Investment Analysis: Warner Bros. Discovery Inc. (WBD)

WBD is a global media and entertainment powerhouse that owns a highly valuable collection of IP, operates one of the remaining 5 major movie studios, has a best-in-class management team, and has significant growth drivers over the next few years. We think overly pessimistic investor sentiment over the shares are completely misguided. The stock currently trades at ~$11, which we believe is a significant discount to intrinsic value.

Executive Summary

Who doesn't want to own a high quality cash generative business that is being managed by top tier executives paired with an opportunity to 3x your capital? Warner Bros. Discovery (NASDAQ: WBD) is that business. The company is on track to generate at least $5 Billion in FCF during 2023 off of ~$11 Billion in EBITDA and we believe WBD has numerous levers to pull over the coming years to grow EBITDA and FCF. The stock is also dirt cheap.

WBD's largest shareholder is John Malone, who is basically the Warren Buffet of the media industry and has a track record of generating 30% annual returns over multiple decades. Malone is arguably one of the most successful CEO's of all time (profiled in the book The Outsiders) . Malone was CEO of TCI (Tele-Communications Inc.) from 1973 to 1998 and his performance can be summed up by a direct quote from The Outsiders:

“From his debut in 1973 until 1998 when the company was sold to AT&T, the compound return to TCI’s shareholders was a phenomenal 30.3 percent, compared with 20.4 percent for other publicly traded cable companies and 14.3 percent for the S&P 500 over the same period.” - The Outsiders

If that wasn't good enough, in 2014 Malone purchased shares of Charter Communications (NASDAQ: CHTR) and made a 12x return in 8 years - incredible. He currently sits on WBD's board of directors.

CEO David Zaslav and CFO Gunnar Weidenfels are also top notch and have applied their no BS approach to the merger and have made substantial progress on reorganizing the business and are laser-focused on free cash flow. Most streaming peers, including HBO Max, were pulling content from competitors and collapsing multiple windowing platforms into one - DTC (direct-to-streaming). When WBD management took over, they realized this business model made no sense and that making movies for $40MM+ directly for streaming was not a profitable endeavor. So they quickly pivoted and focused on utilizing all windowing opportunities to maximize every dollar of revenue across the whole theatrical ecosystem (movie theaters > HBO Max > licensing out content to other platforms, etc.). They were the first to realize this and are well ahead of industry peers who are now trying to play catch-up.

WBD shares are trading at a 17% FCF yield and we believe intrinsic value is ~$35 per share versus the current stock price at ~$11. We think this is an opportunity to 3x your capital or more over the next couple years. WBD is currently Seaside Private Capital's largest position.

Investment Thesis

Warner Bros. Discovery Inc. (WBD) is the product of a $43 Billion spin-off merger, where AT&T spun-off WarnerMedia through a Reverse Morris Trust (tax free) and Discovery Inc. sequentially acquired WarnerMedia to form a media juggernaut that, combined, would have a bigger content library than streaming giant Netflix. The transaction closed on April 11, 2022 and the stock initially traded around $25-$30 per share, but then subsequently dropped into the teens, and even the single digits, but has since partially rebounded to ~$11, which is where the stock sits today. To be fair, the story has been quite choppy since the consummation of the merger.

A few speed bumps WBD ran into right out of the gate:

AT&T management hastily slapped together CNN+ prior to the merger, which WBD management had to quickly shutdown. That was a $500MM setback right from the get-go.
AT&T management fluffed up subscriber numbers and touted HBO Max had over 100 Million subscribers at deal announcement. WBD management redefined subscribers as customers who actually pay for HBO Max, which was actually closer 90 Million (a downward adjustment 10 Million subscribers). AT&T was handing out free subscriptions to cell phone customers and included that into the subscriber base, even if customers never activated those free accounts. This startled investors since streaming was all about subscriber growth.
2022 was the year of rising interest rates and inflation, which led many economists predicting a recession was around the corner (and they are still predicting this). This has led to a weak ad market in which firms are cutting marketing spend until the economy stabilizes. This has been a negative for WBD's ad revenue.
EBITDA guidance for 2022 was put out at $9-9.5 Billion and $12 Billion for 2023, respectively, which was lower than initially touted during the merger (closer to $14 Billion for 2023). For reference pro forma 2020 EBITDA was $12 Billion.
1. Updated Guidance for 2023 is now closer to $11 Billion in EBITDA due to ongoing writer/actor strikes and weak ad market.
Investor's view of the streaming model has changed quite drastically over the past 18 months. People realized that growing subscribers regardless of cost is not a great business model. Netflix also reported lousy earnings, which hurt sentiment.
AT&T shareholders have been forced sellers of WBD since they just want a stock that pays dividends.

On balance the company has dealt with quite a few challenges early on, and by the way, these issues are all layered on top of your typical merger-related noise (restructuring costs, integrating two different company cultures, etc.). So investors have been rightfully pessimistic over the first 18 months, but we think this is a short-sighted view.

A few incremental positives:

WBD primarily has fixed-rate debt at a 4.6% weighted-average interest rate, which they are now able to buy back below par value given current rate environment.
WBD has already paid-off ~$11 Billion in debt and should be comfortably below 4.0x leverage by year-end 2023. WBD expects to reach an investment grade rating sometime in 2024.
Synergy targets increased from $3 Billion to over $5 Billion.
1. Management also outperformed synergy guidance during the Discovery/Scripps merger. They get high marks here in our view.
WBD management re-launched their combined streaming product, Max, and have already reached breakeven EBITDA a full year ahead of schedule.
Management has full command and control of the business. They were the first to pound the table on questionable streaming economics and quickly course corrected.
Management has taken a much more disciplined approach to the movie business, which has been notorious for green-lighting big budget movie flops.
1. Early blockbuster success - Barbie is the 14th highest grossing film of all time, currently at $1.4 Billion at the box office.
Gaming business was originally regarded as a non-core asset, but will now be a key asset moving forward.
1. Hogwarts Legacy generated $1.3 Billion in revenue as of May 2023.
Management is Guiding to $5 Billion in Free Cash Flow for 2023, substantial improvement YoY.

Altogether we think the company has executed very well in a difficult environment. We also believe that the difficulties presented are very short-term in nature, particularly the weak ad market and the actor/writer strikes. We expect WBD will have somewhat choppy results from year to year given timing of movie releases, sporting events (Olympics, World Cup, etc.), and election cycles (2024 being an election year), but the timing of these events doesn't impact the business over the long-term. Ultimately we think this is a very profitable business that will produce substantial FCF with Mr. Zaslav. providing FCF guidance of "substantially higher than $5 Billion" in 2023. We think FCF can easily hit $8 Billion over the next few years.

Across any valuation metric, shares are dirt cheap today. We estimated WBD shares are worth ~$35, nearly 3x higher than the current share price.

Valuation

On any valuation metric we think shares are incredibly cheap.

Our primary valuation source for WBD utilizes an EBITDA multiple, which we think is applicable for the business given a) still a decent amount of clean-up on the income statement post-merger and b) Given industry consolidation to date we think this highlights the true value to a private buyer, which is a very possible outcome after April 2024 (when M&A restrictions from the Reverse Morris Trust expire). FY 2022 really only consisted of 8 months of ownership and included a lot of messy restructuring charges and many business course corrections. Still, WBD finished the year with $9.1 Billion in EBITDA, which we think was a commendable achievement.

WBD currently trades at a substantial discount to the peer group at ~8x EBITDA. The comp group trades at ~16.0x on average. We believe Netflix (NASDAQ: NFLX) should trade at a premium to the group, and at a bare minimum WBD should trade in line with Paramount (NASDAQ: PARA) at 14.0x EBITDA. However, we do think Paramount is actually in a worse position, strategically and financially, versus WBD. So 16.0x EBITDA seems reasonable to us.

Peer Comp Table and WBD Valuation (FY 2022 EBITDA):

Based on this analysis WBD shares should be worth $41.51 to a strategic buyer.

For underwriting purposes I like to be conservative. So let's say WBD should trade below the peer group average, in-line with AMC Networks (NYSE: AMC) at 12.0x, which we think is substantially inferior to WBD. We get to $26.45 per share, still over 2.3x higher than the current share price. Dragging our conservative 12.0x EBITDA multiple through 2023 and 2024, we can see a valuation of $37.08 in 2023 and $48.57 in 2024. Our EBITDA and leverage targets are also within management's updated guidance. See below.

I should also point out that based on historical transaction multiples in the media and entertainment sector from 2006-2021, transactions have averaged 17.46x EBITDA. MGM Studios was the most recent acquisition at 27.5x EV/EBITDA in 2021 by Amazon. Multiples in the space vary greatly depending on the specific set of assets, profitability, etc. For what it's worth, the Time Warner transaction in 2016 came out to 13.87x, in-line with paramounts current trading multiple.

Historical Media transactions from 2006-2021:

As a sanity check on our EBITDA valuations we also analyzed an un-levered discounted cash flow (DCF) approach given management's FCF guidance for 2023. I should note that we think the business won't hit "run rate" FCF until 2025 and that we consider our analysis overly conservative with an assumption that FCF grows at 3.5% per annum.

There are a couple drivers of FCF on a go-forward basis that are not currently being accounted for which are:

Substantial costs re-launching Max streaming platform and simultaneously running HBO Max and Discovery+ platforms. We expect these costs will be a tailwind for FCF growth as these backend systems are consolidated.
Max will begin launching overseas in late 2023 and into 2024. Management believes each incremental subscriber will be added at a 50% profit margin. Max reached breakeven 1 year ahead of schedule, which implies management's EBITDA target of $1 Billion can be reached in 2024 vs. 2025. Streaming is no longer a FCF bleeder and will now be a positive contributor to FCF growth.
Ad market is starting to see signs of a recovery. FY 2024 will also be an election year, which should provide a nice boost to ad spending. We estimate that at least~$1 Billion in EBITDA was lost this year due to ad market weakness.
We think WBD can tender offer longer dated debt at 20%+ discounts to par value given the fixed rate debt at ~4.6%, which was locked in when 30-year treasuries were ~2.4%. Currently 30-year treasuries are over 4.4%. This should lead to an accelerated debt paydown, thereby reducing interest expense and increasing FCF.
CFO Gunnar Weidenfels has repeatedly mentioned there is a lot of opportunity to clean up WBD's working capital. FY 2023 EBITDA to FCF conversion is expected to be ~45% vs. run-rate target of 60%.

With those 5 items providing substantial tailwinds in 2024 and beyond, we think our numbers are very conservative. As a point of reference, implied 2024 EBITDA guidance is now ~$13 Billion, and assuming 50% FCF conversion we get to $6.5 Billion vs. $5.12 Billion in our model. At a 60% run-rate FCF conversion we get to $7.8 Billion. So lots of upside opportunity here on FCF. We are also somewhat agnostic as to specific timing of EBITDA and FCF. Although guidance has been reduced for 2023 and 2024, we think most of these issues are transitory in nature (ie. ad market) as opposed to a permanent step-down and WBD will capture their share of economics when these transitory issues pass. We used a 9% discount rate in our model.

DCF model below.

We get to a valuation of $38.39 per share. Again, we think these numbers are extremely conservative.

Although we don't expect the company to be chopped up and sold off in pieces, it's always a helpful exercise to understand where valuations are for each individual segment via an SOP Analysis (sum of the parts). On a sum of the parts basis the stock is absurdly cheap.

Given historical transactions for movie studios (shown above), we believe 17.0x is a fair, maybe even conservative, multiple for one of the 5 remaining major movie studios. MGM sold for 27.5x in 2021 and we think as the industry continues to consolidate, top movie studios are becoming a scarce resource. At 17.0x we think the the studio segment alone is worth $19.17.

The network segment, which is the traditional pay-TV division is actually pretty interesting. Although the pay-TV audience is in a secular decline, it's also extremely profitable and subscriber losses are slightly offset by price increases and cost savings. As recently as this month (September 2023), multiple bidders have been interested in ABC Networks (NYSE: DIS). Media mogul Byron Allen has offered $10 Billion for ABC, which comes out to 8.0x EBITDA. He's publicly stated he's interested in acquiring more legacy TV networks at similar multiples. We think ABC is a reasonable comp for WBD's assets. Using 8.0x EBITDA multiple we get to $32.99 per share for the network segment alone.

Last, but certainly not least is the DTC segment. Comps are pretty choppy in this segment and the only real comps we have are Hulu and Netflix. Disney and Comcast (NASDAQ: CMCSA) have an arrangement, where more likely than not Disney will purchase Comcast's remaining 33% interest in Hulu with a valuation floor set at $27.5 Billion ($9.1 Billion for Hulu's 33% stake). Hulu's value was determined using a revenue multiple of 2-3x (2.90x according to my math). Using this framework I get to $11.52 per share for the DTC segment. We can also cross-reference Netflix's EBITDA multiple at ~20.0x. Assuming a discount to Netflix, we assume 17.0x EBITDA for the DTC segment which gets us to ~$7 per share, which seems reasonable. We use the revenue multiple in our model below.

Sum of the Parts Valuation:

Our total SOP Analysis gets us to $63.68 per share. You could argue that multiples should be lower, which we have certainly stress-tested already. If we slash the studio segment EBITDA multiple to 10x, network segment to 7.0x, and DTC segment to 1.0x revenue, we still get $44.12 per share. Maybe this is more realistic given the current interest rate environment. But this still highlights the significant upside potential.

We also like to look at FCF multiples and FCF yield as well since these are a time-tested method of valuation. FCF multiples across the media and entertainment industry range from 15.0x-30.0x. Assuming a very conservative 15.0x FCF multiple on $5 Billion FCF guidance for 2023 we get $30.77 per share. Based on the current share price of ~$11 WBD trades at a 17.1% FCF yield. We think this is very attractive.

Internally at Seaside Private Capital we estimate ~$35 per share valuation based on the averages between EBITDA multiple, FCF multiple, and DCF analysis using projected YE 2023 financials.

Management Compensation

We think analyzing and understanding management compensation is a critical component as a shareholder, and we want to make sure the management team is properly incentivized to produce shareholder value. In this regard we like how management compensation is tightly aligned with shareholders at WBD. We can see how motivated Mr. Zaslav is by simply looking at the latest proxy statement. The CEO is clearly incentivized to get the share price up above $30 per share and continue to grow it over time.

CEO David Zaslav's Equity Comp:

We also think the board is highly competent and has the right incentives in place to create shareholder value over time. Primary metrics the board are using to evaluate performance include: Revenue, Adjusted EBITDA, Adjusted Free Cash Flow, and Year-End Paid Subscribers. For 2023 compensation the board wanted to place additional emphasis on growing adjusted free cash flow and debt reduction so an additional bonus pool was created to further these objectives.

To further solidify this point on management alignment, insiders have been actively purchasing shares on the open market since the merger closed in April 2022. Below is a list of open market purchases by WBD insiders.

Take notice that nearly all of these purchases are above the current share price with most purchases in the $18-$19 range. It should also be noted that John Malone acquired ~$2MM additional shares in November 2022 via put options, which are not shown in the above table. Insiders clearly think the stock is undervalued.

Summary

Warner Bros Discovery Inc. is a world class media and entertainment company that we think should be trading closer to ~$35 per share vs. the current share price of ~$11. This equates to a 3x return on capital from current pricing, and we also believe that our valuation may prove overly conservative. There are a number of upcoming catalysts set to boost FCF at the company, which we think many Wall Street analysts are not fully appreciating. WBD is currently the largest position at Seaside Private Capital and we continue to accumulate shares at these depressed prices. We like the combination of cheap price relative to value, high quality business that produces substantial FCF, and a management team that knows how to run a business for the benefit of shareholders. An added bonus is that John Malone is WBD's largest shareholder, who also sits on the board of directors, ensuring management's interests are aligned with shareholders.