Kevin Winter
With Warner Bros. Discovery (NASDAQ:WBD) stock now down almost 50% from its pre-merger price, I recently took a look to see if, despite my earlier trepidations, this new price made a buy “irresistible,” as some have argued.
The stock may well be undervalued … but there’s a chance it’s not, and at any rate, I wouldn’t call it irresistible. Warner Bros. Discovery has one big cloud hanging over an otherwise strong business. Besides its levered balance sheet, I mean.
Warner Bros. Discovery Key Metrics
Currently, Warner is trading at roughly a 16.5 forward P/E at around $15 per share. The new company is the result of AT&T’s (T) decision to spin off WarnerMedia then merged with Discovery Communications in a deal which saw old Discovery shareholders retain 29% of the combined company. In addition to receiving the other 71% of the equity, AT&T’s side of the deal also received $43 billion in cash, which was added onto the debt balance sheet of the new Warner Bros. Discovery company alongside Discovery’s existing debt. Thus, while we don’t actually have our first official quarterly balance sheet report for the new company yet, it currently has somewhere around $57 billion in debt while trading at a market cap of only $35 billion. This puts its debt-to-equity ratio uncomfortably high, especially for a media company, with debt substantially outpacing market cap. And all this is an environment of rising interest rates.
Is Warner Bros. Discovery Stock A Good Value?
With the S&P 500 trading at around a 20 P/E, this means that Warner is a bargain here if you believe this level of earnings is sustainable.
This does also illustrate, however, that the argument that has been advanced in some quarters that Warner is a screaming buy is somewhat overstated. Unless Warner generates substantially more profit than expected, even a return to average P/E would leave it below $20 per share – and well below where it was trading just six months ago, when its predecessor Discovery went into the latest Warner merger at $30 per share.
Of course, forward P/E is only as good as the profit estimates you plug in. Is Warner poised to outperform expectations? Is it in danger of underperforming? These, we all know, are the key questions.
Warner Bros. Discovery’s Three Segments
Because the merger has been so recently completed, a full integration of its various constituent pieces isn’t even really begun yet, let alone completed. For this reason, I am instead going to adopt a sum-of-the-parts approach to evaluating it.
The new Warner Bros. Discovery essentially consists of three separate components:
– The Discovery cable networks, including those purchased in the merger with the old Scripps company just a few years before this latest merger, which are all reality, lifestyle and infotainment (true crime, biographies, science & tech, etc.) oriented. This is represented by the discovery+ streaming service.
– The Turner cable networks, including news network CNN. These are still so deeply enmeshed in the pay-TV old-line monopoly that, with the shutdown of the abortive CNN+ after barely one month of operation, they don’t really have a streaming service yet. These networks have traditionally embraced a combination of scripted and sports content, with a sprinkling of reality TV. Turner Classic Movies gives it a strong position in that subcategory as well.
– The rest of the non-Turner old Warner Bros. and various odds and ends, represented by the HBO Max streaming plan. This includes Cartoon Network, CW Network – though that’s about to be sold, we’re told – as well as HBO and the movie/TV studio proper.
Discovery Cable Nets
Unafraid of cord-cutting
The old-line Discovery was one of the most poorly served constituents of the old cable bundle, routinely pulling in upwards of 20% of TV viewing time while only netting around 5% of subscription payments from cable customers – as CEO David Zaslav never tired of complaining about.
Although Discovery does have a considerable international presence, last quarter its US Networks accounted for 99.8% of adjusted operating income. International Networks and the Corporate segment essentially cancelled out. Even setting that aside and looking at pre-Corporate breakdowns, US Networks accounted for 91% of operating income. Because Discovery did not break out its discovery+ streaming operation separately, it is not possible to say what share of this is currently streaming.
What can be said, however, is that discovery+ and the old Discovery nets it represents, seem well-positioned to thrive in a streaming environment. Increasingly, I have been evaluating content companies by how they would fare in a pure-streaming environment, i.e., if they had to generate all their revenue by streaming subscriptions, how many would they have to sell to cover their content spending.
Significant profit growth ahead
Old Discovery proper, comes off very well on this metric. As Zaslav always says, Discovery really was penalized by the previous system because it rarely got advertising spending commensurate with its share of viewing time. At 20% of pay-TV viewing time even before the merger, Discovery presumably has that percentage of households at least, but realistically it has far more. Netflix (NFLX) has roughly half of US households despite only accounting for around 8% of total US viewing time on TVs.
Granted, discovery+ might not achieve ratios that high because the average viewer uses it over three hours per day, suggesting that viewership comes from relatively fewer subscribers. I will pencil in 40 million subscriptions, at $5 per month, meaning that discovery+ could replace roughly 75% of the subscription revenues the pay-TV bundle is generating even if pay-TV completely disappeared.
Meanwhile, advertising has the potential to considerably expand revenue. Discovery has spoken in the past of tripling the CPM rate, and management is not backing down from that projection. Tripling of revenue is unlikely since ad loads are being reduced, but even a 50% increase in ad revenue would put this segment’s EBIT at $3.5 billion per year – 75% above 2021 levels. We will assume International generates no operating income at all.
Warner Bros. and HBO
The non-Turner side of Warner is where most analysts are focusing their attention. HBO Max is the new streaming service at Warner Bros. With all the digital ink already spilled here at Seeking Alpha on that topic – including by this author – I won’t revisit everything that has been said about the issue, to save room for the real question I think is key. Suffice it to say that the decision to invest so heavily in growth has had a considerable impact on EBIT in this segment. A nearly $600 million Q1 2020 EBIT profit has turned into a $60 million loss in the old HBO segment, despite a 50% rise in revenues as spending on marketing and content has more than doubled.
Officially, the TV/Studio segment has increased EBIT, but a lot of that probably gets filtered out in inter-segment transactions as HBO Max is buying more content than ever from its sibling. Altogether, non-Turner EBIT fell by $400 million over the past two years last quarter.
If we assume that these investments will ultimately bear fruit, we still have to account for the more competitive nature of streaming, which is less profitable as a result for all participants compared to the old pay-TV monopoly. But some sort of rebound would probably be in order. On the other hand, if these investments fail, EBIT will probably continue to fall even further.
I will be optimistic here – since I’m about to be rather pessimistic – and pencil in a continuation of pre-COVID profit levels from 2019, about $4.5 billion in “Segment Operating Income,” which excludes certain major costs under AT&T’s accounting. AT&T’s reports show that about 1/3 of segment operating income doesn’t make it to EBIT for various reasons, so I will call it $3 billion in EBIT. I know this will strike some as too low, but the carnage currently sweeping Netflix and Disney (DIS) is at least some circumstantial evidence that investors should be cautious about penciling in massive profits for even a large streaming operation.
The Key To WBD: Turner Networks
Happy Two-Year Anniversary
This brings us to the key to Warner Bros. Discovery’s profitability, which in my opinion is not being given quite the attention that it should be: Warner’s Turner Networks division.
Because I’ve already written about Turner Networks and its potential issues before, I will refer you to those previous works and only write about new developments since then. That won’t take long, since there haven’t been many. Turner just passed the two-year anniversary of being dropped by fuboTV (FUBO) and there’s no indication that fubo is willing to capitulate or that Turner is willing to drop its price.
Many industry analysts are, for now, dismissing this as a one-off. Something unique to fuboTV that is unlikely to carry through the system, with fubo too small to matter whether they carry Turner or not. And to be fair, they have a point: no one else has dropped Turner since fuboTV’s radical decision two years ago, and with many content contracts running three to five years, you would think someone else has had the chance to do so by now, probably several someones. And none of them have taken it.
A Story of Declining Profit
That’s fair enough, but I’d be careful about assuming everything is fine with Turner. From 2019 through 2021, WarnerMedia’s combined operating income fell from $9.3 billion to $7.3 billion. That decline was split almost evenly between the two years. Things may be getting worse. In AT&T’s last quarterly earnings before the spinoff, WarnerMedia’s operating income dropped over 35% Y/Y.
While the majority of that can fairly be ascribed to HBO Max and the investments it requires, it alone cannot explain all of it. AT&T decided to stop breaking out Turner results separately right around the time fuboTV proved those networks weren’t essential – I’ll spare you my thoughts about that – but their last report did provide a modicum of details for reconciliation purposes.
“Basic Networks” – what they renamed Turner Networks – saw its subscription revenues freeze at $2,013 billion Y/Y, despite the fact that pay-TV is raising prices upwards of $10 per month every year and passing veritably all of it onto content providers. And advertising revenues actually fell. Meanwhile, Direct Costs – almost all content spending – rose over 12%.
Preliminary Number
What this illustrates is that Turner’s profit is going to come under considerable pressure regardless of whether it suffers further blackouts or not, simply by virtue of the fact that the pay-TV universe as a whole continues to shrink so dramatically. The bundle is down to 75 million and has steadily shed upwards of five million per year for the last three years. But the sports contracts which now form the heart of that universe didn’t see their payouts shrink proportionally. They are contractually committed to rise, regardless of the system’s underlying health. This means that a Turner that is standing still revenue-wise is hemorrhaging profit.
The best way to handle Turner, then, may be to start with its current EBIT, and then derive a separate estimate for how much we think it will decline. So for now, I’ll pencil in a preliminary $3.9 billion Segment Income, again discount 1/3 to $2.6 billion, in accordance again with 2021 numbers this time.
Projecting Turner’s Future
Management’s alarming embrace of profligacy
Now, the question is, how is that number about to change?
Even more alarming than Turner’s current status is the growing indication from management that it wants to double down on Turner’s sports-without-football strategy, rather than re-evalaute it. At a time when CEO Zaslav is pretty much raining fire and brimstone on the entire scripted content side of Warner for not containing costs adequately, he is also indicating that he thinks Turner was “clever about getting long-term [sports] rights.”
Turner’s new strategy: more of the same
The new Turner leadership team is already in place – including the new head of Turner Sports – and seems to reflect this apparent conclusion by management. The only big news so far is that Turner will soon shutter all scripted entertainment content production, relying on an eclectic mix of reality shows to carry it through the 21 or so hours of the average day a sports game is not on. The heart of Turner Sports, the co-primary NBA national broadcast deal, is up for renewal and Turner has given every indication it intends to be the winning bidder – unfazed, apparently, by reports that it will as much as triple in price.
Meanwhile, the Big Ten, a budding super-conference to rival the SEC after the acquisitions of USC and UCLA, is even as we speak conducting the auction for its next set of TV rights, expected to go for about half of the NBA’s current rights, i.e., about 1/6 what the NBA will soon charge. Reports say Turner’s not interested.
Apparently, a major shift in sports strategy, either away from sports altogether or towards more profitable ones, is not forthcoming.
Potential financial implications
It would be difficult to overstate how disastrous such a new NBA deal could potentially be. If indeed Turner’s payments are about to climb from $1.2 billion per year to $2.4 billion (double) or $3.6 billion (triple) Turner will face nothing less than an existential crisis. It sounds crazy they would even consider such a thing. The upper end of those numbers would constitute almost the entirety of Turner’s profit stream. And remember, Turner’s revenues have already stopped growing.
And yet the NFL deals recently concluded for a similar increase in aggregate dollars, despite being locked into the same declining pay-TV ecosystem. TV executives have a nasty habit of just assuming that whatever they pay, they’ll pass it on with a markup to the cable/satellite companies, who will pass it on to customers.
Deal’s not done yet
The one saving grace here is that the new, expensive NBA deal isn’t done yet. And maybe it never will be. Zaslav is preaching cost control, and if he wants the ultimate example of old-guard management’s fiscal profligacy, he need look no further than Turner’s sports strategy. With extensions of the NBA deals apparently not done yet, he still has time to change course.
Because Turner’s pending NBA negotiations involve an amount equal to practically the entirety of the division’s profit, it is difficult to make a firm projection of Warner Bros. Discovery’s future without knowing how its most important content negotiation is going to turn out. If the deal goes through, Turner will have a massive new content outlay at precisely the time that its revenue growth potential appears to have stalled.
WBD Financial Model
Whatever number you choose to pencil in for Turner, the final stage is to deduct interest and taxes from EBIT. I will be assuming the 21% statutory federal rate. For debt it’s a little more complicated; rates are rising as the Fed tackles inflation. Setting Turner aside for the moment, of the $57 billion debt only $10 billion of the acquisition debt needs to be refinanced before 2032, but longer-dated debt is already above 5% interest and the refinancing will probably be at least at that level, especially if WBD is seen as more risky by then.
At a weighted 5.5% interest rate, debt will eat up $3.14 billion of annual payments. Subtracting that from the $6.5 billion the non-Turner divisions are projected to generate leaves $3.36 billion, minus 21% of taxes leaves around $2.65 billion per year which, at a 20 P/E, should produce a company with a $53 billion market cap even without Turner. The stock currently trades for around $35 billion. That would put a fair stock price over $21 per share.
I’d be careful about penciling in anything long-term for Turner profit. Remember that Turner doesn’t have a corresponding streaming service and sits at the very heart of the pay-TV system. This suggests that its profit is probably unsustainable regardless of what it does with the NBA.
But if the company is foolish enough to renew and then the pay-TV bundle collapses, Turner could actually swing to a negative number and drag the other divisions down. That is the true nightmare scenario that could see fair value plunge even lower than it is today.
Investment Implications Elsewhere
A brief aside before concluding: much of what I’ve said here about the NBA’s potential danger applies with equal force to Disney, Turner’s partner on the deal which is also apparently determined to re-sign at any price. These dangers of sports in a streaming world are also why stocks like Netflix, which eschews sports altogether, and fuboTV which is more willing to prune non-football channels, are perhaps not as poorly positioned for profit as some think. Please see my other articles for details on these companies.
Investment Summary
Ultimately, whether WBD is a good buy or not, even at these depressed prices, depends entirely on whether or not Zaslav really intends to double or triple Turner’s sports footprint. If he avoids that foolish course, there is real profit potential here. The old Discovery nets and HBO both have real potential. There is probably no way for Turner to avoid seeing its profits contract, as the pay-TV monopoly it profits from is collapsing no matter what Turner does. But if it manages to simply make less profit, instead of generating massive losses, the other portions of the company should be able to compensate for it and still generate meaningful profit.
I would also keep an eye out on just how high interest rates go and how much extra EBIT will be necessary to cover them. But frankly, even with Warner Bros. Discovery’s over-leveraged balance sheet, that is secondary to what Zaslav decides on Turner.
I am a Hold, and avoiding the stock, even though I think it probably is a little oversold at these levels. I want to know what Zaslav is going to do about Turner Sports first.
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