Warner Bros. Discovery: Superhero Content Vs. Villainous Debt

In this article, I briefly continue my thoughts on Warner Bros. Discovery (NASDAQ:WBD) and its current state. I remain bullish, having added to my long-term position very recently (and I will continue to add when I can, especially if the stock continues to hang around these levels). I will consider recent comments from the CEO and share my observations.

Brief Introduction

Warner Bros. Discovery had a challenging time earlier in the month (November 3) when it released earnings numbers for the third quarter. Expectations were missed, operational cash flow was scant, and free cash was nowhere to be seen…for a company that has a lot of debt. The company does have nearly 95 million reported streaming subscribers for Q3, but that represented a sequential gain of just under 3 million new users.

Doesn’t sound like a great long-term setup…but the company is still young, and the first set of earnings reports won’t matter in the big scheme.

Yes, execution risks are always there. Right now, though, investors are being compensated for taking the plunge and placing the stock in their portfolios of media companies with a share price on the lower end of the 52-week range, a decent valuation, and a prime set of media assets combined with a streaming combo that is ready to grow its subscriber base and expand its advertising reach.

Content Remains King

Looking at the conference call transcript, as well as the transcript to the RBC Capital Markets Media Technology/etc. talk, it remains the case that buying this stock is basically a bet on Batman… it may sound humorous, but it really is the truth. CEO David Zaslav is all-in on the company’s brands.

What he has to balance, very carefully, is the two mindsets present: he wants to be the guy who isn’t afraid to cancel a project for a tax write-off in the morning, lay off a few people in the afternoon, and then wind his evening up by telling a few A-list actors and directors that their quotes are laughably high, while simultaneously being the man who green-lights several high-profile, expensive projects based on Superman and other DC characters. It’s a tough tightrope to walk.

During the call, Zaslav mentioned that he tied Matt Reeves, director of the latest Batman film, to an overall theatrical deal, as well as Quinta Brunson on the episodic side. Chuck Lorre was also highlighted as bringing his talents to HBO Max. You may recall that Zaslav is a careful evaluator of talent transactions, so while these types of things can be expensive, this is one of the bets shareholders are making with WBD – that the overall cost of talent will be rationalized (hopefully the quantity of debt will keep him in check on this aspect of the thesis).

Analyst Declan Cahill inquired about the content strategy. Zaslav seems to be in Disney (DIS)-mode here as he basically wants to increase the quantity of sequels/prequels/reboots and so on:

… we’re going to have a real focus on franchises. We haven’t had a Superman movie in 13 years. We haven’t done a Harry Potter movie in 15 years. What the — the DC movies and Harry Potter movies provided a lot of the profits of Warner Brothers Motion Pictures over the last 25 years. So focus on the franchise. One of the big advantages that we have, House of the Dragon is an example of that. Game of Thrones, taking advantage of Sex in the City, Lord of the Rings, we still have the right to do Lord of the Rings movies.”

Besides wanting to focus on expanding the volume of IP material – a very smart, if obvious, move – Zaslav also wants to make certain, by my read, that the secondary IP is always in motion – i.e., sold to competing platforms in addition to hanging out on H-Max some of the time. Whereas a company like Disney tends to be a little more all-in with exclusivity on its platform (in a general sense, as obviously Disney will play the same game when it wants to), WBD seems to not be hung up on exclusivity so much as its content ages. The CEO seems to want the older catalog stuff licensed out more aggressively than it has been in the past. Of course, when you’re the new sheriff in town, you’re going to make statements like that, as in, this time it will be different under my watch, but as I’ve said before, buying this stock is in part a bet on the CEO’s actions matching his rhetoric.

In fact, let me just throw a few bullet points up before I continue on, based on commentary from the call and the conference:

• WBD wants to ensure that any content that it is not being utilized to any critical-mass extent on streaming is licensed out.
• The company is dedicated to getting its corporate foot in the door of free-advertising-supported-television, the so-called FAST model.
• It no longer wants to experiment too radically with theatrical windows – i.e., let the box-office bucks rack up, let H-Max/Discovery content fend for itself.
• The company doesn’t sound like it wants to test out too many new concepts in theatrical or episodic… maximize the use of IP.

If you consider the above, what it tells you is WBD is re-positioning itself in this new stage of the streaming wars: go for the dual-income stream of advertising revenue and premium subscription fees, don’t make increased volume of content the goal (instead, the combination with Discovery, which was the whole point of the merger, will fill out the volume concerns), concentrate on subscriber growth in a less-aggressive manner, especially given the inflationary environment/poor market conditions.

On the volume issue: I personally can see why Zaslav may not want to focus on overspending on content, especially secondary/tertiary-level material. That’s the big knock on Netflix (NFLX), of course – it has a ton of stuff to watch, and a lot of it is subpar. It’s the old 80/20 rule where most of the value for Netflix can be sourced to a few headline-driving hits that drive social-media/watercooler-type zeitgeists (some might say that Netflix is more like 90/10 or higher). However, volume, especially if it is produced very carefully and very economically, isn’t a bad thing to have, either, because large libraries will always be a draw and will always equate to a certain level of sign-ups and retention. It also allows for possible franchises to start at H-Max and then migrate over to other platforms. As an example, a show might incubate on H-Max/Discovery, and if it isn’t doing much for the streamer, maybe it could take its erstwhile streaming-exclusivity equity and port it over to TBS/TNT; or it could become the source material for a theatrical project. Plus, consumers sometimes want more options than they’ll ever use to simply feel like they are in charge of selecting the next thing to watch instead of doing the same thing over and over (watching Stranger Things, Adam Sandler pictures, so on).

Based on comments the CEO made at the RBC conference, he isn’t shy at all about competing with Disney/Netflix. He first paid his respects, naturally:

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 then:

But one of the opportunities is that those companies haven’t grown much. We thought they would each have picked up another 30 million, 40 million subscribers in the US, another 100 million subscribers. We were afraid they would run away from our ability to catch them or to catch the consumers’ interest.”

He finished by saying the future was unclear for the streaming wars; the last one standing in terms of growth/subscriber-base is not necessarily already written in some book of corporate destiny.

While content may be king, and Warner Bros. itself may be a king of certain IP territories (DC, etc.), Zaslav will need to be cautious. First of all, for all the talk of WBD IP, I obviously don’t have to point out that Disney isn’t lacking in that area; Netflix, one might argue, is lacking in IP specifically incubated at theatrical, and lacking in strategy of foresight by not perhaps announcing any Stranger Things films for the multiplex. Given the latter, one might say Disney has the most to gain from going at it with Netflix and WBD; DC is certainly powerful, but Marvel has first-mover advantage with its portfolio.

But, talk about recent news that could change a lot in that regard: Zaslav picked James Gunn and Peter Safran to steer DC. Safran is a respected producer who has worked in the DC universe, with Aquaman being one high-profile example; he also helped out with the Conjuring series.

James Gunn – well, Disney CEO Bob Chapek can’t be pleased. (Update: Well, I guess that is more of a hypothetical question at this point.) He’s responsible for turning the Guardians of the Galaxy franchise into another shareholder-value-enhancing piece of cinema. He too has worked with DC, and now, DC will have his services full-time. Zaslav did say he needed to find his own Kevin Feige; now he has an equivalent with these two human resources. Now he just needs to clone executives from the Pixar side to ensure animation becomes more competitive; give him some time.

Yes, content is king. WBD has a lot of it. It’s why I am betting on this stock.

Conclusion

Let me wrap this up by reiterating the main drag on the thesis: the debt. Gross long-term borrowing on the balance sheet was $50 billion. I don’t like it either, especially as it compares to the market capitalization. But the company knows what it is up against, and I expect at some point there will be news flow about aggressive de-leveraging events beyond cash-flow allocation – as in, some asset sales. Certainly, as I’ve mentioned before, the video-game department might be looked at.

At the time of this writing, the company sported a good valuation rating of B- from SA, but I expect the valuation to trend down from here depending on price action (it already has trended down a bit the last few months).

I am more focused on the pullback in the shares from a technical perspective. Given the collection of assets, I am betting that the quantitative fundamentals improve over time, and that this is a good media stock to own. The yearly price action ranges from under $10 all the way up to $31. The stock has been on a steady decline. There have been some recent bounces off the low – which I bought recently – but I expect the $9.52 level to be taken out for further downside given market sentiment.

I am looking to average in at the lower end of the range before the next bull market asserts itself. The big risk here is the debt, and Zaslav et al. are looking for any and all synergies to reduce cost structure and bring up the free cash flow. Management is motivated, and with the IP behind it, I think it just makes sense for me to look to add at these price levels. I am long-term bullish on content, advertising, and subscriber growth.