Warner Bros. Discovery, Inc.
Q1 2013 Earnings Call Transcript

Published: 7 May 2013

Operator:

Good day, ladies and gentlemen and welcome to the Q1 2013 Discovery Communications Incorporated earnings conference call. My name is Alice and I will be your operator for today. At this time all participants are in listen-only mode. We will conduct a question-and-answer session towards the end of this conference. (Operator Instructions) As a reminder this call is being recorded for replay purposes. I would now like to turn the call over to Mr. Craig Felenstein, Executive Vice President of Investor Relations. Please proceed, sir.
Craig Felenstein:

Good morning everyone. Thank you for joining us for Discovery Communications 2013 first quarter earnings call. Joining me today is David Zaslav, our President and Chief Executive Officer, and Andy Warren, our Chief Financial Officer. You should have received our earnings release, but if not feel free to access it on our website at www.discoverycommunications.com. On today's call we will begin with some opening comments from David and Andy after which we will open the call up to your questions. We urge you to please keep to one or two questions so we can accommodate as many folks as possible. Before we start, I would like to remind you that comments today regarding the company's future business plans, prospects and financial performance are forward-looking statements that we make pursuant to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These statements are made based on management's current knowledge and assumptions about future events and they involve risks and uncertainties that could cause actual results to differ materially from our expectations. In providing projections and other forward-looking statements, the company disclaims any intent or obligation to update them. For additional information on important factors that could affect these expectations, please see our annual report for the year ended December 31, 2012 and our subsequent filings made with the U.S. Securities and Exchange Commission. And with that, I would like to turn the call over to David.
David Zaslav:

Thank you, Craig. Good morning everyone and thank you for joining us. Discovery is off to another great start in 2013, building on the sustained operating momentum we generated across our balanced portfolio throughout 2012. Our unwavering belief that investing in high quality content with real stakes, superior story-telling and compelling characters is paramount to long-term value creation, continues to pay off. To larger audiences we are delivering around the world are translating into significant advertising gains, while at the same time the appeal of our content is providing additional opportunities to capitalize on or diverse distribution platform and the further evolution of the global pay television market. As we focus on capturing market share and maximizing the full organic growth potential inherent in our asset portfolio, we are also beginning to dig into the operations of our recent acquisitions so we can create additional value and further strengthen our long-term sustainable growth profile. With our strong market share growth and the recent acquisitions, we now reach more than 2 billion subscribers, up from 1.8 billion last year. Before I turn the call over to Andy so he can take you through our financial results, let me take a few minutes to discuss a few of the initiatives driving our strong organic growth, as well as some of the opportunities we expect to focus on as we integrate our newly acquired businesses. I mentioned on our year-end call that we have delivered four consecutive years of viewership growth across our domestic portfolio, and that momentum has certainly continued into 2013 as we delivered the best first quarter in the company's history. Viewership across our U.S. networks was up 3% this past quarter among key adult 25 to 54 demo led by the growth at our flagship network, The Discovery Channel. Discovery built upon its record fourth quarter with 10% growth in Q1, led by Gold Rush, Bering Sea Gold and Yukon Men, all of which contributed to Discovery's number one ranking on Friday nights in the quarter outpacing even the broadcast networks. Several of our other networks also delivered meaningful growth this past quarter, including Animal Planet which increased its audience another 6%, building upon the 17% growth they generated in 2012 and making it a top 20 network for men in the U.S. In fact Animal Planet has now delivered 16 consecutive months of growth. Amongst its key demo and with returning hits like River Monsters, capturing more viewers than it did a year ago, the network is poised for continued success. Two of our recently rebranded networks are also continuing to show real audience gains. Destination America is quickly becoming a lifestyle destination for viewers with double-digit growth this past quarter, following its 35% growth in 2012. And Velocity, while in only 45 million homes, grew its viewership by over 50% year-on-year, delivering a highly coveted upscale audience to our advertisers. Driving the potential of our valuable distribution real estate by investing in new brands and breaking new ground that ignites viewers' curiosity, remains a priority and we will continue to invest incrementally in these new networks if they demonstrate the ability to attract larger audiences and deliver real value to our advertisers. Similarly, our domestic joint ventures are also continuing to develop their audiences. The Hub was up over 50% this past quarter among kids two to 11 for total day. Separately, OWN viewership was up 3% in its key women 25 to 54 demo despite the difficult comparisons to a year ago, which included the highest viewed program in the network's history, Oprah's interview with Whitney Houston's daughter. OWN's viewership momentum ratcheted up again in April as viewership grew 9% led by returning favorite, Iyanla
Andrew Warren:

Thanks, David, and thank you everyone for joining us today. Has David mentioned, Discovery is off to a great start to the year building upon the strong results we delivered throughout 2012 as we leverage both the large audiences that we are generating around the global, as well as our increasing international subscriber base. On reported basis, total company revenue in the first quarter increased 7%, led by 17% international growth and 1% domestic growth. Note that domestically, the prior year included $45 million of additional licensing revenue primarily related to our licensing deals with Amazon. Excluding licensing revenue and the impact of foreign currency, the total company revenue growth was 12% with double-digit gains in both advertising and affiliate revenue. Total operating expenses on reported basis increased 14% primarily due to higher content amortization that we have previously discussed. The current quarter also included a one time compensation expense as well as additional deal related costs associated with our acquisition of the SBS Nordic business. Eliminating $8 million of licensing cost in the prior year and the impact from foreign currency movements, total company expenses increased 13% versus the first quarter of last year. Importantly, given the higher content amortization and the timing of anticipated marketing spend, it is expected that operating expense growth excluding the impact of wholly owned acquisitions will remain in the mid-teen range for the next two quarters before meaningfully abating in Q4. On a reported basis, adjusted OIBDA in the first quarter declined slightly, but excluding the licensing agreements and the impact of foreign exchange, Discovery's continued ability to generate revenue growth in excess of expenses translated into an 8% increase in adjusted OIBDA for the quarter. Net income from continuing operations increased to $231 million in the first quarter driven by the strong operating performance, as well as a $92 million gain associated with raising our ownership interest in Discovery Japan to 80%. The quarter also included $46 million of higher equity earnings, primarily due to significantly improved results at OWN. These items were partially offset by $59 million of losses associated with foreign exchange contracts implemented to hedge the purchase of SBS Nordic, $21 million of higher mark-to-market equity-based compensation due to the increase in the stock price, and $26 million of higher tax expense. As I mentioned last quarter, we are in the process of restructuring our international operations to ultimately lower our effective tax rate over time. For the current year, we still anticipate an ETR of around 38%. Free cash flow decreased to $105 million in the first quarter primarily due to higher content investment, as well as increased equity compensation payments and the timing of cash taxes. The programming spend continues to pay off in terms of ratings momentum and higher advertising revenue, but we still anticipate content spend growth to slow down considerably for the full year which should contribute to significant free cash flow growth for 2013. Turning now to the operating units. The U.S. networks continued to perform well during the first quarter. On a reported basis, total domestic revenue increased only 1%, as 8% advertising revenue growth from viewership gains across our portfolio and a favorable ad sales pricing and demand environment were partially offset by 9% lower affiliate revenue due to the additional $45 million of licensing revenue in last year's first quarter that we spoke about earlier. Excluding licensing revenue, total domestic revenue improved 8% versus a year ago with affiliate revenue increasing 6% due to higher rates and to a lesser extent, additional digital subscribers. It is important to note, that our licensing revenues were down in the first quarter. We do anticipate a meaningful increase in either the second or third quarters due to the third year of the Netflix agreement. Current ad market trends continue to be encouraging with double-digit scatter pricing above the gains that we garnered during last year's upfront negotiations. We have some nice ratings momentum across many of our networks. With the healthy macro environment continuing, we anticipate continued high single-digit ad growth in the second quarter of 2013. Turning to the cost side. Domestic operating expenses were up 8% from the first quarter of 2012, which included $8 million of additional costs associated with digital licensing agreements. Excluding these costs, operating expenses increased 11% compared to a year ago, primarily due to the expected higher content amortization associated with the increased programming cash spend over the past two years. On a reported basis, domestic adjusted OIBDA declined 5% versus last year's first quarter but excluding the impact of licensing agreements, adjusted OIBDA increased 6% year-on-year. Turning now to our international operations. We continued to deliver strong momentum across our global operations with reported revenues expanding 17%, led by 23% ad and 15% affiliate growth. Excluding the impact of exchange rates as well as additional advertising sales from the acquisitions of wholly-owned businesses, total revenue growth was 16% with advertising and affiliate revenues increasing 17% and 15%, respectively. The advertising revenue growth was broad based with double-digit growth across nearly every region led by Western Europe, mainly from the continued success of several of our free to air initiatives, particularly in Italy and Spain. On the affiliate front, the revenue increase was driven by subscriber growth, especially in Latin America, from the continued growth in Brazil and Mexico as well as from the consolidation of Discovery Japan. Operating cost internationally were up 24% on a reported basis. Excluding costs from the acquisitions of wholly-owned businesses and the impact of foreign exchange, operating expense growth was up 17%, primarily driven by the anticipated increase in content amortization as well as from the consolidation of Discovery Japan. Our international segment delivered 13% adjusted OIBDA growth in the first quarter, excluding foreign currency and the impact of acquiring wholly-owned businesses, as our international team continued to generate strong revenue increases while thoughtfully investing in key growth initiatives. Before we look forward to the remainder of 2013, I do want to mention that the first quarter also included a couple of one time corporate costs related to compensation and the SBS transaction which we closed at the beginning of April this year. Turning to the full year. We are encouraged by the sustained momentum across the portfolio and the continued strong ad sales pricing and demand environment in many of our key markets. As a result, we are leaving our guidance unchanged despite the SBS transaction closing about one-month later than originally planned. For the full year 2013, we still expect total revenues to be between $5.575 billion and $5.7 billion, adjusted OIBDA between $2.425 billion and $2.525 billion, and net income between $1.2 billion and $1.3 billion. Given the delayed timing of the SBS close, it is now less likely that we will be towards the top end of these ranges but given the momentum across our businesses, these ranges remain possible outcomes. We do anticipate narrowing these guidance ranges on our second quarter earnings call. Turing to our financial position. With a strong balance sheet and continued financial and operating momentum, we remain committed to further building our core businesses so that we can drive additional long-term growth and enhance shareholder returns, be it through investing in existing networks and platforms or through exploring external initiatives. While that is our first priority, given the strong free cash flow that we are generating, our gross leverage targets and our long-range free cash flow per share growth assumptions, we have the unique opportunity to both continue returning capital to shareholders and also investing in our businesses. As previously discussed, given the capital needs associated with the timing on closing the SBS transaction, we did not begin buying back shares this year into the second quarter but we still anticipate returning similar amounts of capital to shareholders through buybacks in 2013 that we did in 2012. Our buyback activity during the second quarter includes $256 million of preferred stocks associated with the Advance/Newhouse transaction that we announced last quarter, which is part of the total anticipated share repurchases this year but was not done under the existing $4 billion authorized share repurchase plan. Since we began buying back shares towards the end of 2010, we have spent over $3 billion buying back shares reducing the outstanding share count by over 78 million shares or 18%. Thanks again for your time this morning. Now, Dave and I will be happy to answer any questions that you may have.
Operator:

(Operator Instructions) And your first question comes from the line of David Bank of RBC Capital Markets. Please proceed.
David Bank:

Two questions. I guess the first is, under the category of, no good deed goes unpunished, 8% ad revenue growth is obviously really strong but when you think about the pricing you achieved in the upfront, the pricing in the scatter market, the ratings momentum you've achieved, I'm kind of curious like what are the other factors that are sort of arguably maybe holding back that ad revenue from being a little bit stronger given all those factors. And the second question is, I guess more for Andy, can you just clarify the impact of the Japan consolidation on both the revenue and expenses in the international (inaudible)? Thanks.
David Zaslav:

Great. Thanks, David. Well, we delivered a little over 8% this quarter which we felt very good about. We had market share growth of 3%. The market was strong. It was up about 20% from the upfront. But we also began seeding a number of our new networks with advertisers. And we still have a ways to go in terms of bringing up the CPM on some channels like Animal Planet, that's now a top 20 channel for men, ID, that's the number nine channel in America and continues to grow. So we'll continue to get some additional growth out of that. This quarter continues to look strong, maybe even a little bit stronger than last quarter in terms of pricing. So if we continue to grow our market share, I think you'll see us in the high-single low-double in domestic.
Andrew Warren:

Okay. David, just to add to that, just remember, last year U.S. ad sales were up 13%. So on a two-year basis, it's tremendous year-over-year growth. And to get to your question about Japan, we're not actually separating or splitting that out separately or quantifying it, because it is a business we were in before with 50% investment and we only increased that to 80%. So on a very bottom line basis, it's a fairly de minimis impact. But broadly speaking, as far as the impact on revenue and expenses, for the whole company it's less than one point. So I'd just give you a sense of its size. It's relatively insignificant on a total company basis.
David Bank:

Okay. So you wouldn’t say it really impacted international operations then? Is that…?
Andrew Warren:

Well, it is consolidated within those numbers but the impact is fairly small. As I said, it's really less than one point for the total company on both revenue, expense, and profit.
Operator:

Thank you. And your next question comes from the line of Todd Juenger of Sanford Bernstein. Please go ahead.
Todd Juenger:

If I could follow up just a little bit back to domestic ad growth, I know you don't -- and I am not expecting that you would disclose anything sort of at a network level. But I wonder if you just would share any comments about sort of the difference between, what I'd call the flagship network versus your digital tier network? A lot of the ratings growth, as you pointed out, is coming from the digital tier networks. We know they have lower CPMs. I was just wondering, when you think about their whole growth of 8%, would you be willing to characterize sort of, were the mid-tier networks growing faster than that and the flagship network is growing slower? Or any way you can help us decompose how we think about the growth rates of those different lifecycles of networks? Thanks.
David Zaslav:

Sure, thanks Todd. First, Discovery had a good quarter. It was up about 10%, which was very strong with a lot of new series, and Discovery is mostly male and we were able to take advantage of that. TLC was down about 1% or essentially flat. The industry itself was down 2%. So TLC did a little bit better than the industry but we had less premiers in the first quarter. We're coming back with Long Island Medium, we’re coming back with Breaking Amish. In the summer Honey Boo Boo will come in. So, I think that we expect that we'll see a little bit more momentum on the women's side with TLC. I think that would have helped us. The broadcasters were down significantly in prime and in daytime, and that put a little bit of a squeeze on the women's side. And so we were able to take advantage of that with TLC, but not as much as we would have liked to and we’re hoping to in this next quarter. ID continued to grow because of that. And when you say digital networks, we have TLC and Discovery that are fully distributed, but we also have Animal Planet that's fully distributed. And Animal Planet now is a top 20 network. It's going to take us some time in order to get our CPM up but we’re getting double growth there. It's growing significantly, but also our CPM is growing. So that is a fully distributed network. And when you say digital, we now have ID in over 80 million homes. So 80 million homes, the number nine network in America, number six network in daytime, number five in late night, yet we're still not getting the full premium for that. So those would be, what I would call our big networks, with Animal Planet and ID providing some meaningful growth no matter what over the next couple of years. And then the smaller networks, we call them emerging because they’re continuing to be very fast growing. But Destination America, Velocity, those do have lower CPMs. And when I said we're seeding, we're trying to get advertisers into them so they could feel the value of being on those platforms. They could see that we can put up some very strong ratings when we have original content and that once we get them hooked into those channels, we'll be able to drive the CPM on that. So I can't really break it out except to say that I think if we can drive a little bit more of our female demo in the next six months, given where a lot of the viewership and advertisers are looking for female, we could maybe even over index more.
Todd Juenger:

That’s very helpful. A quick follow-up if you don't mind. Back on the emerging network, in terms of distribution growth there has been a lot of focus on affiliate fees and reset of your negotiations, all that. What is the opportunity there? You've got ratings up strongly at a lot of these emerging networks. You've invested a lot to rebrand a few of them. How real is the opportunity to grow the distribution further, some of those that are in 40, 50, 60 million homes? Thanks.
David Zaslav:

Well, we redid only a few of our deals this year. We've talked about the fact that they feather in over the next five years. This year was less than 20%, a little bit more than 10%. So it was a lesser percentage, but we were able to get higher increases. In those deals we were able to get more distribution for Science, more distribution for Destination America, more distribution for Military. So when we can pick up higher fees and get more distribution, that's a formula that works very well for us because we get the guaranteed revenue on that extra distribution, but also three of the fastest-growing cable networks in America over the last three years has been ID which has gone from 50 to over 80. Science which went from 45 to over 72 and Velocity continues to grow aggressively. So if we can get the per sub fees on that, then not only do we get the guaranteed economics, we get the asset value and the ability to get advertising. So we will be looking for that in addition to the very simple, what is our actual CAGR on our total sub fee base.
Operator:

Thank you. And your next question comes from the line of Doug Mitchelson of Deutsche Bank. Please proceed.
Doug Mitchelson:

I am trying to get to that CAGR on your total sub base, so I wanted to make sure I had the math correct on the domestic affiliate rules. In the fourth quarter, you had $288 million of domestic affiliate revenue and in the first quarter you had $308 million. So that’s $20 million of growth in 1Q versus 4Q, so that's 6.9%. And in theory your sub base between the two quarters should have been relatively similar and that should have been mostly price. So am I thinking about that right? Did your renewals drive that kind of price acceleration or was there something unusual on either one of those quarters that hampers the comparisons?
David Zaslav:

Well, our renewals as I said is, we did very well but in terms of the percentage it would bring it up. It wouldn't bring it up dramatically because in terms of the scale of deals that we did. The number of subs that were not that significant. There would also be in there, Doug, some additional digital. We have deals where every time the digital box is deployed, every operator has to carry every one of our channels and has to pay us on those channels. But that's been true every quarter and we, to your point, we really haven't seen any better sub growth this quarter than we've seen last, in fact it's pretty flat. So kind of agree with you.
Doug Mitchelson:

And then on the, there is a little bit of a lag, right? When you cut a new deal with your distributors and you improve the distribution of some of your digital channels by moving them to more broadly distributed tiers, maybe the Nielsen data lags, but we sort of show some of that take up happening in April versus the year-end deal timing. Is that right or is the Nielsen data just lag in to the take up to immediate?
David Zaslav:

I think there is a little lag but the deals don't necessarily mean that we close the deal at the end of December and they have to launch January 1. In fact, they can't. There is a 60-day requirement that's pretty standard under the franchise rules, where they have to notify customers of what's coming. So the actual launch of more subscribers for our channels would've happened at the very earliest 60 days afterward and sometimes it's really just a commitment to launch the channels during the year for a longer -- when deals are four or five years long. So you'll see it coming in.
Doug Mitchelson:

So there could be a little bit of tail to this, because I know relative to the international growth you're seeing we're sort of parsing basis points, but we are still curious. Thanks very much.
Operator:

And your next question comes from the line of Ben Swinburne of Morgan Stanley. Please proceed.
Ben Swinburne:

I just have one sort of housekeeping for Andy then a question for David. Andy, the net income guidance, that includes all of the below the line stuff this quarter, all the good and the bad guys, right?
Andrew Warren:

Correct.
Ben Swinburne:

Okay. Great. David, just picking up on this advertising theme. You've been in the broadcast replacement game for a long time taking share from the networks and I'd imagine you think that there's a lot left to do there, so I'd be curious on that first topic. But then when you think about online video, do you see any analogy in online video whether it's YouTube or some of the assets you've acquired, and television to what the cable business was facing 20 years ago looking at broadcast. How real of a threat or an opportunity do you view online video as an advertising business over the next, say, three to five years?
David Zaslav:

Thanks, Ben. Okay, on the CPM, the CPM differential between broadcast and cable remains a little over 30%, and that's really good news for us. In the U.S. market where our subscribers are flat and viewership on cable is flat, that provides real win that are back, and that applies to all of us. In particular, if we can grow market share and continue to push on CPM. And the story on compressing that CPM I think is getting stronger because the rating points that we're able to deliver not just us, like on a Friday night where we're the number one networking beating the broadcasters, on OWN when Oprah can put on content. She is the number one network for African-American women beating all the broadcasters. Those stories are -- we have a huge number of those stories where five or six years ago that didn't exist. The scale of viewership on cable is higher. The demo of viewership on cable is stronger. And so I think it's going to take time, probably three or four years. It will never be even, but we'll get that pickup and that I think will continue to be a benefit for the U.S. business. On the online side, the CPM's that we're getting on streaming video on the web are quite high. And we've actually been shifting aggressively away from the page view and the unique approach that many of us in this business took. So we had aggregated over 60 million uniques with a gazillion page views. But with Google and Facebook out there, it kind of really commoditized in some ways the ability to sell on those pages and we still do it, but the prices are not rising. If anything, they are going down. And so we have really pivoted aggressively towards streaming. We bought a company called Revision3. It's the number one non-fiction streaming company in the world. They were doing about 150 million streams a month when we bought them. They are now 300 million streams. JB Perrette, who runs our business, has been pushing our streaming business across every one of our brands. We launched 12 live streaming channels of live Puppy Cams, and the young animals on Animal Planet about six weeks ago and they are doing very well. So, our number one focus in terms of the digital business right now is on the streaming side because the CPMs are quite strong. Having said that, it's not clear where it's going to go. So, we're playing in this space. We want to learn everything about it. We want to continue to look at consumer behavior, but it's confusing right now. People are still watching more TV than they ever have. We're able to grow market share in the U.S. pretty significantly over the last couple of years, including this past quarter where we are up 3%, last year where we were up 8%. Outside the U.S. we're growing market share dramatically. And so, we are really playing both ends. Let's do a great job of telling stories and building characters and building our brands and let's assume nothing is going on, and then let's have an aggressive team taking our content and our characters on the web and also through Rev3 doing content a different way. And I think it's going to be a couple of years before we really see what happens.
Operator:

Thank you. And your next question comes from the line of Michael Nathanson of Nomura. Please proceed.
Michael Nathanson:

One for David and one for Andy. David, if I may ask a question, when you look at what Netflix has done with agreement with A&E, kind of they couldn't come to agreement with A&E a while ago, and then Viacom, they kind of changed their mind in talking about shows rather an output deal. I wonder how you are thinking about your relationship with Netflix and how should we think about what’s going to happen when it expires. So just your view on that.
David Zaslav:

Okay. Thanks, Michael. When you step back, and I've said this before, but as we look at all the people that are knocking on our door now for content, for the next couple of years I think there has never been a better time to be in this business than right now. We own all of our content, which makes us somewhat unique. Our content works around the world which makes us unique. And there's more people that want it for more windows. So in the window you're talking about, we got Amazon, we got Netflix, we're stronger now I think, because five years ago we had 4% of the viewership on cable. Today we have 10%. We have brands that are stronger. We have a lot of good content. We're going to take our third year option on Netflix because we've seen no degradation in audience. And that’s, I think, a significant incremental margin for us with Amazon and with Netflix because they are buying content that's mostly 18 months and older. Some of it two, three, four years old. Our relationship is good. They like our content. We like this window. Our deal doesn't come up for almost another year and a half. When it does come up with Amazon and with Netflix, we think we'll do well as long as we have a lot of really good content that people like, and we also have a big bulk of it. In the end, they still need to nourish people, the idea that (inaudible) said to me a number of times is, they don’t have everything, but when people go there they'll find something good. And we have a lot of good stuff. So I think we'll do well, Michael. In addition, we now have a lot of the cable operators here in the U.S. and BSkyB just launched their SVOD platform, and that's good for us. So you have LOVEFiLM, you have Netflix, and now you have Jeremy Darroch launching his own SVOD platform in the U.K. There is a good chance that's going to happen here. We are talking with lot of operators. So that's a positive. And then we have TV Everywhere which is a tighter window, which we haven't done deals yet but we think we can get significant incremental value for that.
Michael Nathanson:

Okay. Let me just [triangulate] for one second. You mentioned success in Spain and Italy on the broadcast side, which is pretty amazing given how tough those markets are going on broadcast advertising. So can you talk a little bit about what's the sales pitch, how you gain those dollars? Is it a pricing led strategy, is it just the low base you are growing from? So anything more on Spain and Italy will be helpful.
David Zaslav:

Okay. Well, our model when we say free to air is really different than a traditional broadcast model, because we own all of our content. When we went into Spain, our cost of content is almost zero. We have the content, we have it in language, so we essentially buy a stick and we can put programming on there and we're able to gain market share. In Italy -- and by the way, Michael, we've now reached a point where we've lapped almost all of our free to air channels. So the growth that you're seeing is pretty pure. In addition, Italy, we're just finding that our content is working fantastic. And the experience we're having there, that's the reason that we went into Spain where it's very strong. It's the reason that we're finding additional growth in Germany. This model of taking male content and putting it out on a male channel, taking female content and putting it on a female channel, and the amount of content that we have to put into those two baskets. In Italy, our market share was up 70% with our two channels and that's without switchover. And with switchover now, we're the number three player in Italy, so second only to Rai and Mediaset. So we're also getting scale which will help us with our pricing.
Operator:

Thank you. And your next question comes from Jessica Reif Cohen, Bank of America Merrill Lynch. Please proceed.
Jessica Reif Cohen:

I have a couple of questions on the international side. First, on the businesses outside the U.S., what is your channel share versus the audience share? Is there a way for us to think about how your current portfolio is positioned, whether you are over-indexed or under-indexed, and how much room is there to add channels? So that's the first question.
David Zaslav:

Okay. First, I think that we're in the beginning stages of trying to take advantage of the fact that we have between six and 14 channels in 220 countries. So, we're clearly the number one platform media company in the world and our challenge domestically and internationally was to take advantage of that. We've done a good job here in the U.S., but we have a long way to go. I think you'll see a lot of growth from us here in the U.S. because we have 14 channels and we only have about 10% share. Outside the U.S., the story is even stronger. We were able to light up TLC around the world, reaching over 300 million homes in a year and a half. And the growth that we're seeing on TLC around the world continues to be significant. ID, we're rolling out. So we're beginning to take advantage of our channels, Jessica, and I think you're going to see meaningful market share growth. We had 25% market share growth in the fourth quarter, we had 16% market share growth in the first quarter. But I guess to step back, when I look at our international business, it's probably the biggest growth engine and the most compelling story that we have, and right now we're hitting on all cylinders in a real sustainable fashion. So looking at this past quarter, subs were up 12%, market share up 16%, ad sales up 25%, and affiliate revenue up 15%. So, you got all those hours up. At the same time when you look at the 220 countries that we're serving locally, more than two-thirds of those countries are either in recession or flat, and on top of that we have invested in TLC, ID, taking Kids into Asia, launching new broadcast channels, and when you digest all that investment and the fact that more than two-thirds of the countries are in recession, we're showing 17% growth and 25% advertising growth and we're growing share. And so what's most striking to me is we have a sustainable model where we can grow between 15% and 20% when we're dealing in markets that are mostly flat or down. And that’s the market condition we're expecting. And with our local teams one of the things that you've seen is the cost increase, it's because we're putting -- we put local ad sales teams into Colombia, we put our local ad sales team into Italy. That more investment that we think will pay off with more sustainable growth. The kicker here is, if over the next couple of years things stay exactly the way they are or even if they get a little worse, we think we could show double-digit or certainly sustainable growth the way that you've seen in the last two quarters for us. The wildcard is, which we're not expecting, is if the marketplace turns, if Western Europe starts to pick up, if a lot of these countries that are flat or in recession turn and we have been growing 15%, 17%, 18%, that's going to be the real fuel for extraordinary growth for us. Because we're gaining market share, we got more channels, we got local teams on the ground and we're growing aggressively in markets that are not good. So to me that is really, that's our game.
Jessica Reif Cohen:

Okay. And then actually I have a follow-up to one of your comments David on SBS. Can you give us any more color on the cost and revenue synergies? Where do you think these margins for the SBS properties can go over time relative to your core international businesses?
David Zaslav:

Specifically, we certainly have cost synergy because we've been in business there for 20 years, we were over there last week. We have different sets of offices, we're looking at people, we’re looking at delivery. So there will be some meaningful cost synergy. But also, we now have over 40% market share in Norway with significant broadcast asset, cable assets. So the power ratio of SBS in terms of advertising was a lot higher than our power ratio. So there'll be some revenue synergy in terms of advertising and we expect that when we go to market together that there should be real opportunity on the affiliate site. And we're already seeing that there is going to be in addition to that, when you take Eurosport and you lay Eurosport on top of our opportunity universe in those four markets, we even have more whether it's how we sell, whether it's how we bid on content. So we feel like there will be a step back in margins this year as we digest this, but we're very happy with what we saw. It's a great management team, the business is performing very well. It didn't close as quickly as we would have liked, but we are off and running and we're running hard.
Andrew Warren:

Just to add to that, Jessica, even though we only closed SBS a month ago and Eurosport now four months ago, in both cases in the early stages here, we're very happy of what we see the opportunities for, both revenue and cost synergies. Both are at least at or above our deal expectations. So the early signs are very positive.
Operator:

Thank you. And your next question comes from the Richard Greenfield of BTIG. Please proceed.
Richard Greenfield:

I really wanted to follow-up on Jessica's question in terms of, not specifically SBS margins, but just the overall international margin. I mean, you were at 45% last year, if it wasn't for Discovery Japan, I assume you would have been down in the 40% range versus the 41% you reported. Just trying to understand as you look out over the next, call it several years, if you took a three to four year view, that 40%ish margin is 1,500 basis points behind where your U.S. margin is currently. How do you think about where international margins should be as you get to the scale that you're going to have following this acquisition? I mean is this 40 to 50 over a four or five year timeframe? Like, how do you think about the overall opportunity relative to where your U.S. business runs?
Andrew Warren:

Yeah, Richard, it's Andy. It's a good question. We knew going into this year that SBS, and we stated this, will be about a 500 basis point dilution to the overall international margin. That plus the content amortization catch up as well. But now that we have a new baseline that we're going to work off of given the conversation around synergies, given the conversation around infrastructure, is largely in place in international. As Dave mentioned, we have feet on the ground now in over 50 countries adding to the sales teams in Colombia and Italy etcetera. So we now think we can get a lot higher percent of profit flow through for every incremental dollar, especially as the percent of ad sales becomes higher and higher. So we feel very confident that from this now lower base we've established with the content (inaudible) with SBS, we can meaningfully grow margin in 2014 and beyond. It's a huge focus of the international team.
David Zaslav:

The other thing that you'll see is the situation that we're having with Animal Planet and with ID, and that we had with TLC a few years ago, as the channels start to grow you have to get on the media planners budget, and you don't get on at a very high rate. You have to build yourself up. And so we’ve launched a lot of new channels and we've grown a lot of market share outside the U.S. We now have local teams on the ground and we're seeing meaningful growth. You saw 25% ad growth, but it's even going to get higher because a lot of the channels that we're selling, they are early stage. We're getting good market share but our ability to drive price will be something that will take over the next three to four years for us to get full value for.
Richard Greenfield:

And in terms of the programming spend overseas to get there? In terms of how that impacts the margin?
David Zaslav:

Well, the programming spend that we have right now, it's pretty steady. The good news for us is, when it comes to Science and Animal Planet and ID, ID in particular is working really well. We didn't know that it would work the way Animal Planet and Science has worked in terms of taking almost very little local content and just using existing content that we have with sort of a global approach. TLC does have a meaningful amount of local, but you see it in the numbers. It is less than we thought. We thought it was going to be about 40% share and it's more at about 60% share. It will probably stay about where it is right now. So overall I think you'll see -- we don’t expect that we're going to have to invest significantly more. It's about where it is now.
Operator:

Thank you. And your next question comes from the John Janedis of UBS. Please proceed.
John Janedis:

David, historically, you’ve talked about Discovery being synonymous with non-fiction programming. I'm just wondering, with the introduction of some scripted fare at the upfront, what was the driver? Does that give you an incremental opportunity to monetize the audience and should we expect more if we get the ratings?
David Zaslav:

Look, our ratings are up at Discovery and we're having a lot of momentum. It's important for us to be open to what do the viewers want and how do we continue to nourish them. That's what this business is all about. People only watch eight to ten channels. The fact that our share was up 8% last year and 3%, it means they are spending more time with our channels and you have to earn that. Fiction, we've seen in the marketplace that viewers have really related to fiction on occasion on non-fiction channels. We've been very successful with Alaska and with Gold on Discovery. We are the number one show with Gold Rush. Then Bering Sea Gold has been very successful for us, Last Frontier in Alaska. So for us to do Klondike on Discovery, we thought was a good first swing at the fiction which is a lot more expensive, to see if we do something in our wheelhouse and we get behind it, will the Discovery audience, will they love it, will they mean into it, will they feel like that makes them feel closer to Discovery. And we're going to have to see. It's an experiment. I think it's going to do very well. But it’s a very small piece of our overall strategy. It's much more expensive. It doesn't repeat as well, and so for us it's a big tent pole. You might see us using scripted if this works as a tent pole strategy, sort of the way we use Frozen Planet on North America as part of that overall approach in [aggrandizing] the brand. But it's not going to change who we are, we are non-fiction with those brands. You'll see us playing more in the fiction area with things like SBS, where we have broad entertainment, sports networks, where that's the foundation of what we do in those four markets where we have between 30% and 40% market share.
Operator:

Thank you. And your next question comes from Anthony DiClemente of Barclays. Please proceed.
Anthony DiClemente:

Just a question for Andy. David mentioned taking the third-year option on your Netflix deal. I think that that comes up later this year but I was wondering if you guys could clarify exactly when that would be, like what quarter would that option kick in. And then I’m also assuming that that's contemplated in your full year guidance. Is it included or the expectation for taking the third-year option is included in your full year guidance, is that correct?
Andrew Warren:

Yes, Anthony. It’s both in our full year guidance and it will be either in the second or third quarter. It really all depends on what we take the option. So we're not going to say which quarter yet but it will either be second or third, and it is included in our full year expectation.
Anthony DiClemente:

Okay. And then we go for one full year subsequent to that, it would extend.
Andrew Warren:

Yeah. That’s right.
Anthony DiClemente:

And then on that theme, I guess for either of you, can you talk about, are there other online distributors. You said there were plenty of players knocking on your door, are there others? And what would the structure and type of content look like for other players out there in addition to Amazon and Netflix perhaps?
David Zaslav:

Sure. Hi, Anthony. Look the TV Everywhere is a big piece of windowing strategy. We haven't done any of those deals yet. We are talking to operators. The good thing about TV Everywhere is it's measured on the web and it will be measured next year on the [Pad]. I just met with a bunch of operators in D.C. the other day. There is a real drive to push into that space. We just haven't done deals yet. We all agree there is value, we think there is more value there. We have 10% market share, we have a lot of great content. And so I think there is a question of when that will happen and it's a fight over value. On the SVOD piece, I wouldn't be surprised if a number of the operators get into that space, and Netflix has been very effective, Amazon has been effective. So, I think it will be good for us, the more people that want to pay for our content, the better. And then there is Over-the-top. There is continues to be the discussion of Over-the-top. Eventually, it will happen, I don't know if it's going to be this year, next year, in four years. But the idea of more people wanting to pay more money to get access to content that we own is a good thing. Now it's a good thing over the next couple of years. The bigger question is, four, five, six years from now, how good of a job that do we do as an industry, getting the right economics for each of those windows. And any those windows get much bigger, because people spend a lot more time and does that mean that we end up doing better or worse. There is no question we’re going to be doing better in the next couple of years.
Anthony DiClemente:

I just want to follow-up on that. That's a good point in terms of, if over the next few years SVOD sort of takes share from ads supported as the form of monetization online of choice. You've taken a strategy, David, in terms of really windowing out the SVOD deals you've done in terms of longer tail library content. Could you see that changing if the SVOD business really becomes for consumers and viewers, the business model of choice vis-à-vis ad supported online.
David Zaslav:

Look, we will have to follow the consumer, what does the consumer do, but we have to do it rationally by figuring out what are the right economics. We don't want to undermine an existing business that is very effective for us or about 50% subscriber fee, and we could be doing deals in some markets that are very low penetrated on cable around the world, like Brazil, to make a little bit more money. But Brazil is still only 26% pay penetrated. They grew over 20% in this past quarter. That's the place that we're going to make a lot of money and when people first get introduced to television, we want them to be introduced to cable TV, which is the core of what we do. We don't want them to be confused by some other offerings. So I think we have to be careful as an industry as to how we approach this. The fact that traditional distributors are getting into this space is a good thing. If we are talking to an existing distributor customers of ours that has big scale and is paying us for our content in traditional manner, then at that point doing a deal with that distributor for more money to give them more windows, by definition, it will be more difficult to undermine that relationship because it's with the same person. But we have to make sure we get the right economics, because you are right, if in five years we're not getting the right economics or the business models aren't effective on some of those platforms and they begin to take some scale away from traditional television, then we'll be worse off. On the other hand, today people are watching more television than they have and we're getting paid for every one of those platforms. So it feels awfully good. That's good. The bad is that if we get overconfident then we don’t get the right economics on those additional platforms.
Operator:

Thank you. And your next question comes from the line of Michael Morris of Davenport & Co. Please proceed.
Michael Morris:

A couple of quick ones on affiliates and then one on content. Domestic affiliates, I believe last year your core affiliate rate ex-digital grew somewhere in the 4.5% to 5% range. So my first question is did your subscribers who are not under new contracts so far this year, did they continue to grow at a similar pace there?
Andrew Warren:

Yes, they did.
Michael Morris:

Okay. And then David, you mentioned the number of subscribers up for renewal this year, you categorize it as a little more than 10%. Can you talk about...?
Andrew Warren:

That was last year. Last year was less than 20% and we basically said directionally that it's about over the next five years, it’s basically even. So if you would model that out and you modeled out 20% a year, you wouldn't be too far off on either side.
Michael Morris:

So when you said that less than 20%, those weren't sort of January 1, 2013 subscribers, or that was kind of like at that date? I know it’s not always exact, but so to speak?
Andrew Warren:

The deals that we did last year in aggregate represented a number of subs that was less than 20% of our total base in the U.S.
Michael Morris:

Okay. Go ahead.
Andrew Warren:

That’s it.
Michael Morris:

Okay. And so as we look into the number of new subscribers or updated contracts into 2014 over 2013, you think that 20% is sort of the right number we should be using?
Andrew Warren:

Ballpark, yes.
Michael Morris:

Okay. And then just on the content side, to follow up a bit on the scripted content. You did acquire into both scripted and sports in Europe. Would you consider acquiring into either of those in the U.S.?
David Zaslav:

We always look opportunistically. I think we’re very late to the party on sports and it's very expensive and there is a lot of great players playing in that space and fighting that fight. We think what we have with Eurosport, which we have a right to take a control right in, in about 19 months, is very different. It's in 59 countries. It's the only pan-European sports platform that exists. So it's a very unique platform with unique leverage. So sports is difficult. I don't see us playing in a meaningful way in fiction on our existing platforms, in some way that would skew your models. But if there were channels available here in the U.S., we always look. We think we have enough scale here right now but for the right price we always look at everything. Our focus is going to be much more outside the U.S., that's where we think we have a real advantage, both in terms of teams on the ground and scale.
Craig Felenstein:

Operator, we have time for one last question, please.
Operator:

Thank you. Our final question comes from the line of Tuna Amobi of S&P Capital IQ. Please proceed.
Tuna Amobi:

David, you used the word robust in your characterization of your upfront outlook. So I just wanted to get a sense, how robust you think this will be? Clearly, you guys have been taking share for several years now, and it seems to me that your position this year is relatively better than last year in the upfront environment. So I'm wondering how this whole changes your strategy and any kind of color that you can provide would be helpful. And for Andy, so you laid out three criteria for your M&A strategy, and I was very curious that you were willing to take a significant margin hit in the SBS and yet you made a point it was EPS and free cash accretive, and I'm wondering, given that dynamic, is this something that one can expect would -- I mean, it's not common that the kind of margin compression that SBS would result. On a timeframe it sounds like, from your comments, it would take a few years to normalize. And I'm wondering, why you think that's kind of the right approach in terms of how you view assets and if that's something that's peculiar to the international market or if something you will also consider in your U.S. acquisition criteria, if that makes sense. Thanks you.
David Zaslav:

Okay, let me start. The upfront to some extent is outside of our control. We go in with a significant amount of momentum. The market right now is strong. Pricing is strong. But we're more of a follower than a leader with that and that's because we're in the cable business, and that's the way it works here in the U.S. So we'll see where CBS or some of the bigger broadcasters go. Depending on where they come in, we'll make the decision depending on how up the pricing is, last year we did about 55% of our inventory, but we did very, very well with scatter. And the question is, depending on how high we can get an increase on the upfront that will determine whether we do 45%, 48%, 50% or 55%, and how much we bet on scatter. So I think we have all the right wins at our back going in. We're just going to have to see how the marketplace is. It feels good now, we'll have to see. On SBS, just a couple of points and then I'll pass it to Andy. That's a dual revenue stream business. I mean it's very unusual. 30% of it is sub fees, number one. Two, we think we have a lot of synergy and it's not going to take us a very long time, we think we can move those margins pretty quickly. And three, it does play against our model. If we had bought an asset like this in one market that had a unique language where we couldn't use it across other countries, it would've been more difficult. The fact that you have Norway, Denmark, Sweden and Finland and you can produce content and share it across those markets and we could use their content, they could use ours, we think gives us a real chance to grow our international business and also to reinforce the geographic diversity that we have. Those are very stable markets and we think that we can grow them and we can use this synergy to do it.
Andrew Warren:

So you are right. We've laid out three kind of deal criterion that we look at. One is free cash flow and EPS accretive, day one. Two is an unlevered IRR of at least low teens. And three is, buy at a multiple that’s less than ourselves and ideally less than 10, and SBS clearly meets all of those three criteria. And so, look, I'd just add to David's point, while it is margin dilutive day one, we do very much believe in our ability to grow margin, not only with that business but with the overall amalgamation of D&I in total. So, we're very, very bullish on what our margin profile kind of looks long term. I think this is the right kind of step back in margin year one, with a lot of thoughts around how to gain that through ad sales leverage, top line leverage, infrastructure in place and then synergies.
Craig Felenstein:

Thank you very much everybody for joining us and please follow up with any questions that you have. Thank you.
Operator:

Thank you for participation in today's conference. This concludes the presentation. You may now disconnect and good day.

Warner Bros. Discovery, Inc. Q1 2013 Earnings Call Transcript

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Warner Bros. Discovery, Inc.
Q1 2013 Earnings Call Transcript