Discovery Plus Scripps Just Makes Sense

 | Jul 20, 2017 | 9:00 AM EDT
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This commentary originally appeared on Real Money Pro at 07:00 a.m. ET. Click here to learn about this dynamic market information service for active traders.

When looking for a job, "networking" can be a wonderful thing.

The concept can also work well when a programming provider like Discovery Communications (DISCA) makes an overture to Scripps Networks (SNI) to combine and prosper.

The companies' content does not overlap. There could be major cost savings as personnel redundancies are eliminated. A combined entity would have more bargaining power and appeal when selling to cable/dish/fiber optic and foreign television packages.

I previously spotlighted the value of Scripps Networks at bargain valuations in 2011, again during the fall of 2015 and in September of 2016. SNI typically sells for an average P/E of about 17x, along with a modest 0.80% yield.

At the indicated lows (green/blue starred, below) the stock's multiple was extremely discounted. Shareholder yields at those times were running well above normal.

On Wednesday, July 19, 2017, the stock jumped to north of $78 on the merger talk.

Even after that move, SNI looks like a decent bargain. At $78.09 it trades for just 14.3x this year's consensus EPS estimate of $5.48 while yielding 1.54%. It will be cheaper than that if they're able to deliver on the $5.75 now expected for 2018.

Note: The chart above was based on estimates in effect last fall. Projections have become more bullish since then.

Discovery Communications, too, rose on news of the proposed business combination. It ended Wednesday at $27.18, up from a 52-week low of $23.95. At that price DISCA sits at only about 12.2x its 2017 estimate and 10.8x 2018's EPS projection for $2.59.

Profits have risen nicely since 2010, when EPS weighed in at just 74 cents a share. DISCA multiple has been all over the map since then, with an average P/E of about 20.6x. The present valuation looks remarkably like the four previous 'best entry points' (green-starred) during the last seven and a half years.

A regression to a more normalized multiple supports a 12 to 18-month target price north of $53. That would be as a stand-alone. Partnering with Scripps could make upside even larger. After all, in both 2013 and 2014, Discovery topped out above $45 on EPS of $1.49 and $1.66.

Option writers, willing to own DISCA if exercised, can sell Discovery Communications' Jan. 2018, expiration date puts at $25 or $27.50 strike prices. That would either secure profits, if the options expire worthless, or a very nice net cost basis, if the puts get used.

I was paid as much as $1.25 per share on Wednesday for the more conservative strike, lowering my break-even level to just $23.75 per share. Accepting $2.30 per share for the in-the-money $27.50s would mean potential purchase at a far-from-scary net price of $25.20.

Future stock market action can never be guaranteed. The half-decade long chart above shows, though, that owning DISCA at either of those "if exercised' prices would have been a winning position more than 98% of the time since Jul. 19, 2012.

If there's a deal struck with SNI, the stock may surge quickly. Even without one, I expect Discovery to do very well from today's depressed valuation.

Buy some DISCA shares, sell some puts or consider doing both.

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