Warner Bros. Discovery: Big media energy

Since the completion of Warner Bros. Discovery’s blockbuster spin-off on April 8th, the stock has been on a steep decline of close to 30%. In addition to the anticipated sell-off by income-focused AT&T retail and institutional investors who had received shares of WBD as part of the post-spinoff special dividend, the recent risk-off environment for equity investing has also weighed on the stock’s performance from a valuation perspective.

But on the fundamentals front, the new management team under the leadership of Discovery CEO David Zaslav has been swift and eager in materializing on the $3 billion in post-merger synergies as previously promised. Two of the most notable actions taken to date include 1) the abrupt shutdown of the merely weeks old CNN+ news streaming platform, and 2) heightened focus on investments that will “generate real return” instead of a blind “content arms race”.

Going forward, we foresee further removal of “chunky investments” previously engaged by AT&T-managed WarnerMedia that lack “financial foundation” and fall short of “meeting the [return on investment] hurdles” expected by WBD management. These short-term pains are expected to drive longer-term gains by bolstering the consolidated company’s free cash flows and contributing to its deleveraging target – a pressing matter given the additional $55 billion in debt acquired from WarnerMedia. Accordingly, the strategy will inevitably enable greater flexibility across WBD’s balance sheet and capital structure to support longer-term growth and drive greater shareholder returns down the road.

With Warner assets now placed back into the hands of experienced media and entertainment veterans from a management standpoint, and the impending combination of direct-to-consumer (“D2C”) streaming platforms HBO Max and discovery+ driving further headways into the burgeoning streaming market, WBD is tracking favourably towards its near-term financial targets of $3 billion in cost synergies, $52 billion in revenue and $14 billion in EBITDA by 2023. WBD’s consolidation is the big media energy needed to jumpstart growth and capitalize on fast-expanding opportunities in media and entertainment that include D2C streaming and digital advertising. Paired with the stock’s significantly undervalued nature – it is essentially priced as a declining business – we remain optimistic that the potential for close to 3x gains is still within reach.

Beating Competition
The pandemic and associated social distancing measures over the past two years have brought to light the massive market for on-demand video streaming enabled by the advent of internet-connected mobile devices. Global consumer spending on entertainment and media is expected to advance at a compounded annual growth rate (“CAGR”) of 3.9% into a $915 billion market by 2025. And much of this acceleration will be driven by demand for video streaming services, which is expected to rapidly expand at a 10.6% CAGR through mid-decade to become an $80+ billion industry. The number of streaming subscribers doubled from about 125 million to more than 250 million between 2019 and 2020 in the U.S. alone, underscoring the shift in consumer behaviour towards the way they approach media and entertainment.

Recognizing the immense growth opportunity presented by on-demand video streaming, many traditional entertainment and media companies, including WBD, have launched their own platforms. The transition from pay-TV to streaming is also the only strategy that makes sense. To date, on-demand video streaming has overtaken about a third of total TV viewing time in the U.S. And in order to stay relevant, legacy entertainment and media companies like WBD will have to place more emphasis on diversifying their revenues outside of linear TV.

As streaming continues to chip away at pay-TV viewership, there is still significant runway for further expansion by the emerging industry, which makes strong tailwinds for WBD’S HBO Max and discovery+. But the number of services that households are willing to pay for is limited, especially as consumer sentiment dampens ahead of a potential economic downturn. In response, there has also been a lot of consolidation among the big players, which again, points to WBD’s longer-term strategy.

With a combined base of more than 100 million subscribers across HBO/HBO Max and discovery+, WBD now operates the third largest D2C streaming business after Netflix  (200+ million subscribers) and Disney (150+ million subscribers through Disney+ and Hulu). WBD also owns the second most-demanded catalogue of streaming titles after Disney. It commands 18.3% of related market share compared to Disney’s 19.8% under Disney+ and Hulu, and Netflix’s 8.2%, underscoring the media and entertainment giant’s ability in sharing the growth of rivals as competition in streaming ramps up.

WBD’s best-in-class content library has essentially indirectly enabled a revenue-sharing mechanism amidst the increasingly crowded streaming landscape by bolstering its strength in generating distribution revenues from licensing IP rights to rivals like Apple TV+ , broadcasters and other service providers as discussed in our previous coverage. Having the most attractive content library within the industry is a key competitive advantage for WBD. It will be more likely for WBD to charge distribution fees for licensed content to a competitor like Apple TV+ or Netflix, than vice versa.

The consolidated company’s “unparalleled IP” is also eating away at competition’s market share by curating offerings to match subscribers’ needs and budgets, as demonstrated by its subscription growth momentum. Looking ahead, the eventual integration of both HBO Max and discovery+ will only unlock greater top-line synergies:

“In streaming, we have a massive opportunity to reach the widest possible addressable market by offering a range of tiers, all with the most compelling and complete portfolio of content. A premium and attractively priced ad-free direct-to-consumer product, a lower-priced ad-light tier, something we have had tremendous success with and is our highest ARPU (“average revenue per user”) product, and some very price-sensitive markets outside the United States, we can even offer an advertiser-only product.”

WBD’s massive content portfolio is both a competitive advantage and an answer to the price sensitivity of most streaming platform subscribers. Based on observations by previous WarnerMedia CEO Jason Kilar, more than half of HBO Max subscribers are price sensitive and have chosen the cheaper ad-enabled tier. The observation is also consistent across other streaming platforms, like Disney’s Hulu, which has ad-enabled sign-ups exceeding 60% of its subscription base.

While both HBO Max and discovery+ currently generate dual revenue streams by offering “ad-lite” and “ad-free” options for their respective global subscribers, the eventual combination of both platforms is expected to enable additional tier options – such as films only, sports only, or a premium all-in package – that can cater to different user needs and budgets, and maximize its global share of on-demand video streaming subscription volumes. The added contribution of Discovery’s advertising strength into WBD is expected to bode well for the company’s ad-lite offering and help drive greater market share gains in streaming over the longer-term.

Withstanding the inflationary environment
Considering the current macroeconomic climate, where inflationary pressures are forcing consumers to cut budgets on discretionary spending and geopolitical tensions are barring business from being conducted in certain economies, it is a tough time to be in the media and entertainment business. However, WBD’s diverse revenue stream is expected to help cushion some of the impact. In addition to WBD’s growing prominence in D2C streaming, its prowess in IP content distribution, as well as advertising, theatrical sales, and linear pay-TV enables a well-rounded, diversified entertainment and media revenue portfolio that proves favourable under the current macroeconomic environment.

Based on the most recent financial performance at WarnerMedia and Discovery prior to their merger, advertising accounted for 18% and 47% of total revenues, respectively. Although ad spending is expected to see some near-term softening as advertisers adjust for waning consumer sentiment ahead of a possible recession, WBD’s diversified ad distribution channels, which all boast industry-leading reach, are expected to reduce some of the impact. In linear TV, WBD currently draws the most prime-time viewership than all of ABC, CBS, NBC and Fox combined. This positions the company favourably for the 22% of total annual ad spend allocated to TV commercials. The growing subscription base of HBO Max and discovery+ also makes them attractive sources for the increasing shift in ad spending towards digital platforms. Video streaming platforms are now home to about 23% of total ad spend in the U.S., and the figure is expected to expand further as digital advertising’s more than 60% share of the broader advertising market today is projected to grow at an 11% CAGR through 2030.

Content distribution is another strong revenue stream for WBD as discussed in the earlier section. Prior to the merger, content distribution accounted for close to 35% and 45% of WarnerMedia and Discovery’s total revenues, respectively, with consistent year-on-year growth. Within the increasingly competitive streaming industry, a trusty strategy for attracting subscription growth is to ensure high-demand content, whether organically produced in-house or licensed from other media companies, are available for viewing at subscribers’ convenience. Having now created one of the most coveted content libraries in the industry that includes many of the “most iconic brands and franchises”, WBD will continue to benefit from distribution demand, even in today’s inflationary environment. And this is expected to offset some of the anticipated near-term softness from its other revenue streams like advertising and viewership subscriptions that are more prone to potential changes in consumer behaviour.

WBD’s continued commitment to ensuring a comprehensive media and entertainment portfolio that includes sports and news broadcasting, in addition to scripted and unscripted programming, is also expected to help sustain viewership in the inflationary environment. A prime example would be the latest formation of WBD’s joint venture with U.K. telecom giant BT’s sports televising unit, BT Sports. The joint venture, which is expected to close before the end of the year, will create a “new premium sport offering for the U.K. and Ireland” that encompasses one of the “most extensive portfolios of premium sports rights including the Premiere League, UFC, the Olympic Games, Australian Open” and many others. And although the company has recently pulled the plug on CNN+, CNN remains the leader in global news reporting and journalism. News reporting has been deemed by WBD management as one of the most scalable mediums in media, and “being able to own the greatest brand in news is really compelling” for the company’s longer-term fundamental prospects. The recent developments in sports and news are also expected to bolster WBD’s continued advertising and subscription (both pay-TV and streaming) growth in the long-run by retaining existing and attracting new viewership.

Strong fundamentals
In addition to diverse revenue streams, management’s steadfast commitment to maintaining “durable and sustainable free cash flow generation” for WBD will continue to be a lifeline to its ongoing deleveraging plans and longer-term growth trajectory. With Discovery’s yearslong track record in expanding free cash flow margins (1Q22: 8% vs. 1Q21: 6%), WBD has a strong chance of lowering its current gross leverage to a range of 2.5x to 3x over the next 24 months as management had intended.

However, the deleveraging process will not be without its pain. Recognizing that WarnerMedia had generated $40 billion in annual revenues with “virtually no free cash flow”, WBD management under Zaslav’s direction has been swift in restructuring the business’ investment initiatives. WBD’s decision to rip off the band-aid and adopt an aggressive business plan that included pulling the plug on CNN+ after investments of $300+ million by previous management is definitely not an easy one for investors to digest. However, it does prevent spending an additional $700 million from the originally approved $1 billion budget for a project that likely will not generate meaningful returns within a reasonable timeline. And continued execution of this aggressive strategy, especially under the expertise of media and entertainment veterans that have shown a positive track record in turning Discovery into a “free cash flow machine”, shows promising potential for redirecting WBD back on track towards positive shareholder value.

The possession of a strong balance sheet and healthy capital structure will allow greater flexibility for WBD to invest strategically into expanding its market share and remaining competitive within the media and entertainment business over the longer-term. The amalgamation of two of the largest content libraries in the industry under one roof through WBD also eliminates the need to engage in a “D2C spending war”. Instead of having to engage in a content arms race like other streaming platforms, WBD already boasts an industry-leading content library. Paired with its generous cash flows, WBD is catapulted a step ahead in the process of becoming a “fully scaled global streaming leader”.

Taking the foregoing analysis into consideration, WBD is tracking favourably towards generating consolidated revenues of $52 billion and EBITDA of $14 billion by 2023. Although WarnerMedia’s estimated bottom-line contribution for the current year is about $500 million short of WBD management’s expectations, the swift and resolute measures taken to date to improve operating efficiency across the newly combined business are expected to drive positive offsets.

The impending combination of WBD’s D2C streaming platforms next year is also expected to consolidate some of the subscriber volume growth observed over the past two years for each of HBO Max and discovery+. Essentially, streaming subscribers that currently pay for HBO Max and discovery+ will no longer count as two under WBD’s current member base of more than 100 million. However, the top-line synergies discussed above (e.g. multi-tier offerings) are expected to bolster WBD’s global streaming market penetration and drive higher ARPU to compensate for the consolidated subscription volume growth in the long-run.

Our forecast expects WBD to achieve $52 billion revenue by the end of the current year, which is 12 months ahead of management’s guidance. The projection takes into consideration WarnerMedia and Discovery’s standalone top-line performance during the first quarter, as well as their respective historical top-line growth trends driven by robust advertising and content distribution sales, and fast-expanding subscription volumes. And over the longer-term, WBD’s consolidated revenues are expected to expand at an 8% CAGR over the next five years, driven by a favourable combination of continued streaming market share gains, robust content distribution sales, and strong retention of increasing digital advertising dollars.

Cheap valuation
As discussed in our previous coverage, WBD’s current trading multiple is not reflective of its anticipated growth prospects. Analyst estimates for WBD’s current year revenue growth on a normalized basis (i.e. CY/2021A Discovery and WarnerMedia revenue vs. CY/2022E WBD revenue) range from 3% to 10%. However, at its current 1.1x 2022 forward EV/sales multiple and 0.9x 2022 forward price/sales multiple, the market is pricing WBD at negative revenue growth for the year, which represents a significantly undervalued opportunity.

We remain confident that the stock has potential to become a $100+ billion company over the next 12 months. Our price target for the stock following the completion of its spin-off remains at $45, which represents upside potential of more than 150% based on its last traded price of $17.74 on May 20th.

Our price target is derived by equally weighing WBD’s projected 2023 revenues by a price/’23 sales multiple range spanning 0.9x (bear case), 2.0x (base case), and 2.8x (bull case). The base case valuation multiple applied reflects the current streaming peer group average price/’23 sales multiple of 2.0x. The bull case price/’23 sales multiple of 2.8x applied bumps WBD’s valuation back in line with the streaming peer group based on its average consensus CY/2023E revenue growth estimate of 7%. The bear case price/’23 sales multiple of 0.9x applied represents the stock’s current forward trading multiple. The equally weighted average method applied in determining our price target for the stock intends to smoothen out any over-valuation allocated to WBD’s non-streaming businesses (e.g. digital advertising; content distribution; linear TV), since we have used the streaming peer group’s valuation trends as a benchmark. Seeking Alpha