Erik Khalitov
Consensus sentiment has been largely positive on Warner Bros. Discovery (NASDAQ:WBD) leading up to its merger, yet the stock has wiped out more than half its value since completing the blockbuster transaction. While earlier bull cases were primarily focused on the valuation re-rate potential for WBD as it transitions from traditional media and entertainment in linear and cable networks to growth opportunities within the massive streaming and digital advertising business, such expectations were crushed by the post-merger management team’s decision to prioritize profitability. And while WBD’s focus on profit over growth has instead coincidentally satisfied investors’ newfound preference of investments “tied to large near-term cash flows” under today’s volatile market climate ahead of global macroeconomic uncertainties, the stock has yet to show a sustained uptrend, leaving many supporters baffled by the persistent selloff.
To better understand the paradox between WBD’s robust fundamentals and its shares’ declining performance, the following analysis will go through some of the key potential bear cases weighing on the stock this year, and gauge whether the company has what it takes to overcome them.
1. Missing Transaction Targets
Prior to the completion of the WBD transaction, management had guided 2023 revenues of $52 billion and EBITDA of $14 billion, with a 60% free cash flow conversion rate that would make a meaningful contribution towards the company’s long-term deleveraging goals. Yet, during WBD’s inaugural earnings call as a newly-merged company for the second quarter, management decided to slash guidance for 2022 and 2023 EBITDA, citing near-term macro challenges as well as worse-than-expected cost inefficiencies identified in the legacy WarnerMedia business:
Having concluded this process, we determined that certain legacy WarnerMedia budget projections that were made available to us prior to closing, varied from what we now view as legacy WarnerMedia’s budget baseline post-closing. On taking a deep dive in pressure testing, what we found, our assessment has resulted in lower EBITDA projections…While these factors will, of course, impact our 2022 financial performance and 2023 to a lesser extent, we have implemented immediate measures to address and redirect the trend line…As you may recall, we first developed our guidance for the combined Warner Bros. Discovery 15 months ago. Today, after 100 days of thorough analysis and financial planning post close, we are adjusting our 2022 and 2023 EBITDA outlook, primarily based on: first, a less favorable macroeconomic backdrop resulting in a more conservative outlook overall and for ad sales specifically. Second, a change in the streaming industry dynamics and our strategic response. And third, as noted earlier, the difference is in legacy WarnerMedia budget projections that were made available to us prior to closing versus what we now view as legacy WarnerMedia’s budget baseline post closing.
The stock immediately saw one of its steepest overnight drops of almost 13% since completing the merger, reflecting a setback in investors’ confidence in the company following management’s decision to walk-back on initial fundamental performance expectations. The stock has yet to recover, sitting at more than 50% losses since the completion of the WBD merger in early April.
Nonetheless, WBD is still engaged in one of the highest growth segments – namely, streaming and digital ads – while also maintaining value characteristics, such as robust profits and strong free cash flow generation backed by competitive advantages that include being one of the largest networks that command the “most prime-time viewership than all of ABC, CBS, NBC and Fox combined”, and owning one of the most expansive content libraries in the media and entertainment industry. Despite revised expectations that would yield a reduced EBITDA of $12 billion in 2023, with a free cash flow conversion rate as high as 50% over the same period and 60% through the longer-term, WBD still boasts one of the strongest fundamentals in the industry.
2. Highly Leveraged Balance Sheet
WBD’s highly leveraged balance sheet is another sore spot for the stock. The company acquired $55 billion in debt as a result of the merger, making its long-term deleveraging goals a primary focus area for investors. Investors are not only worried about the pressure that WBD’s highly leveraged balance sheet will have on the company’s long-term fundamental prospects, but also the weight of rising borrowing costs in the near-term which would introduce risks to its free cash flow margins.
But to address the above two concerns on WBD’s debt-ladened capital structure, the company has been diligently working towards its long-term deleveraging goals, and has demonstrated abundant strength to do so. This is further corroborated by the more than $6 billion in debt repayments made since the merger completed in early April. WBD currently has no remaining repayment obligations due until 2023 ($1.3 billion) and 2024 ($4.3 billion). Based on management’s downward-revised EBITDA guidance of $12 billion for the following year, the company would still have more than sufficient funds to both pay down its near-term debt obligations and reinvest into the company’s long-term growth initiatives even at the lower end of the forecast free cash flow conversion range of a “third to half”.
Paired with immediate actions already taken to right its course towards unleashing greater post-merger cost and sales synergies (discussed in detail here), the near-term operational challenges that have caused WBD to revise its forward guidance will impact its fundamental prospects to a lesser extent over the mid-term and eventually unlock structural margin expansion over the longer-term. This accordingly provides further validation to WBD’s prospects of achieving its gross leverage target of 2.5x to 3x by 2024:
With that, I want to give a quick snapshot on our balance sheet. We are reiterating our long-term gross leverage target of 2.5 to 3x, which we expect to hit by the end of 2024, and our gross leverage will be within our current ratings category by mid-2024 or earlier. As stated before, we will continue to dedicate virtually all free cash flow generated to debt reduction until then.
Meanwhile, on the borrowing costs front, WBD is expected to feel less of an impact from rapidly rising interest rates as global central banks seek to tame record-high inflation. Much of the company’s debt currently boasts a fixed interest rate of about 4%, which provides visibility over its long-term borrowing costs:
Importantly, our debt financing is generally long-term with an average maturity of more than 14 years and a 4.3% average interest rate and equally importantly, interest rates for the vast majority of our debt are fixed.
3. Slow D2C Subscription Growth
Despite boasting one of the largest content libraries in the industry, with some of the most popular and iconic franchise, WBD’s D2C subscription base is still a far-cry from those at Netflix (NFLX) and Disney (DIS). The company reported a combined subscription base of more than 90 million (+1.7 million subscribers q/q) subscribers across both its HBO Max and Discovery+ platforms as of June 30 after adjusting for “non-active, non-core and overlapping sign-ups”, which puts it in third place by subscription volume compared to key rivals Netflix and Disney’s 221 million subscribers each.
But a deeper dive into WBD’s D2C segment would reveal that it continues to benefit from significant growth headroom. Recall that HBO Max and Discovery+ are only available in North America and certain South American, APAC, and European regions, while Netflix and Disney+/Hulu are more broadly available across key geographic regions – including India, which is currently one of the fastest growing markets for D2C streaming. While WBD continues to boast subscription growth, Netflix and Disney are both seeing deceleration and/or declines in the regions in which all three platforms operate in. This accordingly demonstrates WBD’s continued market share gains across regions where its D2C platforms are currently available, while also implying the massive subscription growth runway that remains as it seeks to combine HBO Max and Discovery+ next year with further penetration into additional geographies over the longer-term.
Although the company has only gained 1.7 million subscribers sequentially in the second quarter, the figure is expected to accelerate over the longer-term. The anticipated combination of HBO Max with Discovery+ next year is expected to enable more pricing options and attract a greater volume of viewers from various budget categories, while ongoing globalization efforts would also draw greater traction to WBD’s streaming offerings, putting the company’s target of achieving 130 million paid D2C subscribers by mid-decade within reach.
4. Lack of Focus on Warner Brothers Content Value
Managerial and operational changes at WBD under current CEO David Zaslav’s leadership has also been met with mixed reviews. In addition to the cancellation of high-profile projects that carried over from the legacy WarnerMedia business, Zaslav has also made bold moves in eliminating strategies like “direct-to-streaming” for new movie releases pioneered by legacy WarnerMedia. Instead, Zaslav has restored his favor for the traditional strategy of “windowing” to maximize returns on content investments. He also has big goals for better streamlining the DC comic franchise to enable a “cohesive storytelling universe” like Disney’s Marvel.
Although from a business standpoint Zaslav’s bandaid-ripping decisions are expected to drive greater operational and cost efficiencies, he has yet to prove that the aggressive calls are balanced moves. Put in other words, while we agree that maximizing profitability and returns on investments are important positives, whether they are sustainable remains an uncertainty as it does not seem like there is sufficient focus on growing the business and pioneering new value yet. While rivals like Disney are buying back content rights to bolster its grip on the growing D2C market, and Netflix is roaming out of its comfort zone to test out in-theatre releases, WBD seems to be retreating to the traditional way of business in all aspects, which risks losing out on the growth synergies that come with disruptions observed across traditional media and entertainment in recent years. Instead of pioneering change, WBD could risk finding itself in a constant catch-up game if it fails to find a balance between enabling cost-savings and growth in the process of expanding profitability.
Management has also been making a lot of changes to the Warner Bros. side of things, but less so on the Discovery side of things, which begs the question of whether WBD is in fact making progress towards unlocking merger synergies, or just enlarging the legacy Discovery business. If the latter is true, then the WBD investment thesis could be at risk. As management has acknowledged during its latest Investor Presentation, Discovery is focused on unscripted content. While the business has built some of the most iconic franchises for unscripted content, the genre is less popular among viewers compared to scripted content, with a comparatively smaller fan base. Out of “more than 16,000 TV shows available across 140 U.S. streaming platforms”, more than two-thirds are scripted to enable better capitalization of audience appetite. Much of the content stemming from the legacy WarnerMedia business, which are mostly scripted, is supposed to complement Discovery’s base of unscripted content and enable a more balanced offering portfolio for both viewers and content licensing customers.
While WBD management is not making Warner Bros. transition into the business of mostly unscripted content, recent decisions made in the name of “cost-cutting” could potentially suffocate creativity and even burn bridges with key partners that have been critical to building the Warner Bros. brand over the years. As such, finding a balance in its ongoing synergy-realization strategy remains critical to the direction that the WBD investment is headed over the longer-term.
Final Thoughts
Out of the four bear cases discussed in the foregoing analysis, only the fourth one remains a real uncertainty. However, our bullish thesis on the stock remains unchanged. The WBD stock is currently significantly undervalued considering its near- and longer-term growth and profitability profile on a relative basis to peers. At a forward EV/sales multiple of 1.6x, WBD is trading closer towards industry peers like Paramount Global (PARA) and Comcast (CMCSA), which exhibit lower growth and command a much smaller market share.
While it is currently uncertain whether the stock will trend lower given the unfavorable market backdrop that is expected to remain volatile until Fed tightening has peaked, we think WBD remains a safe and valid long-term investment at current levels. With its long-term growth and profitability prospects solidly intact, the stock is not expected to breach the currently industry-low valuation multiple of approximately 0.6x EV/sales in the near-term. This is further corroborated by the recent support it has found in the low-teens range over the past month, despite renewed market-wide selloffs due to rising recession risks.
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