Warner Bros. Discovery's (NASDAQ:WBD) price has declined by c.68% since Discovery and AT&T’s WarnerMedia closed the merger on April 8, 2022, presenting a significant long investment opportunity. The market has, in my view, incorrectly penalised the company for the declining trend in cable, overestimated the operational risks post-merger, and the competition in SVOD, and misunderstood the company's cash-flow profile and its favourable debt structure. This has led to the company trading at quite depressed multiples, offering the potential for substantial returns.
The company’s intrinsic value is likely close to $19.0 per share (136% upside, considering the price as of 20/05/2024 of 8.1). Even in the event that the investment thesis is proven wrong, the company's downside risk is limited. This is because the market is currently pricing the worst-case scenario for WBD, providing a level of security for potential investors.
While the investment opportunity is promising, it's important to be aware of the key risks. These include a potential price war among SVOD companies and the possibility of compressed EBITDA margins due to a higher-than-expected decline in the cable segment. Understanding these risks is crucial for making an informed investment decision.
Company Background
WBD is a media and entertainment conglomerate formed in 2021 through the merger of WarnerMedia and Discovery, Inc. This strategic union created a powerhouse in the industry, combining WarnerMedia's rich legacy in entertainment, news, and sports with Discovery's expertise in non-fiction and international programming.
WBD operates across three segments: 1. Studios, which encompass television and film production and distribution; 2. DTC, which includes streaming services; and 3. Networks include distribution, internal and external licensing of shows, and advertising.
The company's portfolio is a testament to its strength and potential, including globally recognised networks like CNN, HBO, TNT Sports, Cartoon Network, the film production studio Warner Bros., and the iconic DC Comics in its publishing division. After the merger, WBD emerged as a leader with its diverse content offerings, ranging from blockbuster movies and popular TV series by Warner Bros. to engaging documentaries and Discovery reality shows. With its broad spectrum of entertainment and media assets, Warner Bros. Discovery is a formidable player in the competitive landscape of global media and entertainment.
In the last twelve months, WBD generated $33,817 million of revenue and $6,866 million of EBITDA. Its current Market Cap is $27,775 million, and its Enterprise Value is $71,483 million (LTM EV/EBITDA of 8.1x and a consensus NTM EV/EBITDA of 6.5x).
Investment Thesis
The market is underestimating WBD without peeling the layers of value generation happening underneath: that cable TV will disappear, that the debt burden will harm the company's ability to operate. That competition will unseat WBD from its current position in the media space. However, the probability of all three happening is relatively low.
On the contrary, the company presents strengths that the market hasn’t considered.
On the contrary, the company presents strengths that the market hasn’t considered. Despite the decline in the Networks segment, it is still highly profitable, and it's not going to disappear any time soon. The negative trend is stabilising; the penetration among young adults remains strong (56%), and the competitors for the free time that have emerged as substitutes of cable TV in the past years (SVOD, Livestream..etc.) are slowing growth as industry matures leaving big spaces for Networks, that is the preferred platform to see life events such as sports, realities and news. Moreover, the decline in subscribers has been partially offset by price hikes. Moreover, the Company's financials are rock-solid; Zaslav has been doing a great job post-merger, cutting costs, and cleaning the balance sheet, as WBD has showed consistent EBITDA growth since the merger. These results have been obscured in the bottom line of the P&L due to the high restructuring costs, most of them non-cash charges such as the impairment of old content. WBD has generated $390 million of free cash flow in the first quarter of 2024 and $6.16 billion FCF in FY23. Moreover, this positive trend is likely to continue as the company has raised the target of synergies to $5B, and the end of the WGA strike will reverse the $300-500 million hit of the past year. Finally, Content is king for media companies, and WBD is incredibly well-positioned to leverage this situation. Warner Bros is a pioneer content creator, owning hundreds of successful franchises and being the most successful company in the history of the EMMY Awards. This experience in creating content allows a highly efficient content generation to spend vs its competition.
Valuation
For the valuation, the main methodology has been a DCF & Sum of the Parts (SoP):
a) DTC: The revenue growth of this segment is the result of the Average Revenue Per User (“ARPU”) and the number of Subscribers.
I expect a significant increase in monthly domestic ARPU, going from $11.72 to $14.5 in 2028. Internationally, the anticipated growth in monthly ARPU goes from $3.75 to $5.9. As a result, the blended global ARPU will increase from $7.9 to $9.5. These figures are based on the current trend toward increased ARPU as companies in the industry are leaving behind the price wars to gain market share and are focusing on profitability, with measures like the inclusion of advertising, banning shared accounts and rising prices. Moreover, the international launch of MAX and the expected convergence with its competitors as the market matures will also help WBD increase its average monthly revenue per user. For instance, Netflix's current global ARPU is $11.9, and Max's offering has nothing to envy that of Netflix.
As for the subscribers, the expected CAGR of 24-28 is 3.5% in the domestic market, going from 51.5 million subs to 59.0 million. Internationally, the expected CAGR of 24-28 is 11.5%, going from 46.9 million subs to 81.0 million. These numbers follow the industry trend of increased penetration and the discussed positive dynamics the company is implementing (the international roll-out of Max, rationalisation of the content, etc.).
As a result, revenue is expected to increase by approximately 11% p.a. Fuelled by this growth and operational leverage, the EBITDA margin is expected to be 9.7% by 2028.
b) Networks: The revenue growth of this segment is the result of the # Linear subscribers, # Contractual affiliates EU, the ARPU, the licensing of content and advertising agreements.
The expected revenue decrease per year is 3.2% as Cable TV tends to the 56% penetration of the cohort of young adults and less spending on advertising in TV, partially offset by price increases to consumers (5% increase 2018-2023).
c) Studios: I expect a normalisation at the end of 2024 after the decline attributed to industry-wide strikes involving actors and writers that happened the past year, impacting production and content creation. The expected CAGR of 3.9% 23-28 is supported by WBD's pipeline of films and series and the strategic allocation of content inside and outside its platform.
d) Capex & Content capitalised: c. $18 billion, which aligns with the historical average, excluding the impact of the WGA strike.
e) Terminal growth: 2.0%, slightly below the risk-free rate and expected inflation.
Aggregating all three segments, I obtain the consolidated figures, which are the inputs for the DCF model:
In the base case, we obtain a value per share of $19.0 after considering net debt and minority interest. This implies that WBD would be deeply undervalued, having a potential upside of c. 136% at the current price.
I have conducted a sensitivity analysis of WACC, terminal growth, initial parcel growth, mail decline and segment EBITDA margins to measure the impact of variations in the key assumptions.
Source: Own elaboration.
The valuation is highly sensitive to the discount and terminal growth rates. However, the WACC used is already conservative since I have used the highly levered capital structure and didn’t consider the positive impact of delevering. However, this factor should be monitored in case of sudden spikes in the cost of capital. Moreover, the terminal growth rate is also low, as the long-term expected, inflation is higher than the perpetuity growth considered.
The following table summarises the company's value if we use an exit multiple instead of the Gordon growth model (“GGM”).
Source: Own elaboration.
The above chart shows that WBD would be trading at a discount with a potential upside higher than 100%, even in the downside scenarios. It is also necessary to highlight that this is impacted by the company's high-leverage profile. In the following years, WBD must reduce its debt by focusing on cash flow generation instead of competing by price, even if the company loses some market share with this strategy.
From a relative valuation perspective, WBD trades at a discount to its implied per-share value. The market prefers growth over profitability, but under both lenses, WBD remains deeply undervalued. The EV/EBITDA 24 multiple, when controlled by expected CAGR 2024-27, shows an implied multiple of 9.2x ($18.8 per share, in line with the DCF base case) vs. the 6.25x at which it currently trades.
EV/EBITDA vs CAGR 23-27
Source: Own elaboration.
Main risks
The main risk is a higher-than-expected decline in the cable segment. WBD's cash generation will slow down if churn on pay-TV customers increases, as Networks remain the most profitable segment for WBD. However, in my opinion, the market highly exaggerates this risk; contrary to the current sentiment, pay TV is not dying, it is just stabilising as the SVOD market matures. As stated above, this is supported by the high penetration of cable TV among young adults (56% in the cohort of 18-44) and the reasons people pay for cable TV, all of which WBD is strong. Moreover, there is additional stickiness if we consider that 70% of the customers bundle it with other services such as Internet or mobile. The issue above should be tracked closely despite all these factors, considering that a decline in this segment would result in lower margins and negative growth.
Another key theme to consider is the increased competition in the SVOD market, with big players like Amazon and Apple trying to steal market share from traditional media companies like WBD and Disney and SVOD champions like Netflix. This situation could potentially limit growth and damage the market participants' price-setting capacities. Nevertheless, WBD's scale and history place it ahead of other players in terms of content, resources, and consumer perception. Moreover, market maturity and dynamics across players suggest an aversion to a price war.
As part of the merger, WBD was burdened with massive debt, leading to a Debt/EBITDA ratio of 5x. With this amount of debt, cash flow problems could lead to the need for a capital increase in lousy market conditions, the inability to invest adequately in content, or in the roll-out of Max. This risk is particularly concerning in downturns or when unexpected events, such as below-than-expected revenue from advertising or a significant loss of subscribers, significantly impact revenues and profit margins. However, the company's cash flow generation has proved to be rock solid, and the debt has been asked on a fixed basis just before the increase in interest rates. This has provided the company a substantial competitive advantage, as it has been able to plan the delevering smoothly while having cheap financing.
Finally, the merger of two companies with different long-standing cultures could potentially drive tension in the organisation and pose operational challenges. The merger would necessitate blending different management styles and operational philosophies. Warner Bros.' approach, more attuned to the creative nuances of filmmaking and content production for entertainment, might contrast with Discovery's methodology, which may lean towards factual content and educational programming. The alignment of these divergent approaches requires careful handling to avoid friction and ensure a cohesive operational strategy. Nevertheless, Zaslav has been proven to be a very experienced CEO who is able to handle the media behemoth that arose from the merger.
Conclusion
There is an excellent opportunity to invest in WBD. The company has incredible quality and valuable assets, and the valuation is compelling both from a cash-generating perspective and on a relative basis. This asymmetric risk-reward stock is optimal for profiting from the expected re-rating of the company. Despite the positive outlook, awareness of the risks is also essential.
Alejandro Cano
Alejandro specializes in value investment and financial analysis. He holds an MBA from IESE Business School in Barcelona, Spain, is a CFA Level III candidate and holds an Advanced Valuation Certificate from NYU Stern. With a strong background in M&A valuations and investment analysis, Alejandro has led teams to perform complex financial evaluations and contributed significantly to various financial transactions. His investment philosophy is deeply influenced by value investing principles from renowned investors such as Seth Klarman, Joel Greenblatt, and Francisco Parames.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, but may initiate a beneficial Long position through a purchase of the stock, or the purchase of call options or similar derivatives in WBD over the next 72 hours. 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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