Erik Khalitov
Warner Bros. Discovery (NASDAQ:WBD) has lost close to half of its value since consummating the merger between legacy WarnerMedia spun-out from telco giant AT&T (T) and Discovery. Yet, the stock has maintained trading range-bound in the low teens in recent months, defying rapidly-deteriorating macroeconomic conditions that have pushed key benchmarks into a wipe-out near the end of the third quarter.
The last steep decline observed in WBD was in early August when management slashed guidance for 2022 and 2023 EBITDA due to near-term macroeconomic uncertainties and worse-than-expected cost inefficiencies identified in the legacy WarnerMedia business. Even WBD’s latest announcement of hefty restructuring charges that could potentially result in a more than $4 billion headwind on profits had little adverse impact on the shares’ performance. This suggested that investor expectations for WBD’s near-term fundamental prospects given looming macroeconomic challenges as well as restructuring issues have been tempered.
And with the stock’s slight post-market slump in late trading on Thursday evening following WBD’s double sales and earnings miss, offset by reiterated EBITDA guidance for the year, investors in the stock have likely already largely priced in the anticipated near-term pains pertaining to macro deterioration, restructuring costs, and secular downtrends in legacy pay TV. However, we remain optimistic on longer-term gains still, as the company continues with its implementation of cost-cutting initiatives and adoption of improved content monetization strategies (e.g. windowing, spreading out new episode releases, etc.) to enhance profitability. While we remain cautious over the potential adverse implications of looming macroeconomic headwinds on WBD’s near-term fundamental performance, we believe the company’s resilience demonstrated in the tough 3Q22 operating environment – especially in its growing direct-to-consumer (“DTC”) business – reinforces its prospects for sustained longer-term growth and profitability, which are supported by its competitive advantages spanning a best-in-class content library and diverse revenue and cash flow generating streams.
In the following analysis, we will revisit the top four bear cases facing WBD and discuss what the company’s latest earnings results imply going forward. Although the current macroeconomic backdrop does not bode favorably for WBD, the worst has likely been already priced into its market value today, as the stock continues to trade at significantly discounted multiples relative to peers with a similar growth and profitability profile. Paired with ongoing restructuring efforts, which reinforces the longer-term sales and cost synergies to be realized, we believe WBD remains a reasonable long-term investment at current levels.
1. Transaction Targets and Macro Headwinds
What the bears say: Management’s decision to dial back on its original post-merger EBITDA and free cash flow conversion targets underscores more macroeconomic and restructuring turmoil to come. This could potentially slow the company’s aggressive deleveraging plans, and stifle its long-term growth prospects, especially as competition heats up in direct-to-consumer (“DTC”) services.
The latest update from 3Q22: The probability of economic recession over the next 12 months are nearing certainty, while mounting macro uncertainties also are driving a pullback in ad dollars and consumer spending on discretionary goods and services – a double whammy for two of the largest revenue streams in media and entertainment – even ahead of the holiday shopping season. Yet, WBD management reiterated its 2022 EBITDA guidance of $9 billion to $9.5 billion, underscoring the value of its diversified revenue portfolio as well as prudent execution of its restructuring strategy amidst a rocky macroeconomic backdrop.
On the DTC front, its subscriber count grew 3% sequentially during the third quarter, adding 2.8 million global sign-ups to bring the total count to 94.9 million despite increasing competition and consumer weakness. The resilience was in part supported by the release of House of the Dragon in August. WBD has opted for a weekly release strategy for the long-awaited prequel to hit drama series Game of Thrones, which likely helped reduce churn and improved subscriber engagement with HBO Max’s broader content library. A weekly content release strategy also is well embraced by advertisers, as the lengthened programming schedule provides visibility on viewership and engagement levels to drive ad placement decisions.
This continues to make HBO Max – which has more than half of its subscribers signed up on the ad-supported tier – an attractive ad distribution channel, despite a contracting pool of ad dollars in the market ahead of a cyclical downturn. This is further corroborated by the momentum observed in the DTC segment’s ad revenue stream, driven by resilient subscription growth across both HBO Max and Discovery+ despite increasing competition and consumer weakness. Specifically, DTC ad revenues more than doubled year-over-year on a constant currency basis, reaching $106 million in the third quarter.
Although WBD’s streaming platforms – which will eventually merge – are not yet profitable, continued momentum in DTC ad revenues is a positive sign that points to scale over the longer term. Digital ad formats are rapidly displacing traditional distribution channels (e.g., linear TV, radio, paper, etc.), with online platforms spanning video streaming, audio streaming, and social media outlets being home to almost two thirds of total ad placements. While ad-tech is a largely cyclical industry with significant exposure to looming macroeconomic challenges, digital advertising – especially in long-form video streaming – is expected to remain resilient. The majority of ad dollars were allocated to digital media in 1H22, with long-form video streaming platforms to see 22% year-over-year growth in ad revenues this year, benefiting from additional “non-cyclical ad spend” in November stemming from mid-term elections and the World Cup:
…political forecasts remain strong and, unlike other verticals, appear to be fully funded and not price-sensitive. In an analysis of the data from the Federal Election Commission, spending was up 47% in the third quarter compared to the 2018 mid-terms while overall fundraising is 74% higher, leaving roughly 89% more funds available at the end of September than in 2018.
Source: RBC Capital Markets Ad-Tech Recap
And despite expectations for a more challenging macroeconomic backdrop in 2023 that will cause advertisers to turn more cautious, digital ad spending on long-form video streaming platforms are expected to grow 33% y/y, underscoring secular tailwinds aiding WBD’s transition from linear pay TV to DTC streaming over the longer term.
Meanwhile, the value of WBD’s best-in-class content library is becoming increasingly prominent as competition heats up in video streaming. This is further corroborated by Amazon’s (AMZN) latest inclusion of the entire Lord of the Rings trilogy – which is currently owned by WBD – to accompany its launch of Rings of Power on Prime Video. This is just one realized example of how WBD continues to indirectly benefit from revenue sharing through distribution and licensing of content rights, which we view as a long-term compensatory mechanism for increasing competition in the DTC landscape:
This includes a boost to distribution revenues generated from licensing content rights to competitors like Apple TV+ (AAPL), broadcasters and other service providers, which indirectly enables a revenue-sharing mechanism for Warner Bros. Discovery amidst the increasingly competitive landscape within the video content creation and on-demand streaming sectors. Having the most attractive content library within the industry is a key competitive advantage for Warner Bros. Discovery. It will be more likely for Warner Bros. Discovery to charge distribution fees for licensed content to a competitor like Apple TV+ or Netflix (NFLX), than vice versa.
Source: “Discovery: Promising Potential Upon Materialization Of WarnerMedia Deal”
In addition to DTC, WBD’s Networks segment also continues to command the one of the highest prime-time viewership, faring better than peers in the broader transition from linear TV to streaming. Although the segment faces imminent declines over time as broadcasting and cable’s share of TV viewership time gets eroded by on-demand streaming, it remains sufficiently profitable to fund growth in other high-demand verticals such as WBD’s DTC business in the meantime. This draws optimism that the company will be able to orchestrate a well-balanced wind-down of its traditional linear business while supporting profitability in its DTC business over the longer term.
And turning to profitability – a key focus area for investors in the latest earnings season – WBD continues to make progress on realizing annualized cost synergies, with its target now upped from the previous $3 billion to now $3.5 billion by 2024. Although the company’s ongoing post-merger restructuring efforts have led to some painful band-aid ripping that included cancellation of multiple high-profile projects alongside aggressive job cuts, related cost savings are expected to become more evident once the restructuring efforts near completion next year, and contribute positively to WBD’s long-term profitability strategy. Specifically, the company is on track towards realizing $750 million in annualized cost synergies by the end of the year, with an incremental $2 billion planned for 2023 and $750 million by 2024. With positive progress on WBD’s internal restructuring game plan, we expect the company to remain one of the best positioned media and entertainment giants for sustained profitable growth over the longer-term once macroeconomic challenges subside.
2. Leveraged Balance Sheet
What the bears say: WBD remains significantly leveraged with $50 billion in outstanding debt on its balance sheet as of Sept. 30. With a high debt-to-equity ratio of almost 2x, rising borrowing costs under today’s macroeconomic environment are bound to levy a heavier discount on the value of its future cash flows, weighing further on its valuation prospects.
The latest update from 3Q22: As discussed in our previous coverage on the stock, WBD’s projected forward free cash flows should be more than enough to cover both its near-term repayment obligations as well as any growth investments. Having contributed $6 billion toward its deleveraging goals this year, including repayments made on term loans, fixed-rate debt, and its commercial paper program, the company has no repayment obligations due until at least next year ($1.3 billion) and 2024 (about $4 billion).
On the borrowing cost front, the majority of WBD’s outstanding debt is long-duration by nature, and comes at a fixed rate of about 4%, which provides visibility over its long-term interest expense obligations and mitigates its exposure from surging interest rates. We also view WBD’s long-duration fixed-rate debt profile a competitive advantage against other growth peers and upstarts in media and entertainment, as the capital structure enables continued investments into longer-term growth initiatives without the need for further financing within the near-term as borrowing costs surge. And with its gross leverage gradually approaching its long-term target of 2.5x to 3x by 2024, WBD’s cost of capital is expected to come down accordingly, alleviating valuation pressures on its longer-term cash flows.
3. D2C Subscription Growth
What the bears say: WBD’s subscription growth is less exciting when compared to peers, adding only 2.8 million subscribers in the third quarter to bring the total count to 94.9 million. This makes it a far cry from Netflix’s 223+ million and Disney’s 221+ million subscribers.
The latest update from 3Q22: WBD added 2.8 million DTC subscribers in the third quarter, representing q/q growth of 3%. The slight sequential acceleration is likely partially driven by the latest release of House of the Dragon as discussed in the earlier section, with spaced out weekly releases playing a critical role in retaining subscriptions and reducing churn. However, we expect competition headwinds to pickup over coming months as rivals Netflix and Disney+ start rolling out their respective ad-supported tiers in the current quarter. Specifically, Netflix and Disney+ will be offering a more competitively priced ad-supported streaming service, starting at $6.99 and $7.99 per month, respectively, compared with HBO Max’s $9.99 per month option.
Yet, we remain optimistic on HBO Max’s value proposition, given its leading content library that boasts multiple iconic franchises, which will be further expanded once merged with Discovery+ next year. Over the longer term, WBD’s consideration of adding a free ad-supported tier, alongside ongoing introduction of content-sharing between HBO Max and Discovery+ ahead of its eventual merger will also help differentiate its DTC offerings from other streaming platforms within the increasingly saturated landscape, and optimize its reach across the broad range of consumer preferences. This will accordingly improve its DTC subscription take-rates, and feed back into the segment’s advertising sales which is where the bread and butter of the business lies.
Although WBD boasts slower subscription growth and a smaller subscriber base when compared to rivals Netflix and Disney+, the company is gradually gaining market share in some of the more profitable regions. For instance, Disney may have been demonstrating rapid DTC subscription growth in recent quarters, but a deeper dive would reveal that much of it comes from Disney+ Hotstar, its streaming service provided to the less profitable India market. Meanwhile, Netflix continues to struggle with recovering subscriptions lost earlier in the year within its most profitable North American and European markets, despite its recent return to growth.
Looking ahead, with WBD poised to expand availability of its streaming platforms to other major overseas markets – especially after the combination of HBO Max and Discovery+ – we expect it to displace more of rivals’ market share, while making favorable progress toward its long-term target to reach 130 million DTC subscribers by mid-decade. This would bring about a few advantages, including a greater consumer reach to drive its DTC advertising business, and scale to improve the segment’s overall profitability as it transitions from being linear TV-focused to streaming-focused.
4. Warner Brothers Legacy Content Value
What the bears say: Aggressive cost-cutting initiatives, including reversal of high profile projects and undertakings implemented at legacy WarnerMedia, could stifle value creation needed to stay competitive within the increasingly saturated media and entertainment sector.
The latest update from 3Q22: As mentioned in our previous coverage on the stock, we had called out the lack of focus on Warner Bros’ content value as an ongoing uncertainty. While there’s still much work left to be done on restructuring the newly merged company, with realizing annualized cost synergies of $3 billion a top priority for management, recent developments have been viewed as positive, including the appointment of Director James Gunn and producer Peter Safran to co-lead DC Comics, as well as the successful roll-out of House of the Dragon on HBO Max.
For instance, the appointment of Gunn and Safran as leaders of DC Studios after CEO David Zaslav’s fallout with the previous executive team is potentially a step in the right direction. Gunn, known for his work on superhero films spanning Marvel’s Guardians of the Galaxy franchise, to DC’s The Suicide Squad and the latest spinoff drama series Peacemaker, will take the helm on creativity, while Safran will “handle the business and production side of the enterprise.” Many within the industry have shown positive excitement on the development, underscoring that Zaslav has not stymied creativity in the process of realizing his vision on bolstering the DC franchise’ economic power and influence against rival Marvel.
Meanwhile, the latest release of House of the Dragon as mentioned in the earlier section has been well received, garnering more than 1 billion minutes in viewership time on HBO Max the week of Sept. 19-25. The show has helped WBD’s streaming platform increase its share of total TV usage from 1.2% in August to 1.3% in September, which again reinforces its gradual market share gains in DTC.
However, there’s still much uncertainty ahead on how WBD looks to right the ship on other areas of its DTC business, including CNN and the highly anticipated combination of Discovery+ and HBO Max into one platform next year. This is consistent with management’s reiterated commentary that more “difficult decisions” await as they progress with post-merger restructuring efforts:
We are reimagining and transforming the organization for the future while driving synergy enterprise-wide, increasing our target to at least $3.5 billion, and making significant progress on our combined DTC product. While we have lots more work to do, and there are some difficult decisions still to be made, we have total conviction in the opportunity ahead.
Final Thoughts
Admittedly, the current macro backdrop makes an unfavourable operating environment for WBD’s consumer-centric and ad-focused business. Yet, the company appears to be trekking ahead with their aggressive post-merger cost-cutting measures to bolster profit margins, which is highly welcomed by investors bracing for more macroeconomic turmoil ahead. Meanwhile, ongoing restructuring efforts are also making progress on reinforcing WBD’s market share gains in the burgeoning DTC business. This makes a strong long-term compensatory factor ahead of a secular transition away from linear TV and legacy broadcasting, which is corroborated by the decline in WBD’s pay TV subscribers observed in the third quarter despite already hosting “six of the top-10 cable networks in Primetime.’
While we remain cautiously optimistic on WBD’s near-term performance as it deals with transformational challenges spanning macroeconomic headwinds, complexities in executing one of the largest restructuring projects in media and entertainment, and a secular transition away from legacy broadcasting / pay TV, its positive developments in DTC during the third quarter point to favorable prospects in realizing sustained profitable growth over the longer term. This accordingly makes the stock, which is trading at a significant discount relative to peers with a similar growth profile, a reasonable long-term investment pick at current levels.
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