August 1, 2017 / 2:34 PM / 2 years ago

Fitch Affirms Discovery's 'BBB-' IDR Following Scripps Acquisition Announcement; Outlook Stable

(The following statement was released by the rating agency) NEW YORK, August 01 (Fitch) Fitch Ratings has affirmed Discovery Communications, LLC's (Discovery) 'BBB-' Long-Term Issuer Default Rating (IDR) following the July 31, 2017 announcement that it is acquiring Scripps Network Interactive, Inc. (Scripps). The Outlook is Stable. As a result of the announcement, Fitch has placed Scripps' Long-Term IDR of 'BBB+' on Rating Watch Negative. The rating action affects approximately $3.1 billion of debt outstanding as of March 31, 2017. The Negative Watch is driven by the increased leverage associated with Scripps' acquisition by Discovery. In addition, Fitch expects that Scripps' existing unsecured debt will eventually become pari passu with Discovery's existing and prospective unsecured debt, which will be rated 'BBB-' should the transaction close as currently envisioned. See the full list of rating actions at the end of this release. Fitch views the acquisition positively. The combined suite of programming presents a unique opportunity for advertisers given that they represent 20% of all ad-supported linear U.S. aggregate television and prime time female viewership and five of the top 25 female skewing cable networks. In addition, the merger should provide significant cost synergies, which the company estimates totalling approximately $350 million. Fitch notes the company may realize revenue synergies but does not include any in their assumptions, in line with the company's estimates. Management restated their commitment to maintaining the 'BBB-' rating and will use substantially all free cash flow (FCF) to prepay debt until total leverage returns to the company's target leverage range of 3x to 3.5x. Fitch expects pro forma total unadjusted gross leverage will increase to 4.8x at closing and decline below Fitch's 4.0x negative rating trigger during 2019. Within 18-24 months of closing, leverage is expected to be below 3.5x, following which the company expects to use FCF for internal investment, which may include M&A, with any excess once again being returned to shareholders. Fitch calculated Discovery's unadjusted gross leverage as of the latest 12 months (LTM) ended March 31, 2017 at 3.3x. On July 31, 2017, Discovery announced that it would be acquiring Scripps for $14.8 billion, including the assumption of $3.1 billion of debt, which represents a 10.7x multiple of Scripps' LTM March 31, 2017 Fitch-calculated EBITDA of $1.4 billion. Discovery expects to finance the acquisition with a mix of 70% cash, comprising new debt issuance and cash on hand, and 30% equity, composed of Discovery Class C shares. Following the acquisition, existing Discovery shareholders will own approximately 80% of the company and Scripps shareholders will own 20%. On a combined basis for the LTM ended March 31, 2017, Fitch estimates that Discovery and Scripps generated approximately $10 billion in revenue and $4 billion in EBITDA. Following the merger, Discovery will produce over 10,000 hours of original programming annually, own a library containing approximately 300,000 hours of content and generate more than 7 billion short-form monthly video streams. Management has identified approximately $350 million of potential expense synergies driven primarily by eliminating Scripps' public company costs, optimizing real estate, and integrating corporate functions. Discovery does not include any revenue synergies in this estimate. Fitch believes the company will realize most of the expense synergies. Scripps' current 'BBB+' ratings reflect its portfolio of cable networks and leading home and lifestyle programming brands that deliver above-average 'live' viewership, a preponderance of viewers in the attractive higher-income-women demographic, and solid advertising growth trends. While distribution revenues experienced some weakness in 2016 as a result of multichannel video programming distributor (MVPD) consolidation and the resulting rate equalization, Fitch views the completion of the most recent distribution renewal cycle positively with roughly 80% of the company's subscriber base engaged in multi-year distribution deals with contracted rate increases. Fitch also notes that Scripps continues to offer a good value proposition to distributors given the relatively lower cost of its cable networks relative to peers. Scripps' cable networks continue to be incorporated in "skinny" bundles offered by the emerging virtual MVPDs (vMVPDs), which Fitch believes is illustrative of the relevance of the company's programming and the company's ability to monetize its content on new technology platforms. Most notably, Scripps was recently included in Hulu's 'live' TV offering. KEY RATING DRIVERS Revised Leverage Target: Discovery announced a revision to its leverage target on July 31, 2017, broadening the range slightly to 3x to 3.5x, which remains well within the range for the 'BBB-' rating. Although Fitch expects total unadjusted gross leverage will increase to 4.8x if the Scripps acquisition is completed, leverage is expected to decline below Fitch's negative rating trigger and the company's target leverage within 18-24 months of closing. Thereafter, Discovery's credit profile has sufficient flexibility to accommodate share repurchase activity at the rating level. Business Investment: Fitch expects Discovery to continue investing in programming for linear TV and content for alternative platforms domestically and internationally. Once Discovery returns leverage to within its target leverage, there would be room in the current rating to absorb midsized acquisitions. However, if the company increased leverage to fund more sizeable M&A activities, they would need a credible plan to restore leverage under 4.0x to avoid a potential negative rating action. Shareholder Returns: Discovery has completed more than $7.5 billion of share repurchases from the program's inception in late 2010 through March 31, 2016. However, if the Scripps' acquisition closes, Discovery has committed to using future FCF to repay sufficient acquisition-related debt to return total leverage to less than 3.5x. If the acquisition is unsuccessful, Fitch believes Discovery's credit profile should have sufficient flexibility to accommodate continued share repurchase activity at the current ratings. Solid Financial Flexibility: Fitch anticipates Discovery is positioned to generate annual FCF of more than $1.5 billion, given the high operating margins, global distribution platform and low capital intensity associated with the cable programming business. Fitch expects the combined entity to generate annual FCF of at least $2.3 billion, which is expected to be used initially to repay acquisition-related debt until total leverage declines below 3.5x and thereafter for share buybacks. Rating Strengths: Discovery's ratings are supported by the company's existing strong core brands. particularly the Discovery, TLC and Animal Planet brands, all of which reach nearly 95 million U.S. subscribers and collectively generate 67% of domestic revenues. The combined entity will represent 20% of all ad-supported linear U.S. aggregate television and prime time female viewership and five of the top 25 female skewing cable networks. Fitch's ratings also incorporate the revenue and growth prospects of the company's international business segment, global carriage, leverageable content, robust FCF and solid credit metrics. Ratings Concerns: Ratings concerns center on recent mixed cable network ratings performance, the significant contribution of cyclical advertising revenue, a competitive landscape for similar programming, and volatility associated with hit-driven content. Although Fitch is also concerned with the company's current dependence on the Discovery and TLC brands, this concern would be reduced with the inclusion of Scripps' HGTV and Food Channel brands. DERIVATION SUMMARY Discovery is well positioned within its rating, with a leading position in reality-based and documentary programming. However, it lacks the size and diversification and has higher leverage than The Walt Disney Company ('A'/Outlook Stable), NBC Universal Media LLC ('A-'/Outlook Stable) and CBS Corporation ('BBB'/Outlook Stable). Although the Scripps' acquisition improves Discovery's operating metrics, programming breadth and market position, leverage will remain higher than its peers even after the expected delevering, resulting in the rating affirmation. KEY ASSUMPTIONS Fitch's key assumptions within our rating case for the issuer include: -Acquisition closes in January 2018. -Flat- to low- single-digit U.S. advertising revenue growth throughout base case. -Low- to mid-single-digit international advertising revenue growth. -Low- to mid-single-digit affiliate revenue growth, US and international. -Margins fall slightly after closing of transaction due to SNI's lower EBITDA margins. -Realization of $300 million of expense synergies, layered in over two years. -Debt prepayment using FCF starting in 2018, bringing leverage down to 4.1x at Dec. 31, 2018. -Total leverage falls to 3.2x by year-end 2020, well below Fitch's 4.0x negative trigger and within Discovery's target leverage. -Share repurchase program temporarily halted until 2020, when leverage declines below 3.5x. -$350 million call option exercised in 2019, relating to Put Option on a Discovery asset. RATING SENSITIVITIES Future Developments That May, Individually or Collectively, Lead to Positive Rating Action -An upgrade is unlikely over the medium term, given Discovery's stated willingness to operate at the top end of its higher leverage target and limited brand depth. -An explicit management commitment and compelling rationale for operating at a more conservative leverage metric. -Material viewership on new channel launches that will drive increased advertising and affiliate fees and enhance revenue diversity. Future Developments That May, Individually or Collectively, Lead to Negative Rating Action -A more aggressive financial policy with leverage exceeding Fitch's 4.0x threshold in the absence of a credible plan to return leverage below the threshold. -Meaningful customer defections to free viewing platforms. -FCF pressure from higher programming cost. LIQUIDITY As of March 31, 2017, Discovery had solid liquidity consisting of $267 million of cash, including $106 million held internationally, and $1.4 billion of availability under its $2 billion revolving credit facility due 2021. Discovery's liquidity position and overall financial flexibility are supported by FCF, which was approximately $1.4 billion for the LTM ended March 31, 2017. Maturities are well laddered, with $500 million of senior unsecured notes maturing in 2019 and $1.3 billion in 2020. If the Scripps' acquisition closes, Discovery has committed to maintaining minimum cash balances of $250 million and is expected to generate annual FCF of more than $2 billion. FULL LIST OF RATING ACTIONS Fitch has affirmed the following ratings with a Stable Outlook: Discovery Communications, LLC --Long-Term Issuer Default Rating at 'BBB-'; --Short-Term IDR at 'F3'; --Senior unsecured revolving credit facility at 'BBB-'; --Senior unsecured notes at 'BBB-'; --Commercial paper at 'F3'. In addition, Fitch has placed the following ratings on Negative Rating Watch: Scripps Network Interactive, Inc. -- Long-Term Issuer Default Rating at 'BBB+'; -- Senior unsecured revolver at 'BBB+'; -- Senior unsecured notes at 'BBB+'. Contact: Primary Analyst Jack Kranefuss Senior Director +1-212-908-0791 33 Whitehall St. New York, NY 10004 Secondary Analyst Patrice Cucinello Director +1-212-908-0866 Committee Chairperson Michael Weaver Managing Director +1-312-368-3156 Summary of Financial Statement Adjustments --Fitch makes no material adjustments to Discovery that have not been disclosed in public filings. --Fitch adjusts Scripps' Operating EBITDA metrics to incorporate the payments received or distributed to minority interests, non-cash stock compensation and other non-recurring restructuring charges. 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