distribution fee growth and discovery+ subscriber growth starting in 2021. International distribution growth will lag the US due to discovery+’s slow rollout. Thereafter, Fitch expects revenues to quickly return to low to mid-single digit growth, in line with historical sector performance.
–Margins are expected to decline into 2022 due to discovery+ investment and Olympics continent spending. Margins begin to recover in 2023 due to discovery+’s increasing scale and the top line improvement.
–Capex intensity remains elevated into 2022 as the company finishes its global digital platform buildout and returns to the low 3% thereafter.
–Fitch-calculated FCF Is roughly flat over the near term then grows to $2.8 billion by 2024.
–Tuck-in M&A over the rating horizon.
–Near-term debt maturities are funded with cash on hand than debt issuance long term.
–Discovery returns capital to shareholders using FCF and its significant cash balances.
–Leverage declines to below 3.0x over the rating horizon.
Factors that could, individually or collectively, lead to positive rating action/upgrade:
–Fitch-calculated total leverage (total debt with equity credit/operating EBITDA) sustained below 3.0x.
–A Fitch-calculated cash flow ratio (cash from operations minus capex/total debt with equity credit) sustained above 20%.
–Material viewership on new platform launches that will drive increased advertising and affiliate/subscription fees and enhance revenue diversity.
Factors that could, individually or collectively, lead to negative rating action/downgrade:
–A more aggressive financial policy with gross leverage exceeding 4.0x.
–A Fitch-calculated cash flow ratio sustained below 12.5%.
–Meaningful customer defections to alternative viewing platforms.
–FCF pressure from higher programming costs.
BEST/WORST CASE RATING SCENARIO
International scale credit ratings of Non-Financial Corporate issuers have a best-case rating upgrade scenario (defined as the 99th percentile of rating transitions, measured in a positive direction) of three notches over a three-year rating horizon; and a worst-case rating downgrade scenario (defined as the 99th percentile of rating transitions, measured in a negative direction) of four notches over three years. The complete span of best- and worst-case scenario credit ratings for all rating categories ranges from ‘AAA’ to ‘D’. Best- and worst-case scenario credit ratings are based on historical performance. For more information about the methodology used to determine sector-specific best- and worst-case scenario credit ratings, visit https://www.fitchratings.com/site/re/10111579.
LIQUIDITY AND DEBT STRUCTURE
Adequate Liquidity: As of Dec. 31, 2020, the company had cash of $1.9 billion, net of $161 million held in foreign subsidiaries. Discovery also had full availability under its $2.5 billion unsecured revolver that matures in August 2022, with two 364-day extensions. Fitch excludes Discovery’s $1.5 billion CP program (full availability) given the overlap with revolver availability. Finally, Fitch expects the company to generate more than $2.5 billion of annual FCF over the rating horizon.
Fitch notes Discovery issued approximately $3.7 billion of senior unsecured notes in 2020 as part of liability management efforts. Net proceeds of their May 2020 issuance were used to repurchase $1.5 billion of existing unsecured notes maturing in 2021-2023 and to repay $500 million of revolver outstandings resulting from a March 2020 precautionary revolver draw given the coronavirus’ unknown impact. In September 2020, Discovery issued $1.7 billion of senior secured notes to exchange four series of existing notes maturing between 2037 and 2043.
Fitch also notes that on April 30, 2020, the company amended its credit agreement to provide additional headroom under the leverage covenant through Sept. 30, 2021, when it returns to its prior 4.5x. As of Dec. 30, 2020, Discovery was in compliance with all of its covenants, but did not disclose actual levels. Fitch views the amendment positively as it provides additional flexibility given the significant uncertainty regarding potential negative effects of the coronavirus pandemic. Fitch takes further comfort when this action is viewed in conjunction with the company’s comments regarding maintaining their investment grade ratings.
Discovery’s maturities are well laddered. On March 21, 2021, the company redeemed in full its $335 million June 2021 maturity. The remaining near-term maturity profile includes $599 million in 2022, $988 million in fiscal 2023 and $1.5 billion due in 2024. In addition, the company has redeemable equity balances with put rights of $383 million that may result in a use of cash if the noncontrolling interest holders put their interests to Discovery, although Fitch assigns a low near-term probability of this scenario.
REFERENCES FOR SUBSTANTIALLY MATERIAL SOURCE CITED AS KEY DRIVER OF RATING
The principal sources of information used in the analysis are described in the Applicable Criteria.
Unless otherwise disclosed in this section, the highest level of ESG credit relevance is a score of ‘3’. This means ESG issues are credit-neutral or have only a minimal credit impact on the entity, either due to their nature or the way in which they are being managed by the entity. Fitch Ratings