Discovery buys Scripps to float its shrinking ad business

Discovery Communications buying Scripps Networks Interactive for $14.6 billion has been hailed by many as a match made in heaven – is this a case of tying two bricks together to see if they float? Or are there genuine synergies within the newly formed group? It could be that in two years’ time the combined entity is looking for rescue.

The combined entity’s networks will hold around 20% of the ad-supported pay TV audience in the US, a sizeable business today, but one that is shrinking and shifting to different formats and screens. A quick look at the profit rates for the two companies over the past few years paints a picture of a difficult period ahead for the merged company – one that could perhaps be significantly smaller in just two years.

Discovery’s second quarter net income slipped 8% to $374 million, and was 12% down for the first half of this year compared to the prior year period. While Discovery’s Distribution and Other business segments in the US saw performance boosts in the last quarter, growing revenues 4% and 13% respectively, its Advertising business declined again, a minor slip of $1 million in revenues. Internationally, ad revenues were down 3%, resulting in a total ad business shrinkage of 1% to $805 million for the quarter.

Scripps canceled its second quarter 2017 earnings call this week following the takeover announcement, but its first quarter results showed a dramatic net income drop of 33% to $369.8 million in the US. This was partially offset by growth in its international networks business, rising nearly 20% to $33.6 million, with its Polish TV network subsidiary TVN performing well.

As well as taking on a business which dropped $185 million in income, the acquisition means Discovery will be increasing its debt load from $8 billion to $18.2 billion.

Discovery Communications’ Other segment is made up of a combination of affiliate fees and retransmission fees, which are experiencing rising rates globally, primarily due to investment in sports content overseas, where some 50% of its revenues now come from. The sizeable growth of its distribution revenues, totaling $400 million for Q2, has been driven by higher rates and licensing agreements, to partially offset its declining subscriber numbers.

The current breakdown of Discovery’s revenues in the US looks as follows – Distribution 45%, Advertising 53% and Other 2%. When we trawl back through Discovery’s past earnings, a clear trend begins to emerge. In the same period in 2015, that three-way revenue share was Distribution 44.2%, Advertising 54% and Other 1.8%. Then back in the second quarter of 2014 it was Distribution 43.8%, Advertising 54.9% and Other 1.2%. In 2014, the change in balance becomes increasingly clear, showing Distribution 41.1%, Advertising 57.5% and Other 1.4%.

The point here is to highlight that in just three years, while Discovery’s overall revenues have grown, its advertising business is becoming of gradually less importance to the business as a whole, having contracted 4.5% in this time frame while the US and European markets were growing. In the same period, Distribution has crept up by 3.9% and Other 0.6%. These two sectors will continue to eat away at advertising and before long advertising will no longer be the highest earner in the Discovery household.

In comparison, around 70% of Scripps’ revenue is advertising, with a falling percentage as distribution which includes retransmission. In the past, most networks managed far closer to a 50/50 split between those revenue types.

Now when we line up the other independent cable and satellite networks in the US, we see that those with channels which have nationwide reach include the likes of A&E Networks, AMC Networks, Ion Media Networks and Vice Media (as well as the major national broadcast networks CBS, ABC, NCB-Universal and Fox).

There are a handful of big names which don’t have nationwide reach, Scripps being one, so a combined portfolio of leading TV channels from Discovery Communications and Scripps Networks puts the new company in a much stronger position for retrans negotiations in the coming years.

Discovery will also be diversifying its viewership through the deal, keen to shrug of its label as a provider of predominantly male-oriented content. Scripps is bringing to the party channels such as Home and Garden TV, which Scripps advertisers said this week would help Discovery to target ads at additional audiences. Scripps reaches double the number of female viewers aged 18 to 34 as Discovery does, despite being much smaller in reach, according to Nielsen.

Another silver lining is the company’s ability to produce popular original content, promising to deliver around 8,000 hours of original programming upon completion of the merger. Shipping Scripps content abroad its part of Discovery’s road map, to build on the 3 billion combined subscriber base it currently boasts, although its monthly reach is nowhere near that at 170 million viewers.

Another issue to factor in is what if the pay TV market suddenly shifts more sharply towards skinny bundles? A host of Discovery and Scripps channels could be destined for the graveyard, although Scripps is on board with Hulu’s live streaming service, which is a more positive sign moving forward. Also in a bid to gain millennial gazes, Scripps has developed versions of Food Network and HGTV for Snapchat.

Having said that, the new Discovery-Scripps group has enough content between them to launch a skinny bundle programming offer of its own, with scope to also strike deals with other networks looking at a similar model.

After three years of deliberating the deal, Discovery finally took the plunge, beating away Viacom in a 70% cash and 30% equity deal. Discovery is aiming for cost savings of $350 million, but analyst estimates are pessimistic the company will achieve this, with some pegging savings at a more realistic $175 million.

Just a few days after the announcement came across the wires, Scripps then bagged itself 100% of the Katz broadcast networks for $302 million, having previously owned 5% of the company.

The networks, Bounce, Grit, Escape and Laff, reach over 80% of US households, and Scripps projects that the networks will bring in revenues of $180 million next year. We expect some aggressive nipping and tucking to be carried out within Scripps under new ownership, especially with John Malone backing the deal as a Discovery investor.

Scripps CEO Rich Boehne said, “In today’s fragmented television ecosystem, a growing number of viewers are consuming content from new over-the-air networks as a complement to OTT services. The entrepreneurs at Katz were among the first to take full advantage of this resurgence in over-the-air viewing. We were early investors in the company, and it’s a strategy and team we know well.”

Ken Lowe, the Scripps chairman who is joining the board at Discovery, added, “Some of these brands have a very passionate base that may not necessarily, for the future, be a linear platform, or a platform that we have necessarily thought about in the past.”