2023-11-10 12:08:27 ET
Summary
- Like many highly indebted businesses, Warner Bros. Discovery has been trading in tandem with long-dated treasuries.
- While correct at first sight, a deeper look reveals how wrong this association is in this specific case.
- Effectively, if interest rates stayed high or increased from here, Warner Bros. Discovery could even profit.
Guilty by association
The following chart needs very little explanation: When long-dated Treasury ( TLT ) interest rates move higher, Treasuries lose value - and so do highly levered companies like Warner Bros. Discovery ( WBD ) and Paramount (PARA).
This is justified as debt must usually be refinanced sooner or later - and interest rates will be higher, reducing earnings. And if the business is not growing or in the midst of an investment cycle with uncertain outcomes (like the two referenced media companies), the association established by the market seems absolutely correct.
The more expensive money becomes, the more uncertain growth (or certain shrinkage ) prospects reduce equity trading multiples. As more of the cash earned by those businesses needs to be shifted over to bondholders, less remains for common shareholders.
- Easy, isn't it?
Add a generally sluggish market, a widely expected recession, inflation-burdened consumers, low advertising budgets, and the uphill battle to establish streaming platforms by players who are considered to be simply late to the game, and you get the picture.
Lucky by combination
However, if I look at the chart above, I have to ask whether the businesses of these two companies are really that similar to justify their hard-wired association with long-dated Treasury prices.
Markets like simple narratives. Once established, they tend to work surprisingly well. Price movements become seemingly predictable in a simple way: Just by looking at one chart, you know how the other one will move - and it really works!
- At least for a while.
Yet, businesses are not that predictable. Businesses react to changing circumstances and in some cases can profit from a crisis. And sometimes even a looming bankruptcy can become a positive catalyst, as John Malone pointed out yesterday :
There is an exemption to the antitrust laws on a failing business. At some point of distress, right, then some of the restrictions, they look the other way.
The media mogul specifically referred to a potential merger between Paramount and Warner Bros. Discovery, which might run into antitrust opposition under normal circumstances, but might be allowed because of looming bankruptcy for one or both parties involved.
Malone singled out Paramount's negative free cash flow, which under almost all circumstances represents a liability, but could actually bring about a transformative deal.
Hence, paradoxically, both Warner Bros. Discovery and Paramount could even profit from being burdened by high interest rates in my view.
Enriched by fixation
That said, Warner Bros. Discovery's situation is very different from Paramount's. As I argued in my recent article , Paramount's dividend cut creates massive value simply because it will allow the company to retire $1.6B of debt that would otherwise switch to prohibitively high variable interest rates in 2027.
Warner Bros. Discovery doesn't have such problems. Its debt is almost entirely fixed and has an average maturity of 15 years. And thanks to the interest rate fixation coupled with recent interest rate increases, its bonds trade at a heavy ~20% average discount to their notional values.
Therefore, we might argue that instead of $43B of net debt at the end of Q3, the actual amount the company must reimburse is around $35B (if the debt is retired prior to maturity). And the higher interest rates go, the less it will have to pay back!
Clearly, the company doesn't have the cash to buy back all its debt. Nor would it really want to, since it might represent a competitive advantage over the long term: Many media businesses have levered up during the ZIRP years and are now facing dire prospects. If interest rates don't come down, they will either go bankrupt or be acquired.
By accumulating cash, Warner Bros. Discovery can be the one to profit from that general distress.
Smarter by dissociation
Differently from Paramount, Warner Bros. Discovery is generating real cash to the tune of ~$5B annually, which is forecast to grow at a healthy clip over the next few years.
It will have to pay out for debt redemption just about half of this free cash, since over the next five years its average annual maturities amount only to ~$3B.
Hence, we should absolutely differentiate between the two media companies. The fact that the stock market is treating them as one and the same doesn't seem correct in light of the above and is probably indicative of a market inefficiency.
A few days ago, Warner Bros. Discovery was treated as a financially distressed business by the stock market just because its management guided to a potentially somewhat higher leverage ratio at the end of 2024 (compared to the originally targeted 2.5-3x gross), if the ad market remains sluggish.
But does any of this change the trajectory of the business? Does it create real distress? Will it impair any competitive advantage? - I don't think so. Ad markets will come back. Whether they come back within one or three quarters doesn't really matter over the long term.
While the market almost necessarily applies a summary judgment, relevant details get lost.
Even with a sluggish ad market, Warner Bros. Discovery will have reduced its debt substantially by the end of 2024 and will be on track to further reduce it in the subsequent years, given its high free cash flows.
The company trades for just over 4x its TTM FCF, which is forecast to grow - a valuation which would make sense only under conditions of extreme financial distress. But this is real cash.
Most importantly, the higher interest rates go and the longer they stay high, the more debt the company might be able to retire on the cheap. This reduces financing costs and increases free cash flow.
And if it doesn't and keeps accumulating cash, the more likely it becomes higher cash flow growth thanks to opportunistic M&A of distressed assets - which would reduce its leverage ratio anyway by growing the denominator.
So I think the stock market needs to smarten up and dissociate Warner Bros. Discovery from the Treasury tandem trade.
For further details see:
Warner Bros. Discovery: What A Wonderful Debt