GAN - O'Keefe Stevens Advisory - Warner Brothers Discovery: The Future Is Bright

Summary

• Several positions within the portfolio deserve some reflection; however, the one deserving the most attention is Warner Brothers Discovery.
• While WBD is not a recent IPO, it went through a dramatic business model change.
• It's my mistake to have not used lessons to draw parallels to a portfolio holding WBD: WBD finished a brutal 2022, down 62%.
• We continue to own and believe the future of Warner Brothers Discovery is bright, and in a few years, I hope to write how ill-timed and successful this investment was.

The following segment was excerpted from this fund letter .

Warner Brothers Discovery ( WBD )

Several positions within the portfolio deserve some reflection; however, the one deserving the most attention is WBD. Not surprisingly, it was one of the worst-performing stocks in our portfolio over the past year.

One concept learned from Jeremy Raper at Raper Capital (@Puppyeh1 on Twitter) is "when there's a massive pivot in biz model and under-delivery vs. clear IPO targets, it's generally a big red flag." While WBD is not a recent IPO, it went through a dramatic business model change. I recall two examples of companies that pivoted strategies.

Angus "Gus" Kelly, CEO of Aercap ( AER ), preached how the accelerated depreciation schedule of planes caused accounting earnings to understate economic profits and the balance sheet understated the fair value of assets. AER's assets, new tech, and narrow body were some of the most desirable in the industry. When Aercap acquired GECAS in 2021, Gus discusses the BV and accounting reasons behind the transactions and how they were acquiring these planes at less than BV, even though they could have repurchased shares at a discount to BV. They also acquired 300 helicopters, historically a business line the company did not find favorable. When AER acquired these assets, it was no longer apparent that the company's accelerated depreciation schedule was unique and gave them an edge. Nor was the company acquiring assets that were in line with the previously discussed business model. This change in strategy should cause one to reassess the thesis.

The second was GAN 's acquisition of Coolbet, a B2C Sportsbook. Previously, a high-margin, growing SaaS B2B company shifted into the competitive consumer sports betting world. This pivot degraded the business model and future profitability. The go-forward business economics were likely much worse than the previous standalone business.

Since the sportsbook acquisition, GAN is down 93%. While I suspect the B2B performance has underperformed expectations, this business model pivot played a role. AER has fared better, down only 8% since the GECAS transaction closed. It's my mistake to have not used the lessons to draw parallels to a portfolio holding WBD.

WBD finished a brutal 2022, down 62%. In April 2021, Discovery announced the acquisition of Warner Media for ~$100B. Today, the EV of the combined entity stands at $83B. It's obvious listening to David Zaslov discuss the challenges with the merger, implying Discovery overpaid for the assets. Discovery had previous success with the Scripts merger. Our initial reaction was to think a similar result would occur. However, it should have been apparent the difference between them.

Zaslov, on the Q4 2019 earnings call, three months before the Warner Media / Discovery deal, said:

" …the economics of our model. Our content is a small fraction of what's taking place on the other side of the ledger. The overbid, competitive, spiraling out-of-control costs for scripted, new and repeats is astounding. That is not who we are. We aren't paying hundreds of millions of dollars for content, original or repeats, that we can't even own."

Discovery would succeed in the streaming wars due to unscripted content's cost advantage. Three months later, they acquired an almost exclusively scripted business, valued over 2x legacy Discovery, becoming what Zaslov said it would not.

Maybe hindsight is 20/20, and the only reason to write about this is how much the stock is down. A business strategy transformation that opposed recent commentary should have raised more red flags than it did. Additionally, we were aware but did not realize how significant an impact the legacy AT&T shareholder's sell down of WBD shares would be, creating a sizable headwind.

We continue to own and believe the future of Warner Brothers Discovery is bright. The company issued long-term fixed-rate debt at absurdly low-interest rates, which is a saving grace. The stock is incredibly cheap, the company can repurchase debt at a discount to where they issued it just a year ago, and the business should start gushing cash flows in the coming quarters. In a few years, I hope to write how ill-timed and successful this investment was.

Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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