Warner Bros. Discovery: Disrupted But Not Destroyed (NASDAQ:WBD)

Introduction

As forward-looking investors, we need to weigh the future prospects of Warner Bros. Discovery (NASDAQ:WBD) and decide if those prospects are in line with current market prices. HBO is the most storied part of the business and having a deep understanding of what they’ve been through over the last few decades helps us determine how they’ll continue adapting to a world that is shifting towards streaming. My thesis is that HBO has been disrupted but not destroyed. Throughout all the chaos we’ve seen over the years as the world has started moving to streaming, HBO has continued to maintain the playbook of making content that is a cut above the rest.

The disastrous AOL merger set the stage for disruption as HBO leaders have underestimated other tech companies like Netflix (NFLX) ever since that fallout. A December 2009 InformationWeek article notes the way valuation plummeted for AOL-Time Warner from 2000 to 2009:

When the merger of AOL and Time Warner took place in February 2000, the company, then called AOL Time Warner, was valued at $164 billion. This week AOL is valued at $2.5 billion and Time Warner at $36 billion, according to the New York Times VentureBeat blog.

Business Models & Incentives

The It’s Not TV book by Felix Gillette and John Koblin explains that cable operators have historically been given a cut of HBO’s monthly subscription fee so the cable industry helped build HBO. As the world started moving towards streaming, East Coast HBO leaders didn’t trust digital initiatives after the AOL fiasco and they didn’t want to rock the boat with the cable companies.

Incentives matter! East Coast sales and marketing folks at HBO didn’t want to jeopardize year-end bonuses in order to plant streaming seeds that could take many years to harvest. The half-hearted effort with the HBO Go streaming offering in February 2010 was unsuccessful as those without cable were excluded.

AT&T

Variety has a timeline on the deal between AT&T (T) and Time Warner which was worth about $85 billion. AT&T closed their Warner acquisition in June of 2018 and they rebranded Time Warner as WarnerMedia. Severe disruption continued until AT&T fell out of the picture when the deal between Warner Bros. and Discovery was finalized in April 2022.

One of the many problems with AT&T’s handling of HBO Max was the assumption that all viewing hours are equal. Viewers treat new content like Game of Thrones as a movie where they put their phones away, turn off the lights, eat popcorn and stare at the screen. Common sense tells us that one hour of this type of viewing is not the same as one hour of a popular rerun like Friends where viewers are multi-tasking and essentially just using the show as a background lounge singer. Netflix figured this out a long time ago. Netflix knew that even though their reruns of shows like The Office had the most viewing hours, it was absolutely essential for them to make substantial investments in original content.

The It’s Not TV book points out that AT&T’s Stankey held a firm conviction that HBO’s old library combined with other reruns would be enough for their streaming offering to be a success. Colleagues insisted that new content was needed, but he wouldn’t budge so Netflix continued to disrupt with all their new offerings. In the fall of 2019, WarnerMedia added reruns like The Fresh Prince, The Big Bang Theory and Friends. John Oliver summed up the terrible decisions AT&T was making with HBO Max in October 2019:

HBO Max has you covered. It’s gonna have all your favorites. Reruns of The Big Bang Theory, reruns of Friends, reruns of The Fresh Prince of Bel-Air. You can pay for all of those through HBO Max.” Oliver stared sourly into the camera and concluded his deadpan sales pitch: “HBO Max: It’s not HBO. It’s just TV.”

[It’s Not TV – Kindle Location: 5,264]

On top of the fact that HBO Max didn’t have fresh content, customers didn’t know how to access it when AT&T bungled the launch in May 2020. Roku wasn’t an option and neither was Amazon so it wasn’t a surprise when viewership was underwhelming.

Still A Cut Above

Despite the chaos with AOL, short term incentives, technology challenges and the AT&T debacle, HBO continues to make content that is a cut above the rest and we see this with their Emmy wins. Former HBO CEO Richard Plepler was correct when he said that HBO has a history of betting on great writers and talent.

Now it is important for HBO to balance their wonderful content with the disruption they’ve faced as the world has moved to streaming. WBD CEO David Zaslav showed that HBO has been disrupted when he spoke at the November 2022 RBC Capital Markets Conference. Reflecting on a conversation from a few years ago, he talked about being on the other side of the lake with respect to streaming. If HBO hadn’t been disrupted then they would have been able to get there without the need for a merger with Discovery:

When I did this deal two years ago, when I started talking to John Stankey, we really – our expectation of two great companies, Disney and Netflix, they had already made it to the other side. And we looked at Netflix, it was like they built a house of brick. And Disney had made it to the other side, they had a tent, and they were building their house, and we were stuck in the middle of the lake. And I said to John, I don’t think we’re going to make it alone. And we’re getting tired. We’re too tired to go back. But together, we can get to the other side and we could be the third.

The deal between Warner Bros. and Discovery was finalized in April 2022 such that HBO is now in better hands and their playbook of making wonderful content can be unleashed. CEO Zaslav says the ROI on streaming movies isn’t worthwhile so we should expect to see more success in terms of series.

Despite the fact that Netflix reaches the widest audience, not all creators see them as the first choice. The White Lotus came out in July 2021. Per the It’s Not TV book, filmmaker Mike White said he never seriously considered going to Netflix over HBO.

Producer Carolyn Strauss explains how HBO is still a cut above the rest when it comes to telling exceptional stories:

“Programming-wise, there are still people there, like Casey and Amy and Frannie, who have their roots in a different HBO and are still shaped by that. While they may not have been there in the beginning, they were often trained by the people who were.” As a producer for more than a decade, Strauss continued to supply series for HBO, even after she was pushed out. There was Game of Thrones, of course, but also Chernobyl, a surprise hit about the 1980s nuclear reactor disaster that would take the Outstanding Limited Series Emmy in 2020. Now when she talks to screenwriters trying to figure out the ideal home for their projects, the answer, almost surprisingly, remains the same. “HBO still is the one they want to go to,” Strauss says. “There is still a way that they look at things and a process that they go through, which is a cut above.”

[It’s Not TV – Kindle Location: 5,971]

Valuation

The It’s Not TV book likes to point out how AT&T’s Stankey wasn’t a good match for HBO and this is a complicated equation. The Chip Wars book shows that the US was advantaged in the long run over markets like Japan because market-driven capital allocation decisions were more disciplined in the US than they were in Japan during the 1980s and 1990s. On the other hand, the Flying Blind book makes the point that short-term market-driven capital allocation decisions hurt Boeing (BA) in the long run. There is a balancing act and AT&T’s Stankey went too far with the short-term finance mindset while not doing enough to embrace the long-term creative mindset. I am optimistic that CEO Zaslav will strike the right balance between fiscal discipline on the one hand and creative freedom on the other hand such that the business will thrive. Having said that, even a thriving business can be overpriced so we have to roll up our sleeves and determine what is a reasonable price for WBD today.

Having 94.9 million DTC subs and DTC 3Q22 revenue of $2,317 million, the economics for WBD look different from the Netflix numbers back when they were a similar size in 2016:

	WBD DTC in millions					Netflix in millions
Quarter	Adj. EBITDA	Revenue	Subs		Quarter	Op. Income	Revenue	Subs
Q2 2022	-$560	$2,410	92.1		Q3 2016	$106	$2,290	86.7
Q3 2022	-$634	$2,317	94.9		Q4 2016	$154	$2,478	93.8

Click to enlarge

Streaming is the future and Netflix is a pure-play whereas WBD isn’t yet profitable in this area such that they make all their money from legacy businesses. As such, we should expect Netflix to trade at much higher overall multiples than WBD. Per the Netflix 4Q22 letter to shareholders, they had 2022 operating income and FCF of $5,633 million and $1,619 million respectively. Netflix experienced severe F/X issues in 2022 such that this operating income figure was depressed. Per the 3Q22 10-Q from Netflix, there were 445,020,494 shares as of September 30th such that the market cap is about $152 billion based on the January 20th share price of $342.50. Due to net debt, the enterprise value for Netflix is about $8 billion more, coming in at about $160 billion which is between 28 and 29 times their reported annual operating income which was depressed due to currency fluctuations.

Again, DTC is only part of the picture for WBD as they generate all their positive EBITDA and FCF in other areas. Per the Warner Bros. Discovery 3Q22 presentation, they are working towards company-wide adjusted EBITDA of $12 billion in 2023 with a FCF conversion of 1/3rd to 1/2, meaning $4 to $6 billion. Looking at the 3Q22 10-Q filing, 9M22 FCF is just $835 million.

Due to the fact that interest lowers FCF, it makes more sense to compare EBIT to the enterprise value. The 3Q22 10-Q shows 2,428,396,015 shares as of October 21st such that the market cap is $31.6 billion based on the January 20th share price of $13.02. The 3Q22 release shows gross debt of $50.4 billion including $268 million in finance leases. This is face value which is a little different from the balance sheet which is net of premiums or discounts. This is partially offset by $2,513 million in cash and equivalents such that the net debt is $47.9 billion. There is also $318 million in redeemable noncontrolling interests plus $1,245 million noncontrolling interests for a sub total of $1.6 billion such that the enterprise value is $49.5 billion more than the market cap. As such, the enterprise value is about $81 billion. If management can execute and come through with EBITDA of $12 billion in 2023 then the stock appears to be reasonably priced as the enterprise value is only about 7 times this amount.

Forward-looking investors should keep an eye out for 4Q22 earnings to see if management is on track in terms of doing what they say. It is also important to keep tabs on HBO’s success at the Emmys where they have been immensely successful over the years.

Disclaimer: Any material in this article should not be relied on as a formal investment recommendation. Never buy a stock without doing your own thorough research.