Warner Bros. Discovery: A Streaming Giant In The Making

Summary

• A conservative valuation points to some upside.
• This is an investment for the patient investor.
• Do not underestimate the creator of the 90 Day Fiancé.
• WarnerMedia and Discovery have some of the best assets in its class.
• The future company will be a juggernaut in the DTC streaming space.

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Editor's note: This article was amended on 9/28/2021 to reflect a correction in the FCF valuation.

I bought Discovery Inc. (NASDAQ:DISCA) back on March 29 at $41.50 following the Archegos meltdown. For a stock that was once trading at $77 back in March, it felt like I was getting a bargain. When somebody, in this case Archegos, is dumping shares of a good company at bargain prices, I’m a buyer. When somebody is in a desperate situation, and needs to sell, the buyer is in a good position. I've been following the company for years and an opportunity presented itself. There was "blood on the street" as we say and I moved in. But short-term noise took over the narrative. DISCA fell, and fell, came back for a bit, and then fell off a cliff. At this moment DISCA is trading around $25 despite being a good company.

Data by YCharts

Chart: DISCA YTD Performance

Discovery is my worst investment in a long time. Of course nobody bats 1.000. They can't all be winners. I bought companies in the past that fell 10% after I bought them. It happens and it mostly works out. DISCA sticks out like a sore thumb. I'm down 38% in almost seven months. Simple arithmetic says that's a big hole to come back from. Losing money hurts. It double hurts when everything else I could have bought is going up. It triple hurts when you are public about the purchase (previously documented on the blog). You don't want people to lose money. But again let me reiterate that this is not investment advice and you should do your own research.

The languishing stock price warrants some reviewing. Why is it that I do my best research after a stock is down a lot? I need to ask questions and to be honest with myself. Was this a mistake? Am I trying to make the story work? If so, when is the story going to work? Do I sell? If this is truly a bargain, should I buy more? If I liked it at $41, wouldn't I love it at $25?

What do investors see?

I can't predict the future, but I can try predicting the present. So what do investors see?

• The turning point seems to be the WarnerMedia merger. After the Archegos selloff, DISCA bounced back near my break-even point of $41.50. But following the merger announcement, the market reacted negatively. A lot of debt, deal complexity, and uncertainty clouds the story.
• DISCA is getting kicked around. Sentiment is negative. Sometimes the reason for a lower stock price is a low stock price.
• A complex deal to buy WarnerMedia weighs heavily. We still don't know how it's going to be structured. Is the Reverse Morris trust structure going to be a dividend or an exchange offer for AT&T holders? Details remain scarce.
• We don't know how the streaming services will be rolled out and priced. Well they know but won't tell us. This is a nightmare if you are a Wall-Street analyst that needs key numbers to plug in the financial model.
• Discovery has three classes of shares trading at three different levels. It's not efficient.
• The overhang from AT&T shareholders selling post the deal close. Most T shareholders are in for the dividend. Warner Bros. Discovery (Newco) won't distribute a dividend.
• Cable TV is bleeding subscribers. There's a lot of FCF in that segment but there's no growth and Wall-Street cares about growth.
• A crowded streaming space that's getting more crowded. Growth in streaming is slowing.
• The deal won't close until mid-2022 or later, if they get the regulatory green light. That's another ~nine months? That's an eternity for today's investment timeframe.
• Warner Bros. Discovery will have a lot of debt, ~$55b.
• HBO is the best, but they have made missteps under AT&T ownership.
• Some are doubtful that Discovery can achieve $3b a year in synergies. That's a big number. That's $30b in value at 10x multiple. Great if they achieve it but remains to be seen.

Purgatory

Combine all of this and you have dead money. This means DISCA won't likely significantly move until we have better visibility, more certainty on the deal. However, having said that, I had success with stocks in "purgatory". It’s the place stocks go when they fall out of an orbit. They are in the "nobody cares about them" bucket. They stay in that zone for a while until some event push brings them back. This is where Discovery is. You can value Discovery as a stand-alone business, but we lack crucial details on the merging entity. A stock in "purgatory" can present an opportunity. It's an uncrowded fishing pond. This means you can take advantage of this opportunity to build a position. If you have an investment horizon a little longer than the average investor you can do well in that space.

M&A

I mentioned above that the turning point for DISCA is when they announced the merger with WarnerMedia in a complex deal. For anybody that is familiar with Discovery knows that M&A deals are always in the cards with Discovery. They buy a media business, integrate, then they delever. That's their playbook. But WarnerMedia is a different media animal. It's expensive scripted TV and movies as opposed to cheap reality TV. It's a big bite to chew. It will take time to digest. First you need the deal to get regulatory approval. Then it's the integration. Then the synergies and paying down the debt. This is the boring part of M&A. It's time consuming and there are uncertainties. Things don't always go the way you plan them.

In other words, it stinks and investors don't like it. But that doesn't mean it won't work out. I'm confident it will. Discovery is a great home for WarnerMedia and David Zaslav is the right guy to lead the company. He's a media guy to the bone. He understands Hollywood. He understands the culture. He has the relationships. You are dealing with artists. He gets that. WarnerMedia is definitely under a better ownership.

The value consideration for the merger seems reasonable because not long after the merger announcement Amazon paid a whopping $8.5 for MGM (documented here). The trophy asset is James Bond, but aside that? Yes they are buying a deep catalogue that they can developed but that requires a lot of investment. And I understand that Amazon has a different business model (flywheel approach). A better Prime Video might sell more Prime memberships which would translate into more buying on Amazon.

Changing the Story

The Discovery story reminds me of what Disney (NYSE:DIS) went through a couple of years ago. Back in 2015, Disney's stock was in the tank. There was a lot of heat on the company. Disney was an ESPN story and they were losing subscribers. We know the rest of the story. They made some strategic changes. They bought Fox's entertainment assets and went full throttle into streaming. They changed the story. Today Disney is a streaming story and the market attributes a higher multiple to streamers.

Discovery's story has a similar feel. Discovery is in a declining industry because of cord cutting. However they have embraced DTC streaming and Discovery+ has 18m subscribers. The Discovery+ platform will drive growth forward. Their content is addictive. People can't get enough of the 90 Day Fiancé. During my research I know three different couples close to me that can't dump cable because their wives won't let them. The reason: Property shows and TV reality. Women run the house.

Now with WarnerMedia, Discovery is going to be a heavy weight in cable, in streaming, in Hollywood, and at the box office. It will be up there with Netflix and Disney in streaming. And once the merger is cleared and the dust is settled, it's not farfetched to think that a rival with deep pockets (hint: Apple, Amazon) is not going to look at this gem.

CAPEX Treadmill

There's one part that I overlooked in the streaming business and it's this idea that once the streamers (Netflix, Disney, WarnerBros. Discovery) hit a certain CAPEX run-rate, say $15b-$20b annually, and the space stabilizes, they will achieve some kind of profit margin and generate predictable FCF. I don't think it's that easy. Streaming is shaping up to be a tough business. The competition is heating up. I think the reality is that once they are on this CAPEX spending treadmill for a long time. The economics of streaming require significant scale to turn a profit. People consume content and if you don't have it you lose subs. Higher DTC content spending than expected will be reflected negatively in FCF. Discovery has the advantage of creating less expensive content. The key is trying to find a balance between growing streaming and not cannibalizing the cable cash cow too much.

Debt

The main concern seems to be future debt load. Sure, at $55b it will be a lot. But you need to take a step back and put it in perspective.

Management points to $52b in revenues and $14b in EBITDA in 2023. This gives you a Debt to EBITDA ratio of 4x. It's manageable. $55b at 5% = $2.75b in interest payment. Each $5b in debt repayment shaves $250m in interest payment. You can service that and still invest in growth. Management is also pointing to a 60% FCF conversation rate. That's ~$8.4b in FCF. And unlike AT&T there's no dividend eating 55%+ of FCF. Discovery can service the debt, and you can invest in growth. Debt becomes a problem when it eats all your cash flow and you can't grow. That's not what we have here. As Warner Bros. Discovery lever down, in the long run it could increase the equity value of the company.

Discovery Stock Price and Valuation

What's the amount of optimism that's in the price of Discovery? Not much. Even the ugly assets are worth something. But Discovery is not ugly. It's a great company. They have good brands and it's well managed. They are also focused on generating cash flow. The problem is the deal with AT&T that cast a shadow. This is a classic contrarian play. The best time to buy is when nobody wants it.

Let's work with the number we have. Management points to $14b in EBITDA in 2023. How much is the market willing to pay for that? 10x? Both Netflix and Disney trade in excess of that. ViacomCBS trades at 8x and Warner Bros. Discovery is a superior company. At 10x EV/EBITDA this implies an Enterprise Value of $140b. Remove $55b of debt and you are let with $85b in equity. 29% of that is Discovery, so $24.6b. Discovery's market cap (all classes) is about $18b. This suggests upside.

Management also points to an EBITDA to FCF conversation rate of 60%. This implies $8.4b in FCF in 2023. How much is the market willing to pay for a high quality FCF generator? Let's assume a 5% FCF yield (20x FCF). That's a reasonable number considering that many great companies are trading at sub 2.5% FCF yield.

Even with a margin of safety, it suggests that the market currently undervalues Discovery. The margin of safety is important. The transaction is anticipated to close in mid-2022, so these numbers are projections and are highly subjective.

Summary

I decided to keep Discovery and I might add to my position. My timing might have been wrong but I don't think my reasoning was. I also have a five year plus investment horizon. I shouldn't let short-term events dictate my decision making process. But you also don't want to hold the wrong stock for 5-10 years. If this investment works out, I doubt that I will look back in ten years and talk about this. Nobody is going to remember this. If you invest for the long term, you don’t give up in the short term.

This isn't complicated. Keep it simple. Discovery/WarnerMedia offers a compelling proposition to consumers. Discovery is able to produce quality content for significantly less than other media companies and has a large subscriber base. Yes there's competition but HBO, WarnerMedia, and Discovery have some of the best assets in its the class. The merger with WarnerMedia will give the company enough critical mass of media content to compete with Netflix and Disney in the DTC space via Discovery+ and HBO Max. You will also have consolidation. ViacomCBS, NBC, Amazon, Apple, and YouTube are all fighting for eyeballs. The future Warner Bros. Discovery could be an interesting target once the dust settles.

A conservative valuation points to some upside. I'm bullish. This is an investment for the patient investor.

Do not underestimate the creator of the 90 Day Fiancé.

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