Discovery Is A Strong Buy Thanks To Merger With WarnerMedia
Summary
- Discovery is currently trading at a low free cash flow multiple due to concerns of cable subscriber losses.
- The merger with WarnerMedia will give the company enough critical mass of media content to compete with Netflix and Disney in the direct-to-consumer space via Discovery+ and HBO Max.
- The company is trading below our estimated fair value per share.
Discovery Inc. (DISCK) and WarnerMedia are set to merge in order to better compete in the direct-to-consumer space dominated by Netflix (NFLX) and Disney+ (DIS). This combination creates one of the deepest content libraries in the world, and should allow the new company to better compete for subscribers.
Source: WarnerMedia and Discovery Merger Presentation
The merger is also expected to generate $3 billion per year in synergies which will be reinvested into more content and deleveraging.
Merger deal structure
Discovery is set to contribute 100% of its business and will receive 29% of the common equity in the merged company.
Source: WarnerMedia and Discovery Merger Presentation
Today shares trade at a lower price than pre-merger announcement, and at a very undemanding ~8x multiple to free cash flow. We believe this presents investors with an attractive opportunity to buy the shares below intrinsic value.
With respect to the merged company, management is guiding to an adjusted EBITDA of $14 billion which is $2 billion above pro-forma, and revenues of $52 billion of which $15 billion would come from direct-to-consumer, and there would be more than $3 billion of expected run-rate cost savings.
The only concern we have is the huge amount of debt the company will have post-closing. With the added $43 billion to pay AT&T (T) and the current $15 billion in the balance sheet, the merged company will have ~$58 billion in debt, and a multiple of ~5x EV/EBITDA.
Source: WarnerMedia and Discovery Merger Presentation
Content and global scale
The merger will marry WarnerMedia's acclaimed studios and portfolio of iconic scripted entertainment with Discovery's global leadership in unscripted programming.
It is expected that WarnerMedia's blockbuster content will serve to gather global subscribers, and Discovery's rich unscripted content will help retain subscribers by lowering churn. Discovery also has significant international experience, operating in more than 200 countries, which it will be able to leverage to expand the reach of WarnerMedia's content.
The combined catalog for the two companies will include more than ~200k hours of video content in more than 50 languages, as well as high-quality production capabilities with the Warner Brothers studio. It will be #1 in TV studio by revenue and volume, and the #2 movie studio by box office.
This massive library of content will allow the company to position its direct-to-consumer offering as competitive to that of current streaming leaders Disney and Netflix.
Discounted cash flow valuation
Our thesis is that the shares are already cheap, and are even cheaper when considering the strategic and financial benefits the merger will bring.
We estimate the intrinsic value by using analysts' earnings projections for the next few years for Discovery. These estimates do not take into consideration the merger benefits yet, increasing the margin of safety.
Source: SeekingAlpha
We employ a terminal growth rate of ~5%, assuming above GDP growth for the company as it could benefit from direct-to-consumer global subscribers growth for many years. For the discount rate, we use 10% which would be our minimum return requirement.
| Fiscal Period Ending | EPS Estimate | # of Analysts |
| Dec 2021 | $1.46 | 14 |
| Dec 2022 | $1.97 | 13 |
| Dec 2023 | $2.36 | 10 |
| Dec 2024 | $3.14 | 3 |
| Dec 2025 | $2.80 | 2 |
| Terminal value | $56.00 | 5% growth per year |
| DCF value per share | $42.34 | 10% discount rate |
This results in a fair value per share of $42, significantly higher than the ~$27 that shares fetch currently. Given the considerable disconnect, it seems the market is overly pessimistic about the potential growth of the company. Our fair value estimate would be considerably higher if the merged company achieves the targeted synergies.
Risks
The main risk we see is if the combined company fails to replace lost cable viewers with direct-to-consumer customers. In that case, the company would be valued, much as it seems to be now, as a "melting ice cube".
Another risk worth watching is the regulatory risk that the combination not be approved.
Conclusion
We believe Discovery shares are mispriced even without a merger, given the low multiple to free cash flow at which they trade. If the merger with WarnerMedia goes through, it would be a net positive in our opinion given the expected $3 billion in synergies and complementary media catalogs.
With the assets that the combined company would have in news, sports, scripted, and unscripted content, we believe the company will be able to successfully compete in the direct-to-consumer space.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of DISCK 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
The information contained herein is for informational purposes only. Nothing in this article should be taken as a solicitation to purchase or sell securities. Before buying or selling shares, you should do your own research and reach your own conclusion, or consult a financial advisor. Investing includes risks, including loss of principal.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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Comments (71)
John Malone is elderly and is likely to be less involved in the company in the future.T and Disca have managed to achieve what few other deals has done; it has destroyed the stock price of both .
It could be same or even lower from current price.
