It has been an inauspicious start for the newly formed media group Warner Brothers Discovery ('WBD'). From shortly after the completion of the merger on April 8 to the end of the quarter WBD's share price declined by nearly half to just over $13. At its low at the end of June the equity value of this media giant was a measly $32bn. That despite an estimated $50bn+ in revenue in its first full year as a combined business.
Yes, the traditional pay-TV business is challenged and yes, there is a lot of debt on WBD's balance sheet. No question the integration of two very different organizational cultures is going to prove a challenge, and the financials are going to be messy for some time. But at its core we think this is a fundamentally sound business with a tremendous long-term outlook and we have been buyers of the stock during the second quarter.
A year on from the announcement of the transaction, Discovery and AT&T’s Warner Media business combined to form Warner Brothers Discovery (‘WBD’). Discovery shareholders ended up owning 29% of the business, while AT&T shareholders received shares worth 71% and AT&T received cash and debt reduction to the tune of US$40 billion. Discovery is clearly the junior partner in the combined enterprise, however, the merger came about due to the unrelenting ambition of Discovery’s CEO, David Zaslav, and the deal is effectively structured as an acquisition of Warner Media by Discovery with Zaslav remaining as CEO and Discovery's CFO Gunnar Wiedenfels continuing in that role for WBD.
It certainly wasn’t a cheap transaction for Discovery’s ordinary shareholders given Discovery’s resulting share of the merged business, the level of net debt and the conversion premium paid to Discovery’s preferred stockholders. Nevertheless, it remains something of a coup for Discovery’s more niche, unscripted content business, which faced an uphill battle to compete in an era of streaming competition. The Warner Media business includes powerful franchises such as HBO, CNN, Warner Bros film studios, as well as the rights to major sports leagues such as the NBA, MLB and NHL. Combined with Discovery’s unscripted TLC, HGTV and Discovery channels, as well as rights to major European sports programming, the resulting suite of content represents a widely diversified collection of globally recognized, top-tier programming across a range of genres.
The jewel in Warner Media’s crown is HBO. HBO possesses the ‘must have’ library of content and programming necessary to be a true global streaming contender alongside the likes of Disney and Netflix. And yet HBO’s attempt at a ‘direct-to-consumer’ streaming service, HBO Max, only began two years ago. At the time of the acquisition AT&T hadn’t yet disclosed the break down of HBO Max streaming subscriber numbers and its traditional pay-TV HBO subscribers, but in total there were 73.8m at the end of 2021. That was above expectations of 70-73m, and those estimates had already grown from 67-70m as of mid-2021. HBO saw 9% half-on-half growth in subscribers and is halfway towards a 2025 goal of 120-150m. Zaslav noted on the Q1 earnings call that HBO Max had added 3m subscribers in the quarter, demonstrating very robust growth (Netflix actually lost subscribers in North America over the same period). HBO Max only launched in several European countries at the end of 2021 and the cheaper, ad-lite product was only launched in the US in June of 2021. With Netflix seeing net subscriber losses and looking to launch its own ad-lite version, this is looking like a winning move for HBO. Discovery's own ad-lite product actually delivered a higher ARPU than its ad-free version, so the economics look attractive.
So what is behind the massive drop in the share price?
The increase in net debt is partly responsible, but valuations for other media stocks have also come down, most notably for the high-flying streaming pioneer, Netflix. In addition, AT&T shareholders ended up with 1.7 billion shares in WBD as part of the transaction, many of whom may not have wanted them.
The final amount of net debt for the combined WBD is yet to be confirmed. At a headline level AT&T was to receive around $43bn in cash and debt reduction, but the final figure was subject to adjustments for levels of working capital, which could have been as much as $4.5bn. In the end Discovery appears to have paid AT&T $40.5bn at the deal’s close, which we estimate takes WBD's overall net debt to around $50bn. We will know when they report 2Q earnings on the 4th of August. This is a lot of debt but should be manageable for a business that generates enormous amounts of cash. According to the S-4 registration statement the combined group should generate $11bn in EBITDA in 2024, which would mean net debt to EBITDA of around 4.5 times. This would reduce quite sharply with cash flows initially directed to deleveraging.
Zaslav has also provided a target of $3bn in synergies, and while the target is aggressive, his management team have a strong record of delivery from the integration of Discovery and Scripps. The immediate axing of CNN+ shortly after launch shows he is not messing around. Synergies of that size would help reduce net debt to EBITDA to 3.5 times within a short period. If successful, it would also mean that at a share price of around $14, the business is valued at six times FY24 EV/EBITDA, or roughly half of where peers such as Disney and Netflix are trading. Even without synergies, the business is trading at a very significant discount to those competitors.
Estimates provided in the S-4 show unlevered free cash flow of $7.5bn in FY24, which would put the company on 11x EV/FCF or a 9% unlevered free cash flow yield to enterprise value.
Now it is also true that the traditional linear pay-tv business has been going backwards for a long time, with 4-5% annual subscriber losses and falling viewing times. That trend has been in place for years. Oddly enough, Discovery's affiliate and advertising revenues for its linear programming had continued to grow despite the shrinking audience, which was partly attributable to rising affiliate rates and higher ad prices. How long that can continue is anyone's guess, but it's been going on a very long time. Probably it will provide some cash flow stability at the very least while management focuses on driving growth in the direct-to-consumer streaming business.
A key plank of that streaming strategy, apart from taking HBO+ international, is to reduce subscriber churn. Reducing churn not only lifts overall net subscriber growth rates, but it enhances the lifetime value of each customer. Zaslav appears to believe that pooling HBO’s compelling scripted content with sports, news and the cheap-to-produce, unscripted “filler” content of Discovery, TLC and the HGTV channels will achieve just that. The rationale being that content that appeals to every member of the family and that suits different viewing occasions is much harder to turn off. In a sense, WBD has all the elements necessary to create its own mini "bundle". And at the right price point, or even advertiser funded, it’s a core part of any family’s Pay-TV or streaming budget.
WBD will need to invest behind this new HBO/Discovery+ streaming service and in all likelihood some of the vaunted cost synergies will be reinvested into growing that business through content and technology investments and marketing spend. Zaslav has communicated that free cash flow will go towards a) deleveraging, b) strategic growth and c) to returning capital to shareholders, in that order. In that case the stock is probably not as cheap as some of the multiples we have laid out above. But given the expected returns on that investment and the long runway for growth of this new media giant, that's also fine with us.