2023-11-09 08:37:27 ET
Summary
- Warner Bros. Discovery's stock fell 19% after Q3 earnings due to soft advertising revenue and missed leverage targets.
- The decline in stock is puzzling as other companies facing the same dynamics, like Paramount Pictures, saw their stock rise.
- Despite the decline, Warner Bros. Discovery had a strong quarter and is focused on investing in gaming and streaming for growth.
For a year that saw Warner Bros. Discovery ( WBD ) have the highest grossing movie, the bestselling video game, and the most critically-acclaimed show, its stock has nothing to show for it; the stock is slightly down on the year after getting hammered post Q3 earnings on Wednesday.
Why Warner Bros. Discovery Shares Fell 19% Wednesday
There is really one big culprit; the advertising market. Management said in the earnings call that advertising revenue on the legacy media side remains soft, $1 billion less in revenue year-to-date compared to last year. They added that they have no visibility of when it would rebound, and that they'd miss their leverage target of 2.5-3x EV/EBITDA if it the ad market doesn't come back in 2024.
The decline in the stock is rather strange given that this isn't a company-specific problem, yet Paramount Pictures Corporation ( PARA ) was up double digits just a few days earlier despite facing the same dynamics. I double-checked the advertising performance of the major legacy media companies in Q3 just to be sure. Here is what I found:
All three companies were down high single-digits with WBD down double digits, but not enough to justify losing a fifth of its value while Paramount's stock rose on the same results. Disney did not break out advertising revenue for the September quarter, though they said that it was down as well.
More puzzling was that the quarter was really good; the company will hit its EBITDA target for this year, free cash flow guide for the year was north of $5 billion. Management during the call was generally optimistic that they can print similar numbers for 2024. Yet the stock lost almost a fifth of its value in a day.
This leads us to what many analysts believe is the crux of the matter, which is the implication of the decline in the ad market on WBD. From the Wall St. Journal :
In a note to clients after the Warner call Wednesday morning, Guggenheim Securities analyst Michael Morris said, “We believe that what has been considered the core of the equity investment thesis—consistent leverage reduction despite secular headwinds—comes into question.”
This seems to indicate that technicals are driving the selling. Wall St. analysts were bullish on the stock for the deleveraging story, and now that that will not materialize, they are selling because the models they built their thesis on no longer hold.
More importantly in my opinion, that deleveraging story isn't materializing not because the ad market is weak, but because the company's profitability is exceeding expectations. From the earnings call:
with our strong cash generation, significantly reduced leverage, the outstanding results our games business has delivered, the turn to profitability of our streaming business, and the clear value in our ability to drive franchise returns across the company, we see more and more opportunity for investing in sustainable profitable growth.
Management highlighted the gaming business in particular (which I called the Jewel in WBD's crown in 2021) along with streaming as important avenues for growth. They said they want to invest in helping gaming studios make money year-round, rather than just focus on making games that take 3 to 4 years to get to market. Here is CFO Gunnar Wiedenfels from the Q3 earnings call on WBD's two growth levers:
starting with the games business, we've spent a lot of time over the past year going into a lot of granular detail across all of the areas of our capital allocation. And the games business has shown tremendous success, not only from a P&L perspective, really, as David said, contributing hundreds of millions of dollars to our consolidated profits, but also from a return on investment perspective. I've double and triple checked some of the metrics here because it's such a great investment opportunity. I'm stunned that we haven't been investing more into this opportunity under JB's and David Haddad's leadership here, and I think we have to do more. There's a lot more opportunity there and we're going to start tackling that.
On the D2C side, again just take a step back here. Over just a year and a half, we're now looking for this year at a breakeven positive business after $2 billion of losses last year. We've right sized the structure. We've got a state of the art platform. As David said, we're coming off of a quarter with virtually no fresh content on the platform. We want to get behind that. When we come back, when Casey's content comes back to the platform, we want to get behind it. We know that we can get tremendous returns on our marketing spend behind new content and we will take advantage of that. And I do think we have a real opportunity here.
This shows that things are bad and WBD won't hit its 2024 leverage numbers, it is quite the contrary. Things are working quite well on gaming and DTC that management wants to lean in and invest in those businesses, even if it means temporarily sacrificing 2.5x leverage multiple. They could have simply delayed the launch of Max in new international markets in 2024 for example, if they were truly struggling to hit the leverage numbers.
Ironically, it seems that WBD's management are damned if they do and damned if they don't. When the company cut content spending last year, most famously the Bat Girl movie, the stock was down double digits. Then when they decided to spend money to go after growth, their stock still went down double digits.
But in some ways, WBD management also have themselves to blame. Why mention a guide for full-year 2024 in Q3 of 2023. They could have simply discussed that in when it was due in Q4. It is especially peculiar given that they also didn't rule out the advertising market rebounding in 2024, it's just that they do not know. I find that all the more puzzling because if they don't know, why volunteer to put a lot of doubt on not just WBD, but many of the legacy media stocks? It seems an unnecessary blunder with costly consequences. It could also be, exactly what management wanted.
Is WBD Set for a Merger in 2024?
The earnings call for Q3 was a fascinating read and I recommend that all investors read it. This particular part from David Zaslav caught my attention:
This is a company that's generating over $5 billion in free cash flow. We've paid down $12 billion in debt. What that gives us is stability and sustainability.
And ultimately, in a difficult environment, it's going to give us optionality, because we're surrounded by a lot of companies that don't have the geographic diversity that we have, aren't generating real free cash flow, have debt that is presenting issues. We're delevering at a time when our peers are levering up, at a time when our peers are unstable and there is a lot of excess competitive, excess players in the market. So this will give us a chance not only to fight to grow in the next year, but to have the kind of balance sheet and the kind of stability of a real company, diverse, gaming, TV, motion picture, HBO, linear, that we could be really opportunistic over the next twelve to 24 months.
There are two pieces of information that are an important in this regard. The first is that media investors cheered Roku's results and then Paramount's results, that along with the decline in treasury yields made it look from a technical and fundamental point of view that legacy media stocks might have bottomed. Stocks like Paramount and other smaller legacy media stocks were up 20% in a week or so.
The second piece of information is that due to the Reverse Morris Trust agreement Discovery had with AT&T, WBD reportedly can't engage in mergers and acquisitions for two years, which is due in 2024.
Now call me a cynic, but if I am a buyer of media assets and I see them running away from me I'd try and talk them down. I can't see any other reason why Wiedenfels in particular would give a negative 2024 guidance a quarter early, while highlighting that this guidance was highly uncertain, yet the EBITDA and free cash flow numbers are so strong that it "puts us in a position to focus on growth a little more as we go into next year." While also noting that the market place is crowded and they will look to buy peers, but only opportunistically.
And it worked; Paramount was down almost 8 percent (even though nothing WBD management said about the industry was not acknowledged by Paramount's management in their earnings call). Lions Gate Entertainment for its part was down close to 5 percent.
I have to admit that this is highly speculative on my part. Yes it seems like WBD will look to acquire more media assets in the future. But there is absolutely no evidence that management were jawboning media stocks to keep prices down until they are allowed to engage in mergers and acquisitions. It is more likely that management wanted to be clear and transparent with their investors and the reaction in the stock was accidental.
An Update on WBD's Valuation
I argued in my last WBD analysis that investors should value the stock based on an EV/EBITDA multiple, and that they should ignore (for the sake of conservatism) the EBITDA coming from the networks segment, given the structural challenges the segment faces.
I wanted to update the valuation following Q3 earnings.
EBITDA for both the DTC and studio segment for Q3 had an annual run rate of around $3.3 billion. That would give the firm an EV/EBITDA valuation of 22x. Netflix's is around 29x. It is prudent however to be more conservative on the EBITDA, given the strong performance of Barbie. The average annual run rate of the Q2 and Q3 of 2023 quarters was roughly $2.8 billion. That would give the stock a multiple of 26x, compared to Netflix's multiple of 29x.
Conclusion
Despite management clumsily talking their stock down, I am reiterating my buy rating for WBD following Q3 results. My long-term thesis has been focused on the company's unique asset that is gaming and its inverted flywheel.
This quarter saw management pivot slightly from the de-levering talk towards gaming, noting that it "has consistently enjoyed among the highest ROIs of any of our businesses," and its flywheel, highlighting that "we can get tremendous returns on our marketing spend behind new content and we will take advantage of that."
I do expect the company to continue to pay down debt and look for inorganic growth opportunities if they fall their way.
For further details see:
Is Warner Bros. Discovery Looking To Make An Acquisition In 2024?