Discovery Will Pull Its Market Cap Out Of The Hat, Twice

Summary

• The merger of AT&T’s WarnerMedia and Discovery creates a great opportunity for investors.
• The merged entity will hold one of the largest content libraries with a global reach.
• Summing up the parts and putting conservative multiples based on market peers on operations of the new entity yields a potential return multiple times the investment.
• The upside is high but there’s a floor on the downside with the price depressed following the Archegos saga, despite the execution risk.

Amanda Edwards/Getty Images Entertainment

Investment Thesis

The merger of AT&T’s (T) WarnerMedia and Discovery (DISCA) creates a great opportunity for investors. The merged entity will hold one of the largest content libraries with a global reach. Summing up the parts and putting conservative multiples based on market peers on operations of the new entity yields a potential return of multiple times the investment. The upside is high but there’s a floor on the downside with the price depressed following the Archegos saga, despite the execution risk.

Merger Between WarnerMedia and Discovery Will Create a Content Behemoth

Discovery will merge 100% of its operations with WarnerMedia to create a content king. The new entity will assume $43 bn of AT&T (T) debt and all of Discovery’s current business in addition to operations of WarnerMedia. Discovery shareholders will own 29% of the resulting business; the rest will belong to AT&T shareholders. The merger will result in a huge content library in both studio production and broadcasting and it will have a global reach.

On paper, this seems like a great deal to me. AT&T gets to relieve some of its massive debt burden, Discovery gains extremely valuable media assets which will dramatically increase the value of its DTC offering at an early stage, and the transaction is tax-free for both parties. But not everything good on paper is a good investment; I will try to estimate a value for this nascent entity.

The Merger’s Broadcasting Operations Will Be Worth >$84 bn

I will use the sum of the parts (SOTP) method to calculate the value of the business. I will first estimate a value for the new entity’s legacy operations and sum it with my estimation for DTC operations. I will estimate a value for legacy operations using an EV/EBITDA multiple on the combined EBITDA of the merged entity’s legacy operations.

I exclude streaming services from legacy operations to avoid double counting. So HBO and HBO Max / HBO and Discovery+ will be excluded. I use FY20 numbers for WarnerMedia since it is a fairly stable business and it is the most recent available data. I assume that the EBITDA of Discovery+ isn’t material. The combined EBITDA comes out to $11.5 bn.

I want to point out that this estimate is conservative in that it takes no synergies into account. Combined marketing and bargaining power will enable cost synergies for the merged entity. And more importantly, combining the cost basis (studios, back-office staff, etc.) will result in significant cost synergies. The actual EBITDA of the merger could be higher than what I estimate here.

I use major US broadcasters as the peer group. I think that these are fairly similar to the operations of the combined entity and the multiple should resemble what the market will award it. The resulting median multiple is 7.3x LTM EBITDA.

Source: Capital IQ

I get $84 bn enterprise value by combining the two findings above.

The DTC Offering is Almost Worth as Much as the Broadcasting Operation

I use Netflix as the use-case in my approximation of EV for the DTC operation. I use an EV / Revenue multiple here as revenue growth is prioritized by the market in the land-grab phase of this young market. I use the most recent subscriber numbers for all entities. I use actual revenue numbers for Netflix. For Discovery+ run-rate revenue I average ad-supported offering of $4.99 and ad-free version of $6.99 and use $5.99 as ARPU. For HBO / HBO Max I take the domestic $11.9 ARPU for domestic 47 mn subscribers and adjust international ARPU for the international 22.5 mn subscribers by the same difference Netflix has between its US & Canada ARPU’s and international ARPU’s. This results in $10.2 bn in revenues and $83 bn in EV for the combined entity.

Again I must point out that this is a conservative estimate. Netflix is a relatively mature offering, the other two are much younger and will likely grow much faster warranting a higher revenue multiple. The content library of the merged entity gives it an advantage as well. The revenue synergies will help. The combined value of the two companies will result in more interest by users that will enable faster subscriber growth and better pricing as well as higher loyalty. Additionally, Netflix still has to keep investing in new content and / or borrow content from other owners which is less profitable for Netflix. The huge library of the merged entity means that it won’t have to invest in extra content, only in infrastructure and marketing. This could mean earlier / higher profitability for its streaming offering vs. Netflix. Further, the international markets of the new entity will be much higher ARPU compared to Netflix, as Netflix has penetrated valuable markets and has launched in low ARPU geographies. Overall, I think that the new DTC offering deserves a higher multiple than that of Netflix but I want to be particularly conservative given the execution risk of this early stage.

Putting It All Together Reveals a Large Opportunity; Buy Discovery

The entity will have a large debt burden. It will assume $43 bn of AT&T debt as part of the transaction. This is in addition to $14 bn of existing Discovery net debt including minority interest. This will bring the total debt load for the merged entity to $57 bn.

Combining everything nets an opportunity. The new entity has an EV of $167 bn ($84 bn + $83 bn) and a net debt position of $57 bn resulting in $110 bn of equity value. Only 29% of this will be owned by Discovery shareholders which is $32 bn. This is many times over the current market cap of Discovery of $13 bn.

I think the market has been caught up in the Archegos / Bill Hwang saga and is overlooking the fundamental value here. The technical factors of Archegos loading up on the shares of a few companies and driving the price up with positive convexity resulted in dealers holding the bag when Archegos went under. This then turned into dealers dumping the stock for a long time.

Now is a great entry point. The sentiment is very negative for Discovery and the bar to clear is low. I think that buyers of Discovery today will be greatly rewarded over the long term.

The risk-reward is heavily skewed in the investors' favor. I admit that there is execution risk in the DTC offering. It’s a market-facing headwind in a reopening world with the demand pull-forward and likely less screen time for consumers going forward. More than that, there is fierce competition from Netflix and Disney (DIS). But I maintain that there still is tremendous value here. Even my conservative calculation yields an $8 bn value for Discovery shareholders even if the streaming operation goes for nothing, which is virtually impossible given the value of the content and the subscriber growth. I think that the downside is limited and the upside is multiples of the current price.

Disclosure: I/we have a beneficial long position in the shares of DISCA, DIS 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.