(Note: This article was in the newsletter on September 1, 2022.)
Warner Bros. Discovery (NASDAQ:WBD) is now in the renovation phase. There are all kinds of things (projects, proposals, even budgets) that do not meet the requirements of new managements that have to go. Many times, the market loses sight of the end goal that was so in evidence during the acquisition process. Instead, the market focuses on the equivalent of a house that gets gutted on the way to a total remodel job because that same market worries someone will wreck the joists and collapse the house. That has shown in the recent price action of Warner Bros. Discovery.
As shown above, there was clearly some excitement about the merger prospects before the merger happened. But bad news has a habit of coming out first because management often "takes out the garbage" to get rid of things that frankly are not worth anything. For a merger of this size, a few billions in charges do not change the fundamental story one bit.
Instead, what is happening is the balance sheet is becoming focused upon the assets that are expected to realize the original projection of profitability and benefits that had the market excited in the first place. The immediate problem is the market gets worried that the story has changed or that management will make a mistake that is fatal to the success of the acquisition. It is actually too early to tell that. Nonetheless, Mr. Market often worries about how much more bad news is to come when bad news is the main topic at quarter end.
It would not be unusual for management to adjust the original strategy as economic conditions change or industry conditions change. But changes due to a moving business cycle are often different from permanent profit impairments (or benefits). Yet Mr. Market often confuses transitory with permanent. This confusion can cause individual investors to head for the exits before the benefits (and higher stock price) becomes apparent.
Further confusion exists because a lot of very good investors will state that only maybe one-third of their ideas do work out as planned. Therefore, there is a need for the rest of the time to cut losses and move on. But that accuracy depends upon the work done before the investment is made. Part of that work is exactly what accurate news will make or determine a change in the original story so that it is time to invest elsewhere. Generally stock price movements are not a real good indicator because stock prices often imagine three or four times as many crises as actually exist. That is why due diligence and your faith in it is so important. Then you as an investor will not be part of the panic crowd.
This management has been fairly detailed about "what garbage needs to be taken out".
The minute investors saw this part of the earnings release, they should have realized that management would be taking out enough garbage to fill a whole garbage dump. But the merger was large enough that such an event would still not change the original scenario. Instead, it would remove a lot of useless assets and capitalized expenditures that were not going to generate future returns. There were likely personnel separation charges and hiring costs as well. Clearly the benefits would be coming from the remaining assets.
The big problem is shown by the cash flow number. Once the combined company showed only nominal cash flow growth (even though there was some small period of time to be adjusted for), there needed to be strong and immediate refocusing action taken. Clearly the hurdle for projects undertaken by the previous owner was much too lenient.
The first order of business should be to get adequate cash flow and free cash generated that is normally the case by assets in this business. That is exactly what management appears to be doing despite the current market fears. Even with the one-time acquisition and merger costs considered, the cash flow generation shown above should have probably at least tripled.
It makes little to no sense that Warner Brothers Discovery had an annualized free cash flow rate of about $3 billion and then merged with a larger entity and still had a free cash flow rate of about $3 billion annualized.
There has been some noted concern about the downward adjustment of EBITDA for the current fiscal year. That simply reflects the costs of "whipping the acquisition into shape". The adjustments for streaming industry dynamics are unlikely to be permanent headwinds (though they could be around for a year or two).
Probably the material adjustment was the lower-than-expected EBITDA generation from the acquired assets. Even though management frequently gives information in a way that Mr. Market will focus on a number, management itself is well aware of a range of possibilities before the acquisition was made. Therefore, the lower-than-expected EBITDA reported was probably in the range of expectations. Just as clearly management hoped to not be in that part of the range.
However, nothing in that slide changes the original story about the benefits and potential profits from this merger. There is always the possibility of unforeseen headwinds.
Probably the classic example here is the acquisition of Anadarko Petroleum by Occidental Petroleum (OXY). That merger then ran into all the challenges of fiscal year 2020. Needless to say, all the doomsday predictions were in full swing even as the company attempted to carry out the post-merger strategy. Fortunately, along came an industry recovery (as they usually do get there) and now things look far better.
The current situation with Warner Bros. Discovery is nothing close to that extreme. But clearly the garbage needs to go while focusing on the remaining assets to bring about the original projection of lots of profits. The emphasis on cash flow is justified because the company does need access to debt markets to do business. So, the cash flow needs to support the business adequately.
Despite market worries, there is zero indication of any kind of permanent profit impairment resulting from the current news and activities. If anything, what is happening now should improve prospects even if further course corrections are indicated along the way. The pathway is unlikely to be "straight up". But that is how these things are.
Mr. Market never remembers that management does due diligence before the acquisition. Then actual possession of the assets always turns up still more information that adjusts the strategy to get to the final goal. The idea that anything more than normal "housecleaning" for what is in this case a real big house, just has no traction at this point.
More importantly, management knows this business. This may be the first management in several tries that knows what to do with these assets. The other managements before this one clearly had no idea. So at least in theory, there should be less to worry about here. But Mr. Market does know that there have been a few failures in the past involving the Time Warner assets. So being the confirmed worrier that Mr. Market is has allowed the stock to get to a better bargain level.
Maybe in the future there will be a permanent change in the original acquisition story. If this management is as conservative as its reputation, that is very likely to be the case. But such a revision is likely to be for the better, not the worse that the market imagines.
I analyze oil and gas companies, related companies, and Warner Bros. Discovery in my service, Oil & Gas Value Research, where I look for undervalued names in the oil and gas space. I break down everything you need to know about these companies -- the balance sheet, competitive position and development prospects. This article is an example of what I do. But for Oil & Gas Value Research members, they get it first and they get analysis on some companies that is not published on the free site. Interested? Sign up here for a free two-week trial.
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Disclosure: I/we have a beneficial long position in the shares of WBD, OXY 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.
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