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Warner Bros. Discovery (WBD) is a global media and entertainment company that develops, produces, and acquires scripted and unscripted content such as blockbuster movies, TV shows, sports, and news networks. It monetizes these assets through distribution fees, advertisements, and content licensing. The conglomerate is the product of a long history of M&A transactions, including the recent merger in April 2022 between WarnerMedia, a spin-out from AT&T, and Discovery.

While Netflix and Disney’s stocks have significantly dropped from their all-time highs, they still have a ~13x and ~41x EV (Enterprise Value) / EBIT multiple, respectively. On the other hand, the market values WBD as a dying cable company with a 7.80 EV-to-EBIT* multiple. I believe that this perspective is the wrong way to think about it. The newly formed Warner Bros Discovery has a prestigious brand, a deep library of media assets, a fully scaled content generation machine, and a global reach that instantly catapults it into a market-leading position from sub-scale.

Shrouded by the fear of an industry slowdown amid Netflix losing 200k net subs in Q1 2022, the selloff of WBD is creating an unjustifiably cheap stock. Investors are simply not adequately accounting for WBD’s operating earnings expansion from $3B+ in synergies, leverage in affiliate fee negotiations, and DTC (direct-to-consumer) growth opportunities, in my opinion. Once the fog lifts through the execution of the business, investors will recognize the actual value of the underlying assets. I believe this will cause investors to rerate the stock to a higher multiple against a backdrop of elevated earnings and rapid deleveraging.

WBD is currently worth an equity value of at least $40.85 per share. With a substantial risk-adjusted MOS (Margin of Safety), my buy target price is ~$19 per share. The current market price of $17.35 is below this target. Purchasing the stock at this considerable discount unlocks a fantastic 135% growth opportunity. The current market share price provides an adequate margin of safety and downside protection for the following risks:

Declining Linear (Traditional TV) Revenues

* FY 2022 Pro Forma Estimated. Defined as EBITDA - Maintenance Cap-Ex. EBITDA = Operating Earnings + Amortization of Film and television costs + Depreciation & Other Amortization. Maintenance Cap-Ex = 80% of total cap-ex, including all cash content spend.

Discovery’s Merger Presentation (Merger Presentation)

Warner Bros. Discovery has evolved into a premium media and entertainment IP giant. It owns, co-produces, and has rights to major international films, binge-worthy TV shows, multi-year live sports rights, national/local networks, and more. The merger was a great fit since both sides had what the other needed. For instance, Discovery is the leader in the niche market for unscripted shows, with a reach of more than 80 networks in over 200+ countries.

The company plans to fold its two streaming services, HBO Max and Discovery+, into one product. This streaming service will be a behemoth in the market that will be difficult for households worldwide to ignore. It is like having a blockbuster at your fingertips for the cost of a few cups of Starbucks coffee. Although Netflix (NFLX) and Amazon Prime (AMZN) are two industry heavyweights, the depth and breadth of their exclusive content pale in comparison to what the new HBO Max will offer. They also do not have the same decades of experience in the media and entertainment industry as WBD. The salient difference here is that WBD has its roots as a media content generation company. In contrast, Netflix and Amazon Prime started purchasing rights from suppliers and vertically integrated backward into media production. Despite some recent success with winning awards, shifting into this new business is hard to execute and is not necessarily within the company's circle of competence.

The merger augmented the pricing power that the business has with its TV distributors and advertisers. Discovery already had 20% of the total viewership with its MVPD affiliates. The total viewership will surely increase now that the company has acquired leading networks like TNT, TBS, CNN, Cartoon Network, and Adult Swim. This increased scale will enable them to negotiate better carriage deals since the distributors do not want to lose those networks. Additionally, the threat of a superior and fast-growing DTC revenue stream further increases WBD’s leverage since it is no longer entirely dependent on legacy distribution.

On the advertising front, management notices a level of demand from advertisers that have exceeded their expectations. On an earnings call, the CEO David Zaslav mentioned that more than 800 advertisers purchased inventory on their platform, more than 4x their original target for Q2 2021. Zaslav explained the rationale for the increase in demand.

Premium online video inventory is scarce in the first place because a lot of the viewership is happening on ad-free platforms, that drives super high demand and a hot market environment right now."

Additionally, the new OTT product enables the company to sell more sophisticated targeted ads to customers. This 1:1 level of customization allows them to sell that ad space at a premium to the traditional product. For example, Discovery currently offers an ad-light tier that generates an $11 ($5 sub fees + $6 from advertising) monthly US ARPU with only three minutes of advertising. For linear, on the other hand, the business is receiving a mere $7 ($3.5 sub fees + $3.5 advertising ). Now that the unique value proposition is significantly increasing post-transaction, it should see a step-up in demand from other businesses wanting to target its highly engaged audience on its platform.

WBD’s management and insiders have aligned themselves with shareholders through equity ownership. First off, management is purchasing stock from the open market. For example, on April 27th, Zaslav and his CFO, Gunnar Wiedenfels, purchased a combined 75k shares at ~$1.5 million. Additionally, the board of directors has highly incentivized the CEO and his management team with lucrative options and equity compensation packages. For example, Zaslav was paid an annualized $74.67 million in 2021. He was front-loaded $202 million in stock options over 6.5 years ($31 million per year). In addition to the options, he was paid $43.67 million ($3 million base salary + $13.165 million stock awards + $22 million cash performance awards + $1.1 million other + $4.4 million bonus). The vast majority of his options have escalating strike prices greater than the initial stock price of ~$24. While the compensation is generous, the value of his package will substantially decrease unless he creates shareholder value.

David Zaslav’s Outstanding Option and Stock Awards (WBD S4 Document)

While the other C-suite executives are not paid as much as Zaslav, they still own a sizable WBD equity value relative to their annual pay.

Warner Bros Discovery Insider Compensation (WBD Proxy)

The competition is heating up with Netflix, Apple (AAPL), Amazon, Disney (DIS), Paramount (PARA), NBCUniversal, Hulu (owned by Comcast (CMCSA) and Disney), and Warner Bros. Discovery competing for subscribers. Content is king. Audiences demand a product that consistently provides thrilling entertainment. These participants all have an eye on the prize and must continuously spend to attract customers and minimize churn. Therefore, a company must produce enough revenue through a large subscriber base to sufficiently offset these fixed costs to attain profitability. The logical next step is for the fragmented environment to continue to consolidate.

The WarnerMedia/Discovery deal has paved a path forward for future M&A activity. When Warner spun off from AT&T, it released itself from the regulatory constraints that plagued its former parent. For example, Trump’s DOJ challenged the AT&T and Time Warner merger in the court system for anti-trust reasons. As we have learned from history, government scrutiny often occurs when a distributor also owns cable networks. Now that it has broken off and merged into Discovery via a Reverse Morris Trust, a major pure-play media content company has emerged. I believe the stars are aligning for WBD to either get bought out at a premium or for itself to acquire a subscale player once management successfully hits its leverage target.

On consummation of the union, WBD sent AT&T $40.4 billion in value that was debt-financed. Post-transaction, WBD now has ~$56.4 billion in leverage ($14.8 billion existing + $41.6 billion from the AT&T deal). At ~$6 billion in estimated 2023 FCF, there is a risk that it will not be able to service the debt effectively. Additionally, aggressively paying it down could impede its ability to invest in new content. Management signaled that it would aggressively de-lever and estimated that the business would devote 20% of unlevered free cash flow to interest payments and 50% to principal payments through 2024. With a blended interest rate of roughly 4.41%, the business is on the hook for $2.5 billion in annual payments. This cost is a significant drag on the bottom line. Furthermore, if it does not sustain enough free cash flow after increasing its content investments, there could be pressure to reduce film and tv show budgets. This pullback could impede its growth prospects.

Mitigant: FCF Machine and Disciplined Management

WBD is a free cash flow machine with over $6 billion in sustainable cash flow that includes $3 billion in synergies from cost avoidance. Zaslav’s track record speaks for itself. He has already proved his ability to deliver on quickly reducing leverage through the Scripps deal. Management has clearly outlined its plan to aggressively pay down the debt and lower the debt servicing costs.

Fortunately, there is a ton of low-hanging fruit from eliminating duplicated corporate functions and various lousy capital allocation decisions from WarnerMedia, such as the rich $1 billion investment in a floundering CNN+. There is a good possibility that the estimate is reasonably conservative. For example, there are around $6 billion in technology and marketing expenses between the two distinct platforms. A portion of that is unnecessary in the future.

Discovery’s management projected that its US and International linear revenue would decrease at an annual rate of 4% and 3%, respectively, through 2025. In 2021 alone, its total US networks portfolio subs declined 8%. While this is a known secular consumer shift that has been known for years, cable and network companies are quickly losing their primary stream of revenue. It is the brutal reality of creative destruction through capitalism. While WBD is decoupling from traditional OTA (Over the Air) distribution methods, it is still a substantial portion of its sales. For instance, in 2021, the company raked in ~$12.6 billion in DTC sales ($1.6 billion from Discovery and $11 billion from WarnerMedia). This new and exciting revenue stream represents only about a quarter of total revenue. Thus, those declines in linear subs will have an outsized negative effect on performance. In reality, revenue growth from DTC may ultimately cannibalize linear revenues. Also, since distribution agreements have a limited term, there is no guarantee that the business will be able to negotiate favorable contracts. If the cable broadcasting industry continues to consolidate, there could be further headwinds on future per capita affiliate fees.

Mitigant: DTC adds will more than offset cable declines

While there are significant industry headwinds right now regarding cable-cutting, the DTC adds are value-added and not just cannibalistic. The ARPUs for OTT subs are much higher than from its traditional business. For its ad-light tier, for example, Discovery+ makes $11 a US subscriber from a $5 monthly fee and over $6 in advertising for only 3 minutes of ad time vs. $7 from linear. Zaslav was seemingly unconcerned with losing cable customers stating, “If we lost a million [cable] subs…all we need to do is pick up 650,000 [streaming] subs in order to be making more money.” Warner’s ARPUs are even higher at ~$10 per sub. As long as the company maintains its competitive advantage and can hit its subscriber growth targets, margins should increase.

There is a never-ending content spend treadmill as competition is heating up. Consumers need more and more to justify paying $100 - $240 per year for one subscription. For example, on a cash basis, Netflix and WBD spent $17.14 billion and $15.39 billion (pro forma), respectively, in 2019. In 2021, Netflix’s increased its investment 33% to $22.8 billion ($17.33 billion cost of revenue + $5.47 billion cash addition to content spend over amortization) and WBD spent close to an estimated $20 billion (+30%). For example, on the recent WBD Q1 2022 earnings call, management was surprised at how much WarnerMedia’s management was spending. Due to “previously unplanned projects,” the CFO estimated that the profit baseline from the originally published pro forma numbers is “around $500 million less than expected.” Despite over $40 billion in free cash flow from WarnerMedia, there is essentially no free cash flow. The industry is starting to realize that this dynamic is not sustainable for shareholders over the long run. For instance, Zaslav asserted the importance of a disciplined approach by stating, “ We plan on being careful and judicious. Our goal is to compete with the leading streaming services, not to win the spending war.” Likewise, on the Netflix Q1 2022 earnings report, the company revealed that it lost 200k net subscribers. In response to this downturn, the CFO conveyed that it would be pulling back some of its content expenditures. This stance is an overreaction and misses the mark. Audiences want more compelling content, not less. The solution is to reach a critical mass that will enable a business to spread its fixed costs over a larger revenue base. A streaming company will need to reach an inflection point where the next dollar spent on media is no longer necessary to attract more subscribers.

Mitigant: Robust Library, Increasing Scale, and Disciplined Management

As mentioned earlier, WBD is a media and entertainment production company that has developed a phenomenal library of high-quality assets with an expansive international presence. WBD holds all of the cards. Executives from other companies will surely come calling when they realize that they cannot make it on their own. An acquiring business will need to pay a premium to effectuate a deal. Alternatively, WBD will continue to scale up through further acquisitions of valuable assets.

Zaslav and (especially) John Malone both have a stellar track record of shareholder-friendly deal-making and industry experience to pull this off. While there was a negative operating expenditure surprise on the latest Q1 2022 earnings report from the WarnerMedia side, the executive team has identified “a lot of chunky investments” that are lacking an adequate ROI profile. Management is laser-focused on disciplined spending and eradicating the bad projects started by the prior regime. Once this occurs, operating margins will expand and free cash flow will improve.

WBD’s competitors include Netflix, Amazon, Disney, Paramount (formerly ViacomCBS), and Comcast (NBCUniversal). These staunch rivals all have their own DTC platforms. The company competes with other forms of media that vie for consumer attention, such as YouTube, video games, and social media platforms. While there are seemingly infinite ways that people can entertain themselves, WBD owns iconic media franchises and a phenomenal content generation factory that keeps audiences coming back. The two newly combined businesses have a historical >30% gross margin on a pro forma basis, which suggests that they are separately able to demand a substantial premium for monetizing their media rights despite the fierce competition. Compared to Netflix, HBO Max and Discovery+ are less penetrated.

WBD DTC Metrics (SEC Documents)

2021 FY Revenue vs. Projected 2025 FY Revenue (SEC Documents - Author Projections)

Zaslav believes the company can reach 200 million subs in 2-3 years. Achieving this goal in 3 years is a 32% CAGR from a base of ~87 million unique subs EOY 2021. Considering the synergistic value of the combined content, I think this is undoubtedly achievable. With that said, I conservatively projected 185 million global users by 2025, or a 21% CAGR. Additionally, I estimated a 20% combined ARPU increase to $10.87 since there is room for unit expansion with the added value of the new streaming service. This is not a far-fetched goal considering that HBO Max's standalone ARPU is already nearly $10 and the Global Netflix ARPU is $11.67. Offsetting some of this growth is the decline in linear. I projected a 3.5% annual decrease in legacy revenue for both Discovery and WarnerMedia based on management’s projections in the S4.

Pro Forma Estimated Financials (Author)

Warner Bros Discovery Valuation (Author)

I triangulated the intrinsic EV using a 13x EV/EBIT multiple (based on the lower end of the industry average over the past decade using comp data from NYU Stern over the past decade), a DCF calculation, and an 8 Year FCF payback time. The mean of the valuation methods is $57.28 EV per share or $35.51 with a 38% risk-adjusted MOS. Subtracting net debt translates to a target buy price of $19.09. At the current price of 17.35, there is a 135% potential upside (mentioned in the summary).

WBD is a superb business with economies of scale that allows it to effectively compete in a crowded streaming industry. It is a free cash flow machine that will quickly pay down its debt despite operating in a rising interest rate environment. Ultimately, I believe the management team will realize the $3 billion in synergies by balancing disciplined content spending with adequate content investments. At a 7.80x EV-to-EBIT, the stock offers a considerable margin of safety with substantial downside protection from the risks outlined above.

This article was written by

Disclosure: I/we have a beneficial long position in the shares of WBD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.