2024-01-16 11:16:51 ET
Summary
- Warner Bros. Discovery's post-merger outcomes have fallen short of expectations, leading to a loss of billions in shareholder value.
- The company's potential in 2024, with plans for international expansion, advertising opportunities, and a new sports tier, still holds promise.
- The operating performance of Warner Bros. Discovery has been underwhelming, with declining revenue, profitability below expectations, and significant debt.
In April 2022, Warner Bros. Discovery, Inc. ( WBD ) finalized its spin-off merger with AT&T Inc. (T), a response to the evolving media landscape. CEO David Zaslav has led the merged entity through significant challenges, including declining linear TV, fierce competition, production disruptions due to two strikes, and a mountain of debt. Despite management's efforts to reduce debt and enhance the firm's streaming prospects, post-merger outcomes have fallen short of expectations.
The story resembles Lee Enterprises, Incorporated ( LEE) , a heavily leveraged firm I previously avoided , skeptical of its ability to transition from declining legacy revenues to a profitable digital model. However, I believed Warner Bros. Discovery, under a competent management team, would fare better in optimizing returns and steering the company toward profitability. Unfortunately, a messier-than-expected WarnerMedia and a weak competitive position in a challenging environment led to a loss of billions in shareholder value. This outcome necessitates a reevaluation of my initial analysis from May 2022 and the subsequent developments. Although the results are disappointing, the stock's potential in 2024, with plans for international expansion, advertising opportunities, and a new sports tier, still holds promise, especially at today's depressed price. The business remains in my portfolio, albeit under much closer scrutiny. Despite underwhelming performance, this journey has been an enlightening experience with lessons learned.
From Rosy M&A Forecasts to Painful Realities
The operating performance of Warner Bros. Discovery is underwhelming, especially when contrasted with the optimistic projections presented by AT&T and Discovery in 2021. At that juncture, Discovery's David Zaslav recognized the urgent need to scale quickly to remain competitive. Concurrently, AT&T's CEO, John Stankey, was pressured to divest assets amidst a staggering debt load of nearly $238 billion. WarnerMedia, a standalone subsidiary of the old telecom business, was ill-equipped to compete independently. AT&T's strategy of leveraging a content company to boost engagement across its mobile, broadband, and cable services had not worked out.
AT&T was incentivized to present the divested asset as attractively as possible to the shareholders of both companies, given it would retain a 71% stake in the new entity. Similarly, Discovery endeavored to persuade its shareholders of the significant upside of the merger despite its hefty $83 billion price tag ($40.5 billion in debt + $42.3 in equity). However, the reality of the performance since then stands in stark contrast to the initial projections, bringing to light the challenges and empty promises typical of such corporate mergers.
In May of 2021, Discovery's 2023 projections called for "revenue of roughly $52 billion" with $14 billion of EBITDA and a free cash flow conversion rate of ~60%, translating to $8 billion in 2023 free cash flow with the benefit of synergies.
Discovery Projections by Discovery Management (WBD S4 Filing)
WarnerMedia Projections by Discovery Management (WBD S4 Filing)
Management projected $3 billion in synergies, presumed to be realized within two years. These synergies were essential to rapidly reducing the company's ~$56 billion debt load, aiming to reduce gross leverage to less than 3x within this timeframe. This ambitious goal was set against the 2021 pro forma figures of ~$45.4 billion in sales and $10.6 billion in EBITDA, underscoring the opportunity to streamline the combined operations and significantly improve the economics in a relatively short period.
WarnerMedia Q1 2022 DTC Subs (AT&T Q4 2022 Trending Schedule)
On the DTC side, the combined companies approached revenues of $10 billion from 100.7 million subscribers- 76.7 million from WarnerMedia and the remaining from Discovery+. Of the $52 billion in expected sales for 2023, Discovery expected "at least $15 billion" from DTC.
During the company's first conference call, CFO Gunnar Wiedenfels conveyed a concerning revelation: despite WarnerMedia's over $40 billion revenue in the previous fifteen months, it had generated "virtually no free cash flow." Management thoroughly assessed WarnerMedia's operations in the following earnings report, uncovering more issues. They discovered approximately $2 billion in 2022 EBITDA was adversely affected by missed revenue opportunities and poor investments made by AT&T. As a result, the 2023 EBITDA forecast was lowered from $14 billion to $12 billion. This revision, with a larger mess to clean up, reinforced management's confidence in realizing $3 billion in synergies by 2023.
The fun didn't stop there. The Q1 total subscriber count was revised down by 10 million to 90.7 million, attributing this to an overstatement by AT&T. The original number included unactivated accounts that had received HBO Max as part of a bundle under AT&T's "Mobility distribution agreement." Understandably, this abrupt adjustment led to shareholder lawsuits , adding to the company's challenges in navigating the post-merger landscape.
DTC Subscriber Definition (AT&T Q1 2022 Trending Schedule)
Taking a closer look at the footnotes, however, it does appear that AT&T disclosed " subscribers receiving access through bundled services with affiliates that may not have signed in " on the Q1 2022 Trending Schedule. Admittedly, I overlooked this footnote that clarified the 'inflated' numbers.
WBD Q2 2022 Earnings Call Presentation (SEC Filings)
In the face of this bad news, management attempted to reassure investors with an optimistic DTC guide of $1 billion in EBITDA by 2025, 130 million subscribers by 2025, and 20% long-term margins, including incremental 50% margins.
Not surprisingly, the guidance was not good enough for the market, and investors' confidence in management turning things around amid the linear decline dwindled. Since the merger, the stock has dropped over 50%.
WBD Stock Chart since 2022 (TradingView.com)
Evaluating the Operating Performance
Revenue
In the S4 filing, Discovery had initially projected pro forma revenue of $51.7 billion for 2023, a 14% increase from 2021. However, the company's trajectory has deviated from these expectations, with a 5.6% decline, bringing TTM revenue down to $42 billion. This downturn was primarily due to a 15% drop in Studios and an 8% decrease in Networks sales. On the brighter side, the DTC segment saw a modest YoY increase of 5%. Additionally, a significant reduction of $1.15 billion in corporate-level revenue eliminations reflects a strategic shift from internal to external licensing deals.
In retrospect, management's ambition to grow DTC revenue by $5 billion in under two years and increase Studios sales in a post-pandemic environment while maintaining Networks revenues was shortsighted. Notably, the decline in the linear TV business was significantly more pronounced than anticipated, which was an oversight in my pre-merger analysis. While Max still holds tremendous promise and is probably in the early days of monetization, particularly with the upcoming sports tier and subscriber growth, it has a lot of ground to cover to make up for the highly profitable declining linear revenues, especially in advertising, where legacy revenues are nearly 18x streaming.
Profitability
Despite the revenue decline, the company grew Adjusted EBITDA by 11% to $10.3 billion. Pre-merger management expected $14 billion with $8 billion in Free Cash Flow. Although the fourth quarter results are yet to be reported, Warner Bros. Discovery's profitability is significantly below initial expectations. However, the post-merger performance on cash flow was somewhat redeeming, with FCF conversion reaching the higher end of the anticipated range. In the first four quarters of combined operations (through Q2 2023 TTM), the company generated $3.08 billion in free cash flow from $8.2 billion in Normalized EBIT. For context, Discovery, as a standalone, generated $2.42 billion of FCF in 2021. A paltry ~$700 million first-year cash flow increase in return for handing over $42.3 billion in equity. Ouch!
WBD's Financial Metrics (SEC Filings & Author)
However, Zaslav and Co. were ruthlessly capturing synergies and improving capital allocation. One quarter later, cash flow improved. WBD generated $8.55 billion in TTM EBIT and $5.3 billion in levered cash flow ($7.5 billion unlevered) after a YoY FCF swing from -$200 billion to $2.1 billion in Q3 2023. This uplift was the confluence of several tailwinds, such as realizing synergies, closing the gap between amortization and content spending, using working capital more efficiently, and getting a one-time benefit of several hundred million in strike-related savings. This is also without any interest savings despite the billions in debt it paid down since the company had to hustle to reduce the $7 billion in floating rate debt heading into the challenging rising interest rate environment. Since then, it has paid down most of that with only a little over $1 billion left, which should be mostly paid off in the next few quarters.
Warner Bros. Discovery should see several tailwinds this year, such as $150-$200 million in interest expense savings, $1 billion of cash cost to achieve synergies eliminated, working capital improvement, further narrowing of the content amortization gap, cost-cutting, and increased EBITDA from increasing DTC profitability. However, non-cyclical pressures on U.S. advertising will likely persist. One-time strike savings will disappear while growth investments like global Max marketing ramp up with the upcoming international expansion.
Debt Management
The company faced a substantial challenge at its inception, starting with around $56 billion in gross debt and an Adjusted EBITDA leverage ratio of 5.9x. Since then, the ratio has been reduced to 4.36x, with gross debt at $44.8 billion ($43 billion net) and $10.3 billion EBITDA.
WBD's Debt Maturities (SEC Filings & Author)
It should be able to easily handle its debt servicing with $8.3 billion maturing through 2026 and unlevered cash flows covering interest several times over. In total, $5.9 billion in FCF, $2.4 billion in cash from Warner's balance sheet, a $1.2 billion post-close working capital settlement check from AT&T, and existing balance sheet cash enabled it to pay down $11.2 billion. Despite this rapid debt reduction, the outcome was disappointing as management told the street that it would be less than 3x levered within two years, an improbable goal with just two reportable quarters remaining.
The destruction of capital from those revisions is material. If the original EBITDA target held, you would be looking at ~$3.5 billion in incremental EBIT, equating to ~$35 billion in additional EV. If you also account for $3.2 billion in less FCF paid down over time, there is a total loss in equity value of $38 billion, or 1.4x the current market cap.
Segment Analysis
Networks
Networks Revenue by Quarter (SEC Filings & Author)
Since becoming CEO, Zaslav has faced monumental challenges with the Networks segment, especially rapidly declining linear ad revenues that underperformed the market, with industry linear TV revenues declining 7% vs a decline of 14% for WBD. This indicates issues beyond broader industry cord-cutting trends. The CEO has acknowledged a "generational disruption" but, in conference calls, tends to blame external forces rather than own up to what think are execution failures.
The underperformance of the linear segment is multi-faceted, but I believe a primary factor is its comparatively low investment in sports broadcasting rights. According to management, the company's linear channels command a substantial viewership share, reaching 25% on any night and up to 40% during NBA games. However, this advantage hasn't effectively translated into tangible financial gains. WBD holds rights to the NBA, NHL, March Madness, and MLB, yet it ranks only as the fourth-largest spender on sports rights. In the current media landscape, sports are more crucial than ever as the glue that keeps the cable bundle from falling apart, with at least 40% of linear subscribers drawn to live sports, accounting for 31% of advertising revenue .
I believe management missteps during the 2022-2023 TV upfront cycle further complicated the company's position. The company focused on increasing Cost Per Thousand Impressions (CPMs) rather than securing higher ad volume. However, the expected demand didn't materialize as WBD realized its pricing power wasn't as good as it thought. Advertisers were also busy shifting their spending to digital channels or reducing their budgets in anticipation of an upcoming recession. Under normal market conditions, this approach might have been successful, allowing WBD to compensate for lower volume by selling into a more robust scatter market. However, facing these unexpected market realities, management revised the strategy for the 2023 upfronts, prioritizing volume over price. With upfront contracts starting in Q4 , the effectiveness of this course correction and its impact on WBD's performance remains to be seen.
2024 is shaping to be a more favorable year for WBD, buoyed by two major cyclical tailwinds: the upcoming presidential election and the Paris Olympics. These events are expected to provide a reprieve from the ongoing secular decline in the industry. Magna forecasts a 4.3% growth in linear TV advertising for the year, suggesting that the decline should pause temporarily. This stability could provide a small window for the company's DTC segment to expand internationally during Max's critical year of growth. However, uncertainty looms post-2024, particularly with the fate of the NBA rights for the 2025/2026 season hanging in the balance. Zaslav's assertion that WBD doesn't have to have the NBA seems questionable; arguably, these rights might be more crucial than ever. The NBA and other sports broadcasts are vital for cross-promoting WBD's diverse content, a strategy that has proven successful for promoting hits, such as Barbie . Lastly, the recent Disney-Charter agreement in September could provide more runway and signify an industry-wide shift towards more cooperation between distributors and content providers to extend the life of cable TV. Including DTC streaming apps in cable bundles could help decelerate the trend of cord-cutting, a development that would positively impact future cash flows.
Studios
Studios Revenues by Quarter (SEC Filings & Author)
With a 15% YoY TTM decrease in performance, Studios have fared even worse than Networks. Although this segment has a lesser impact on EBITDA, contributing nearly 25% to the bottom line, it was especially meaningful as it exacerbated the downward pressure on profitability.
Despite recent disruptions caused by strikes, the segment is poised for improvement in the coming years, driven by a robust film lineup with plans for "twice as many theatrical releases," a revitalization of the DC franchise , and increased investment in the very profitable WBD Games unit. It's important to note that the business has thus far been at the mercy of scripted content created under the previous leadership, given that theatrical productions typically take 2-3 years from inception to completion. Zaslav is dedicated to producing high-ROI content, which is evident in the complete overhaul of the DC Universe and a strategic focus on underexploited blockbuster IPs like Lord of the Rings and Harry Potter. This approach contrasts the previous regime's tendency to approve content without regard to return on capital, primarily to boost DTC subscriptions.
According to Gunnar, WBD Games is poorly monetized and was "stunned" that they have not invested more. This smaller unit has averaged $400 million EBITDA over the past three years, and there is much more that they can be doing, such as "always on" gameplay through live services, free-to-play extensions, and other opportunities to generate post-purchase revenue, which sounds like high margin microtransactions to me.
Studios' segment profitability will massively benefit if the company can lengthen the monetization cycles of its video games and continue to milk the IP throughout instead of relying on the initial one-time sale. Hogwarts Legacy validates the thesis of the value of the company's IP, even among younger generations, as it is the highest-grossing video game of 2023 . With a highly engaging game like this, microtransactions may have a significant upside, considering a company like Activision Blizzard generated 61% of its profits from microtransactions in 2021.
DTC
DTC Revenue by Quarter (SEC Filings & Author)
WBD, like its peers, has placed a significant bet on DTC in response to cord-cutting. The focus has changed considerably under the leadership of David Zaslav, who took the helm when the segment reported a $2 billion EBITDA loss on $9.7 billion in revenue. Initially, like many of its peers during the AT&T-led WarnerMedia era, WBD pursued subscriber growth at any cost, a behavior that Wall Street once rewarded with high valuations. This period was marked by exorbitant spending on content by streaming services, escalating costs. At the same time, ARPUs and subscription prices were kept low to attract more subscribers - an unsustainable model.
However, with the Fed's pivot to raising interest rates in 2022, Wall Street's focus shifted toward profitability, swiftly penalizing those unable to demonstrate profits. Unfortunately, this change in market sentiment coincided with the merger's completion. While Zaslav has always been focused on cash flow, particularly to address the substantial debt incurred, the shift in stock market dynamics undoubtedly influenced his pivot. Moving away from the pre-merger objective of rapidly accumulating hundreds of millions of subscribers, Zaslav's approach shifted away from a subscriber-centric philosophy, as Alex Morris from The Science of Hitting aptly observed. Zaslav stated, "I don't really care what the number is. We're not in the business of trying to pick up every subscriber," reflecting a blatant change to a more nuanced, profitability-focused approach.
Shareholders saw the pain when it was evident that the target of $15 billion in DTC revenues by EOY 2023 was unachievable. The silver lining, however, is that Zaslav has arguably positioned the business for a higher quality of earnings than before when subscriber growth eventually picks up again. Management has transformed the business into one that should achieve operating leverage with fewer subscribers. Despite flat sub-growth YoY and a mere 6% Global ARPU increase, the business went from a $2.5 billion TTM EBITDA loss in Q3 2022 to nearly break even (-$59 million). This swing toward profitability was also accomplished during subscriber disruption when the company collapsed the HBO Max and Discovery+ platforms into a single product. This event was a reasonably strong headwind to growth for several reasons, including the known 4 million subscriber overlap between platforms, disengaged or confused users who realized they were no longer interested in paying for a service they do not use, and other technical and payment processing issues. Initially, management failed to recognize or communicate these short-term barriers that would at least partially contribute to the failure of WBD to meet its subscriber targets. However, it is a good sign that despite these adversities, the company has not lost subscribers YoY and has also gained 4.5 million subs since Q1 2022.
Looking ahead, the prospects for DTC appear promising, especially with significant expansion plans in 2024 and 2025. According to the CEO, Max and D+ currently reach only 45% of the world's broadband households, excluding China, Russia, and India, primarily due to existing exclusive licensing deals. While Netflix leads in streaming with 2.6x more subscribers than WBD globally, the gap is narrower in the UCAN (United States & Canada) region. Netflix has 77.32 million paid subscribers compared to WBD's 52.6 million. This comparison isn't apples-to-apples since Max isn't available in Canada due to its exclusive licensing deal with Crave. Adjusting for Netflix's estimated 8 million Canadian subscribers, the domestic difference drops to about 32%, suggesting further upside in international markets.
The upcoming global expansion of Max carries the potential for significant revenue growth, with projections of ~50% incremental margins . This growth is expected to be further enhanced by the synergies resulting from the gradual discontinuation of HBO Max, although losses in wholesale subscribers will partly offset it. A key revenue driver will be the sports add-on, which features over 300 live games. With its transition to a $9.99 monthly fee in the coming months, this add-on is anticipated to generate incremental high-margin revenue. While it's challenging to accurately predict the uptake, considering that half of streaming viewers frequently watch sports, a 10% subscription rate among domestic viewers could feasibly yield $600 million in incremental sales. Incorporating sports into the platform is also a strategic move to reduce subscriber churn. By initially offering the sports tier for free, Max has accustomed users to accessing sports content on the platform, which may lead to higher retention rates once it becomes a paid feature. The effectiveness of this approach and its impact on subscriber churn are critical factors to monitor in the forthcoming quarters.
Final Thoughts
In conclusion, WBD's success rests on enhancing streaming and Studio's profitability while curbing the steep decline in linear TV. The company's weakened competitive position has increased the risk and probability of shareholder value destruction more than I initially thought. The business may need to figure out how to monetize alternative revenue streams supported by its fantastic IP, such as gaming micro-transactions. Absent significant improvements, the sustainability of earnings faces legitimate risks beyond this year in my view.
For WBD to thrive in the streaming era, scaling through consolidation, joint ventures, or bundling is likely necessary. Zaslav's discussions about potential acquisitions, including Paramount, illustrate this need, though WBD's current debt of $45 billion raises concerns about the feasibility of such deals.
In my view, the stock has limited downside risk in 2024, barring a major unforeseen negative catalyst. This year, multiple tailwinds should stabilize or marginally increase revenue and EBITDA. Assuming the company's enterprise valuation multiple remains constant, investors should receive 20% equity growth from the current free cash flow yield. Substantive stock appreciation is possible if DTC growth accelerates and linear declines plateau, coupled with falling interest rates. In a bull case scenario, if EBIT multiples revert to the historical 13x against a $9 billion EBIT and $10 billion in net debt reduction (including $8 billion from FCF for Q4 2023 and 2024, plus a $2 billion decrease in Deferred Tax Liabilities), the market cap could reach $73 billion ($117 EV - $44 billion net debt), translating to a 160% return by the end of 2024. However, such a scenario remains speculative and would require near-perfect execution and improved market conditions. Thankfully for shareholders, the CEO, with hundreds of millions of dollars of very OTM stock options at stake, is highly incentivized to make it happen.
For further details see:
Reevaluating Warner Bros. Discovery: Navigating A Turbulent Transition In The Streaming Age