PARAP - Paramount: Surprise! It's A Bargain

2023-11-03 11:35:28 ET

Summary

• The key risk for the short thesis has always been DTC profitability.
• But bulls have probably been too focused on the SOTP thesis as well.
• If Paramount continues to execute well, the upside could be far larger than expected.

Both longs and shorts were wrong

Paramount Global ( PARA ) ( PARAA ) has long been a battleground stock.

Bulls were looking at the hefty discount to book value, the underlying real estate and movie library and were hoping for a deep-pocketed acquirer.

Bears were betting that this hodgepodge of assets was effectively un-sellable, while the investments into the new streaming business were wasted money and interest rate increases would strangle the company.

It turned out that both bulls and bears were effectively too focused on the sum-of-the-parts thesis, as Paramount will likely prove to become a profitable player in the streaming business.

What was so surprising about Q3/23 earnings?

As Seeking Alpha's earnings preview stated,

Over the last 3 months, EPS estimates have seen 0 upward revisions and 17 downward. Revenue estimates have seen 1 upward revision and 15 downward.

Hence, the sentiment was pretty bearish - and understandably so: The stock was trading at all-time lows, interest rate increases burdened financing costs, the advertising market is bad, everybody is expecting a recession around the corner (this has actually been the case for years), the streaming wars haven't become any better, Hollywood writers and actors were striking, and Paramount had just pushed through a price increase with a likely negative impact on churn rates - well, you get the picture.

And Paramount had even cut its dividend.

Yet the company delivered surprisingly good earnings and free cash flow.

Q3 adjusted EPS came in at three times the expected level, unadjusted EPS was even better.

DTC OIBDA losses were 31% less than one year ago, as even advertising revenues grew 18% in the DTC segment and subscription revenues jumped 46% thanks to the price increase, which did not cause higher churn. Despite higher revenues, DTC expenses shrank 23% YoY. And despite the price increase and 1.3 million subscribers lost in Latin America due to the loss of a hard bundle, Paramount+ net subscriber additions were still 2.7 million. We might argue that the actual additions were therefore 4 million.

In TV Media, despite the bad advertising market and inflation-driven expense growth, adj. OIBDA was only moderately lower than last year's.

The Filmed Entertainment segment obviously suffered from the strike. As the company stated on the call , this segment's result would have been positive without the nearly $60 million of strike-related idle costs.

Even more surprisingly, the company now predicts that its DTC investment losses will be lower in 2023 than in 2022. Until today, Paramount itself had expected its losses to peak this year. And from here earnings should grow again.

How will earnings be impacted?

Earnings estimates will have to rise substantially.

Even more importantly, the idea that DTC is just a waste of money (some analysts even suggested Paramount should shut down the segment) will have to change.

Assuming earnings will be better in each quarter than the $0.30 posted Q3/23, the current consensus EPS estimate of $1.23 for 2024 will move higher.

Here are some of the key impacts to ponder:

1. Price increases took effect at different times for different subscriber cohorts throughout the quarter, which means we won't see the full ARPU benefit of the price increase until Q4.

2. Moreover, as stated on the call,

In Q3, total company OIBDA included nearly $60 million of strike-related idle costs. These are incremental expenses incurred to retain production capabilities while the strike is ongoing. These costs impacted both our TV media and filmed entertainment segments. We expect to incur additional strike-related idle costs in Q4 ... and we expect strong free cash flow in Q4 as the strike continues to limit the production of content.

3. Lower debt due to the net proceeds from Simon & Schuster of $1.3B, lower dividend payments, which result in the debt tender offer , a lower financing cost and extended debt maturities. Higher OIBDA and lower debt will have a substantial effect on the Net debt/OIBDA ratio in 2024.

4. As stated on the call, only a portion of the cash benefit captured in 2023 from the strike is going to be spent back in 2024.

5. The impressive expense control demonstrated in Q3 combined with higher revenues should lead to a massive increase in earnings estimates.

Since subscription revenues on the 63.4m subs Paramount+ had globally at quarter end were $1.14B in the quarter ($18/sub) and we should expect this figure to increase both because of a growing subscriber count and higher ARPU, we can roughly calculate an estimate for DTC revenue one year from now. Assuming net additions at the same pace as in 2023, one year from now Paramount should have about 72m subscribers. If revenues per sub grow another 10%, this makes a run-rate of about $1.4B of subscription revenues in the DTC business per quarter, i.e., $260m more than in Q3/23.

Since total DTC revenues less expenses were negative $238m in Q3, it looks very likely that one year from now DTC will roughly break even, given that we will almost certainly also get a better advertising market (especially political).

The company will also improve its financing costs by about $100m one year from now, as it pays back about $2B of debt between now and then.

While discontinued operations will not contribute their $48m to net earnings anymore, their loss will be compensated by the absence of strikes.

Higher DTC revenues carry a contribution margin of almost 100%, i.e., there are very little additional costs involved and they drop almost entirely to the bottom line.

Hence, instead of $301m of total company pre-tax earnings in Q3/23 (excluding the equity in loss of investee companies), we can reasonably expect about twice as much in Q3/24 - even if the other segments just tread water. This means EPS of about $0.80 in Q3/24.

Assuming this will be the run-rate for 2025, with just moderate growth it is not difficult to see 2025 EPS close to $4.

As a result, at $12 the company is likely trading for just around 6x a cautious 2024 EPS estimate of $2.00 - and for just 3-4x its 2025 earnings.

Conclusion

Paramount as a profitable streaming player is probably the worst case for the shorts ? and for the longs obviously the best case.

It is the worst case for the shorts because there won't be any infinite losses to strangle the company and force it to sell off assets for bargain basement prices. Instead, it will be able to get a good deal - if it wants to sell itself at all .

It will probably continue to restructure, but the fact that it doesn't look like it is forced to sell means that it will realize higher prices. Moreover, it still has levers to pull to increase its overall profitability. For example, so far it has refrained from reigning in password sharing.

As I said in my last article on the company , the dividend cut was a smart move. It has created greater flexibility and thus massive value. Once financing is no problem anymore, Paramount can focus on execution, cost reduction, value-enhancing asset sales and building a better business. It looks like it's working surprisingly well.

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