WBD - Warner Bros. Discovery: No I Am Not Entertained

2023-05-06 11:01:44 ET

Summary

• Warner Bros. Discovery reported Q1 results below expectations, and I am not entertained by the continued disappointments.
• I would like to point out that this is the third quarter in a row where WBD disappointed against pro forma estimates at group level.
• Upon reassessment, I have come to perceive WBD's profitability outlook as much less clear and more uncertain than initially presumed.
• Post Q1 2023 reporting, I update my EPS expectations for WBD through 2025; and I now calculate a fair implied target price of $11.34.
• I downgrade to 'Sell/ underperform' rating.

Warner Bros. Discovery ( WBD ) reported a mixed Q1 2023, surprising markets with a $1.1 billion loss at group level, but a $50 million operating profit in DTC. WBD's weak Q1 performance was reported shortly after Paramount ( PARA ) disclosed a similar net loss of $1.1 billion in Q1, indicating that the challenges facing WBD are related to an industry-wide slowdown in cable TV and film studio industry.

While I continue to like WBD's enormous content portfolio, I now see the company's profitability outlook as more clouded than previously assumed ; and I also expect that the inevitable debt reduction push, paired with necessary ongoing investments in content, will likely not allow for shareholder distributions anytime soon. I downgrade WBD stock to 'Sell/ Underperform'.

For reference, Warner Bros. Discovery stock has underperformed lately: During the past twelve months, WBD shares are down about 32%, as compared to a gain of approximately 71% for competitor Netflix (NFLX) and a flat performance from the S&P 500 (SP500).

WBD's Q1 Results

On May 5th, WBD reported results for Q1 2023, missing analyst estimates with regards to both topline and earnings projections on group level, but highlighting a surprise profitability in DTC. During the period from January to end of March, the US' entertainment conglomerate recorded about $10.7 billion of revenues, a decrease of about 6% versus the combined pro-forma estimate pre-merger, and about $35 million below analyst consensus estimates according to data collected by Refinitiv.

With regards to profitability, WBD's EBITDA was reported at $2.6 billion, up 10% versus pro forma estimates; net loss available to shareholders came in at $1.1 billion (-0.38/share), clearly disappointing against analyst estimates which were projecting a loss in the range of $350-450 million.

Admittedly, Warner Bros. Discovery disclosed that profitability was impacted by charges of about $1.81 billion in write-downs of "acquisition-related intangible assets" and the realization of $95 million in pre-tax "restructuring expenses". However, investors should not ignore that Zaslav also commented on structural, non-merger-related, "challenging revenue headwinds mainly on the linear TV and studio sides".

Notably, the 'Studios' segment reported revenues of $3.2 billion, down 7% versus pro forma estimates, despite the success of 'Hogwarts Legacy', one of the best-selling gaming titles of all time. Adj. EBITDA for the segment fell to $0.6 billion, versus $0.8 billion pro forma (down 23%).

WBD's 'Networks' segment was clearly pressured by macro/ structural headwinds, with revenue falling 10% versus pro forma, to $5.6 billion. Adj. EBITDA fell 10% as compared to pro forma, to $2.4 billion.

Only WBD's DTC performed better than expected, reporting $2.5 billion of revenues and a surprise operating profit of about $50 million EBITDA. Consistent with previous financial reports, the company reported ongoing expansion in its worldwide subscriber count, acquiring an additional 1.6 million subscribers during the quarter, bringing the total audience to 97.6 million subscribers. CEO David Zaslav informed investors that he anticipates the DTC business to generate a profit in 2023, one year earlier than anticipated.

In sum, WBD's surprise profit in DTC of about $50 million is a very small consolation in comparison to the reported group loss close to $1.1 billion, and the declining revenue base across segments. Moreover, I would also like to point out that WBD's significant debt position, which the company took on to finance the merger, is starting to exert pressure on financials and FCF. Specifically, WBD semi-annual interest payments amount to about $800 million (note, interest payments are not included in EBITDA measures!).

Valuation Update - Lower TP to $11.34

Reflecting on WBD's disappointing Q1 2023 report, I adjust my EPS expectations for the entertainment giant through 2025 -- seeing significantly lower earnings power due to (1) industry competition, (2) debt burden, (3) and contracting revenue. I now estimate that WBD's EPS in 2023 will likely fall to somewhere between $-0.8 and $-0.4. Moreover, I also lower my EPS expectations for 2024 and 2025, to $0.45 and $0.85 respectively.

I continue to anchor on a 2% terminal growth rate (slightly below estimated nominal global GDP growth), as well as on a 12% cost of equity (which I think might even be too low still, given the debt/ interest payment risk).

Given the EPS upgrades as highlighted below, I now calculate a fair implied share price for WBD equal to $11.34.

Below is also the updated sensitivity table.

Conclusion

Warner Bros. Discovery reported Q1 results below expectations, and I am not entertained by the continued disappointments. I would like to point out that this is the 3rd quarter in a row where WBD disappointed against pro forma estimates at group level and hit its balance sheet with restructuring expenses and asset write-downs. Moreover, I am also turning negative on the company's enormous net debt position, which was $46.8 billion as of March 2023. Increasingly, I view the Warner Bros. & Discovery merger as an overhyped and overpromised project, pushed by the acquiring company's management team.

Upon reassessment, I have come to perceive WBD's profitability outlook as much less clear and more uncertain than initially presumed. Considering the imminent need for reducing debt and the ongoing requirement to invest in content, it is increasingly likely that the company will not be able to distribute profits to its shareholders in the foreseeable future, and I am not a shareholder anymore

Post Q1 2023 reporting, I update my EPS expectations for WBD through 2025; and I now calculate a fair implied target price of $11.34. I downgrade to 'Sell/ underperform' rating.

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