So this summer, Open Square Capital had the pleasure of having Ramya Sridhar intern with us a second time. Ramya is a rising third-year student at the University of California, Berkeley (Go Bears!).
As an economics major, Ramya interned with Open Square last year, and helped us tremendously with slicing and dicing inflation data, to the point where we've helped readers forecast the trajectory of the Consumer Price Index. This summer, Ramya's focus was a bit different as she wanted to explore the world of stock analysis.
After casting about for ideas, she landed in the media sector, and specifically on Warner Bros. Discovery (“WBD”), a mishmash of media assets formed from the amalgamation of Discovery, Inc. and the WarnerMedia business of AT&T. The marriage closed on April 8, 2022, and the company, with 37,500 employees, launched with a bevy of assets and a huge debt load. Here’s WBD’s own description of its business (WBD 2022 Form 10K).
Warner Bros. Discovery is a premier global media and entertainment company that combines the WarnerMedia Business’s premium entertainment, sports and news assets with Discovery’s leading non-fiction and international entertainment and sports businesses, thus offering audiences a differentiated portfolio of content, brands and franchises across television, film, streaming and gaming. Some of our iconic brands and franchises include Warner Bros. Pictures Group, Warner Bros. Television Group, DC, HBO, HBO Max, Discovery Channel, discovery+, CNN, HGTV, Food Network, TNT, TBS, TLC, OWN, Warner Bros. Games, Batman, Superman, Wonder Woman, Harry Potter, Looney Tunes, Hanna-Barbera, Game of Thrones, and The Lord of the Rings.
With that primer . . . let’s check in with Ramya.
Ramya it's good to have you back.
It’s good to be back.
So tell the readers a bit about what you've been working on.
With the last three DC flops, the wildly popular Barbie movie, and a few classic remakes in the chamber (Willy Wonka, the Color Purple), WBD has been trending in popular entertainment and the news lately. I figured it’d be worth it to obtain a holistic view of the business and to see if the stock was an exciting prospect, or as surefire as David Zaslav (WBD’s CEO) hypes it up to be.
So we don't bury the lede, what does your overall analysis tell you?
If we can use a Disney analogy, WBD is basically Kristoff’s character in the movie Frozen, trying to sell as much ice before winter sets in and destroys his business. Concurrently, he’s also attempting to start a new snow cone business . . . in SUMMER . . . to offset the ice one.
As of now, the melting ice cube business is still way bigger than the new one, but it is melting. Kristoff makes most of his money from this melting ice cube, and his ability/inability to manage that decline will largely dictate whether he can successfully pay down his debts and build-up the new business.
So let’s start with basics, WBD’s make-up and business model. WBD’s business can be segmented into three categories: Studios, Networks and Direct-to-Consumer (“DTC”)
Studios is associated with movie production and theatrical release.
Networks refer to the various television networks they own (including CNN and Turner Classics).
DTC is their direct-to-consumer segment, which refers to their streaming platforms (HBO Max).
The way I see it, Studios is a snow flurry, a bit unpredictable and unreliable. Whereas Networks (WBD’s cable business) is a giant, but melting ice cube. In contrast, DTC (WBD’s streaming business) is a small, but growing one. So the question is, can WBD sell enough subscriptions in DTC to offset the lost business in Networks, meanwhile hoping the Studios can make it rain, errr . . . snow?
The Studios segment contributes roughly 30% of WBD’s total revenue. Studios is what WBD is mainly known for . . . movies, theatrical releases, and content enterprise. The content and movies they produce are the crown jewels of the entire enterprise, and distributed through their channels and/or out-licensed. Consider some of the intellectual property (“IP”) . . . Lord of the Rings, Harry Potter, and the ENTIRE DC universe. These are franchises and storylines that have shaped entire generations, and you’d surmise that WBD will be able to mine the deep veins of IP for years to come. Recent content releases, however, have been lackluster and cast doubts on their ability to execute. The last three DC films (Shazam 2, Black Adam, The Flash) have all failed to live up to expectations.
In contrast, Barbie has clearly broken out, but while it’s a massive success, these kinds of hits are few and far between. Furthermore, it remains to be seen whether Barbie is a one-hit-wonder, or if it’s an IP platform that can be continuously cultivated as a source of recurring content.
As for Networks, it’s likely the most important segment from a revenue and cash flow perspective. Networks contributes roughly 50% to WBD’s total revenue, and nearly 2/3rds of Adjusted EBITDA. Within Networks, advertising and distribution contribute the most to the segment’s revenue with a 40/60 split, respectively.
WBD has recently attributed their inability to hit certain financial goals to an unfavorable ad market. Again, because it’s ~40% of a segment that contributes ~50% to revenue, advertising in Networks alone accounts for at least 20% of WBD’s total revenue. When it comes to television advertising, fears of an impending recession are impacting advertising revenue, and in the most recent Q2 call, WBD highlighted the soft market conditions.
As for distribution, revenues continue to slide. The linear media business (i.e., cable television) has been beset by nearly a decade of cord cutting (i.e., cancelling cable)). The proliferation of streaming services and content has steadily eroded cable subscriber counts, particularly among the younger cohorts.
Fewer cable subscribers also have a knock-on affect on advertising revenue. Hence, 50% of WBD’s revenues are now technically sourced from a declining business.
Lastly, the DTC business line holds the greatest potential for WBD. DTC refers to WBD’s streaming sites, including (HBO) Max and Discovery+. From a revenue standpoint, DTC is the smallest segment, contributing roughly 20% of WBD’s revenue. DTC subscriber growth will be key to stemming the losses from the Networks segment, but for now, many of these services are in the “investment” phase, loss leaders sacrificing their profitability to attract subscribers.
So we’re in the “land grab” phase of the sector?
Yes.
Interesting you say that because the writer’s strike, the actor’s strike, all these labor issues are symptomatic of streaming’s disruption. It’s probably fair to say, streaming economics aren’t profitable at today’s $15/month or $20/month price levels. The cost structure’s too high (and going higher), and the subscription fees too low. There was a reason why cable bills were $100/month.
Agreed. Contrast WBD with Netflix, Disney, Paramount and Comcast, and you can see it play out. We’ll likely need to see higher prices and further consolidation.
It’s like the early days of cable. Reminds me of Cable Cowboys, that book about John Malone. So play this out for WBD. What should we expect?
Despite its “melting” Networks ice cube, with nearly $5B of free cash flow (“FCF”) per year, WBD’s entire business is still quite lucrative. Although it’s likely in permanent decline, the Networks segment will still have a long-tail. Long enough to repay debt and transition to new methods of distribution. WBD’s goal is to grow their DTC business to complement and eventually replace the cable segment. So although there are structural business risks, those are on a longer timeline. One of the biggest challenges for WBD as it executes its strategy is managing its debt load, but if it can successfully pay down its debt in the short-run, investors can win despite the secular headwinds.
So maybe take a dual approach? Short-term and long-term?
Yes. Take a step back. WBD is burdened by quite a bit of debt. Nearly $53B post-close (April 2022), and ~$48B as we write this. WBD’s near-term goal is to reach 2.5-3x 12 month trailing Adjusted EBITDA. Adjusted EBITDA projects out to be ~$12.5-13B next year, and if so, gross debt should be about $39-40B on the high side.
We just closed out Q2 with $48B of debt. So WBD plans to repay $8B by the end of 2024?
Yes, 2023 FCF is forecasted to be ~$5B, so with six more quarters of cash flow, $8.5B should be achievable.
What happens to the stock then?
Well with 2.4B shares outstanding, reducing debt should translate to a higher equity value if we assume the enterprise value stays the same. So paying down debt by $8.5B equates to an increase of ~$3.50/share ($8.5B / 2.4B shares).
Wahoo . . . so stock bumps-up from $14/share (today’s trading price) to about $17.50 per share?
Yes . . . but there’s more.
Repaying $8.5B of debt at 4% interest rate means saving $350M of interest expense, or said another way, increasing FCF by $350M. If we apply a 6x multiple on that increased cash flow stream it’s worth ~$1.00/share of increased equity value ($350M * 6x = $2.1B / 2.4B shares). So there’s another dollar for you.
Wahoo x 2 . . . so $18.50 per share?
Yes . . . but there’s more more.
Repaying the $8B of debt further delevers the company and increases FCF. Solidifying the balance sheet makes the entire endeavor to pivot its business much more achievable. There’s some value in repaying the debt on the entire enterprise. Arguably, we can say that this company deserves a higher multiple if they achieve it.
Holistically they’ll have reduced debt from Q2 2022 to Q4 2024 by nearly $14B if this happens. So a further reduction of $8B of debt in the next six quarters should bolster investor confidence. If we apply a 0.5x multiple (so enhancing the multiple from say 6x to 6.5x), then that’s likely worth another dollar per share (0.5x * $5B of FCF = $2.5B / 2.4B shares = $1.00/share).
So . . . $19.50 by Q4 2024, or an increase of $5.50/share? A~40% increase in 1.5 years? Your 0.5x multiple expansion could be conservative considering WBD is at 6x, Paramount at 9x, and Disney is at 10x
Yes . . . but there’s more, more, more!
Really hammering it home now aren’t you?
There’s “free” optionality here. The DTC streaming business may get better here. Profitability has the potential to increase as others lead the way. Just look at Disney’s recent announcement.
If the generals lead, the soldiers should follow, which allows WBD to piggy-back off of this increase. In the short-run, WBD will need to balance increasing prices with higher subscriber churn. YTD DTC subscribers are fairly flat, but it remains to be seen what a price increase will do. Disney would be a good bellwether to follow going forward, but we can be optimistic about the prospects.
The second optionality is Jame Gunn, the co-writer and director of Guardians of the Galaxy and the writer/director of Guardians of the Galaxy 2.0. These were monster hits that shifted the tone of the Marvel franchise. What were more serious affairs became more fun. In 2022, WBD appointed James Gunn and Peter Safran as the new heads of DC Studios to reboot the DC franchise of Superman, Batman, etc.
In December 2022, Gunn announced that a new Superman movie centered on a young Superman in Metropolis is scheduled to be released in the summer of 2025. Now imagine if WBD is able to replicate the success of Disney’s Marvel franchise. It would allow the company to better leverage the IP of the DC universe across the DTC and Networks business segments. A successful reboot means that the DC Studios can become the engine that again drives the entire company forward.
Lastly, a take-out. As streamers consolidate the space to reduce competition, build critical mass, and enhance profitability, some content distributors (e.g., Comcast, Amazon, etc.) may look longingly at WBD’s library of content and (HBO) Max streaming service. As costs rise and profitability gets squeezed, not all streamers will successfully reach the promised land. In the end, subscribers will likely winnow down their streaming services to 2 or 3 providers, and with Netflix likely to be the first choice, who will be second? WBD’s library of content and a valuable IP could serve as a justification for the second.
Ultimately, I believe Warner Bros has enough IP, and a sufficiently stable, albeit challenged, revenue stream to survive a changing industry even with the harsh competition. The company will pay down its debts with the cable revenue, and the repayment will likely change investors’ perception. If the DC reboot is successful and DTC grows again, the pendulum of sentiment could really swing the other way.
So short-term, wait for the pay down, which should mechanically enhance the stock price, and then at YE 2024 find out whether to wait for the summer 2025 to see how successful, or not, DC Studio’s reboot of the DC universe is?
Exactly. Get paid while you wait.
$14.00/share to $19.50/share in 1.5 years + optionality. ~40% gain? I like it.
So do I.
So, after all these weeks of breaking apart a business, what did you learn and what can you share with people about how stock analysis can be done, improved, etc.?
Initially, I started with financial modeling. Like many analysts I began by creating a discounted cash flow model (“DCF”) of WBD, and was amazed by how comprehensive the exercise could be. Theoretically, it projected the future wellbeing and life of a business, through simple numbers.
Like some sort of data-driven prophecy.
As I dug deeper, I realized how abstract this entire exercise tended to be. It was severely reliant on assumptions, and therefore subject to human error. Less Delphic prophecy, and more shady-carnival-fair palmreading.
DCFs are so reliant on assumptions, and the smallest adjustment to those assumptions can land you miles away. So instead, we refocused on some bigger ideas. Not so much the nitty gritty of financials, which can give you a false sense of security, but on the greater realities of the business. What are the key drivers of this business, of this stock? Who are they, what are they, what do they do, and how do they do it? As I dove deeper on the qualitative analysis, we then went back to the financials to play out our assumptions, and to cross-check our qualitative judgments. In the end, both the quantitative and qualitative analysis gave me a deeper insight into a business that neither one alone could.
Numbers and narratives matter, I suppose.
They always do. Again we thank Ramya for her hard-work this summer, and hope you benefit from her analysis of WBD. As an economics major, Ramya will be entering her third-year at Berkeley, and is open to future opportunities in the economics and financial field.
Feel free to ping us if you’d like to reach out to her. She’ll undoubtedly be a terrific asset for your firm.
Please hit the “like” button above if you enjoyed reading the article, thank you.