Warner Bros. Discovery: An Undervalued Media Giant That Could Dominate Streaming

Investment Thesis

After falling 65% since April 2022, Warner Bros. Discovery’s (NASDAQ:WBD) valuation is at an all-time low. A forward FCF yield of ~25% and the huge potential of its streaming service Max provide us with a compelling entry point.

Short introduction

In April 2022 Discovery merged with WarnerMedia to create a new media giant: Warner Bros. Discovery.

AT&T Inc. (T) spun off WarnerMedia and then merged it with Discovery in what is called a Reverse Morris Trust. Upon completion, holders of AT&T common stock owned approximately 71% of the outstanding shares of Warner Bros. Discovery.

The timing wasn’t perfect. The merger coincided with a decline in traditional advertising revenue. Warner Bros. Discovery expected a pro-forma EBITDA of $12 billion in 2023. It turned out to be just north of $10 billion.

Additionally, AT&T investors are mostly attracted to reliable dividend payments. Warner Bros. Discovery doesn’t offer a dividend. Combined with a high debt load and disappointing results, this has led to a lot of selling pressure over the past few years.

Warner Bros. Discovery now stands at an inflection point. Its television networks account for 80% of the profits but is expected to decline by “a low single digit percentage,” according to Fitch. Will the Max streaming platform become successful enough to offset this decline?

The long-term potential of Max

Max is arguably the most important element of the Warner Bros. Discovery’s story right now. The successful rollout of Max could solidify Max as one of the top streamers for decades to come.

Netflix (NFLX) estimates that the total addressable market for its streaming service is north of 800 million households. As Max is very similar to Netflix, this should be true for Max as well.

Warner Bros. Discovery aims to be in the top 3 streaming services for every market they enter. An ambitious goal, but as Max is estimated to have over 35.000 hours of quality content, not an unrealistic one.

Warner Bros. Discovery is already hard at work to roll out Max globally. This year, Max will be rolled out in Europe and South East Asia, including in markets where HBO Max wasn’t available before, like France and Belgium.

Max has been rolled out in Latin America in February 27 and has been in the top 5 entertainment apps (according to appfigures) since then. Judging by the number of downloads in the Google Play Store (all geographies), the rollout is progressing steadily.

Profitability model for Max

Warner Bros. Discovery has guided for 130M global subscribers by 2025 with $1 billion in EBITDA. Incremental margins were guided to be 50%. In 2018, Netflix also had ~130m subscribers. 5 years later, they had ~223m. A CAGR of about 15%.

When assuming a subscriber CAGR of 15% (based on Netflix’s past growth rate), an incremental EBITDA margin of 50% above 130m subscribers and a 5% growth of ARPU, we get the following numbers:

Max has the potential to be incredibly profitable for Warner Bros. Discovery if they manage to grow it in the coming years. Considering the total addressable market of 800 million households, 200 million+ subscribers is certainly not out of reach.

About Warner Bros. Discovery’s current debt levels

There is a lot of concern about Warner Bros. Discovery’s current debt levels. Many investors fear that Warner Bros. Discovery will not be able to keep up with interest and bond repayments. Looking at the numbers, I believe there is little reason for concern.

As of Q4 2023 the net debt stands at $39.9b, which is a leverage ratio of about 3.9 times EBITDA. It is elevated, but is set to come down. The long-term goal of Warner Bros. Discovery is a ratio between 2.5 and 3.0 times.

Fitch estimates that FCF will be approximately $5 billion annually in 2024 and 2025. I believe so as well. Note that at the current market cap of ~$20b, this would imply a free cash flow yield of 25%. This is an incredible yield even if earnings were to remain stagnant.

When looking at the near term maturities, Warner Bros. Discovery has a lot of room to maneuver. As of Q4 2023, they had a cash balance of $4.3B. If we add $10B of free cash flow for 2024 and 2025 to this, Warner Bros. Discovery has a total of $14.3B to play with. Total debt maturities for 2024 and 2025 add up to $4.9B, leaving ~$9B+ in surplus cash.

Investors should have little to fear when it comes to the debt levels of Warner Bros. Discovery. Debt maturities are evenly spread out over a long period of time at an attractive 4.6% fixed interest rate.

If the stock price stays as depressed as it is, Warner Bros. Discovery might even consider using that surplus cash for a (small) stock buyback program.

How will the linear television decline impact Warner Bros. Discovery?

The market is skeptical about Warner Bros. Discovery’s ability to fully compensate for the decline in traditional television revenue.

As 80% of profits are currently generated by this segment, it’s not hard to see why the market is so negative. Fitch sees continued low single digit annual revenue declines, primarily due to continued MVPD subscriber losses and linear advertising softness.

Short interest is currently at a record high, with 110 million shares being sold short. That’s about 4.5% of all shares outstanding. Quite a high amount.

Let’s model what a decline in linear earnings could look like. The starting point is the $9 billion in EBITDA which the networks segment reported in 2023. If the past few years are anything to go by, the decline should be between -5% and -10%.

Quite a hefty decline, no matter which scenario plays out. The other segments should be able to compensate at least partially for this decline, however.

The networks segment can also be seen as a content engine for Max. There will still be demand for traditional television even without cable. Warner Bros. Discovery is uniquely positioned to deliver on this.

There will also be people, especially in the older generation, that will never cut the cord. This should provide Warner Bros. Discovery with sticky revenue/earnings in their networks segment for a long time to come.

An experienced management team with skin in the game

David Zaslav’s leadership of Warner Bros. Discovery has been controversial to say the least. Zaslav cancelled several completed films like Batgirl, Coyote vs. Acme and Scoob!: Holiday Haunt for tax write-off reasons. This triggered negative media coverage, further eroding investor confidence and prompting additional selling.

The leadership feels the pain of the sliding share price. Zaslav owns about 6 million shares. A few years ago, these would have been worth $150 million. Now they are worth $50 million. Zaslav also holds stock options that could net him more than $200 million if the share price exceeds $35.65 by December 31st, 2027. A powerful incentive for driving up the share price.

The leadership team is also taking steps to address underutilized intellectual property. Take for example Harry Potter, the last film of which premiered over a decade ago. There now is a new TV series planned for 2026. The same can be said for Superman, of which there now will be a new movie in 2025.

I’m also excited about James Gunn taking the reins at DC. His experience directing movies like Guardians of the Galaxy and The Suicide Squad makes me very excited about where DC is headed in the next decade.

Valuation analysis based on peers

To get a fundamental understanding of Warner Bros. Discovery current valuation compared to peers, it is a good exercise to compare them based on underlying profitability. In this example, I will compare Warner Bros. Discovery to Netflix, Disney (DIS) and Paramount Global (PARA).

In the example below, I take the enterprise value (EV) which is the market capitalization + net debt and divide it by the EBITDA. I calculate what Warner Bros. Discovery’s share price would be if it were to trade at the same multiple of that specific peer. Numbers are based on 2024 forecasts by marketscreener. Assumed net debt for Warner Bros. Discovery is $35b.

When we look at other peers that are more exposed to linear advertising and cable, Warner Bros. Discovery valuation falls more in line. In this example, I will compare Warner Bros. Discovery to Comcast Corporation (CMCSA), Charter Communications, Inc. (CHTR) and Fox Corporation (FOX)

Is Warner Bros. Discovery is a traditional media company until proven otherwise? The market sure seems to think so, judging by Warner Bros. Discovery’s valuation. The market does not seem to attribute much value to Max at this point in time.

Main risks for Warner Bros. Discovery

Warner Bros. Discovery’s valuation is not at historical lows without good reason. Traditional media (like cable TV) is in secular decline. Consumers are increasingly opting to “cut the cord” and cancel their cable subscriptions. This is hurting Warner Bros. Discovery’s networks section where 80% of its profits are generated.

Warner Bros. Discovery’s streaming service Max is also not guaranteed to be a success. If Warner Bros. Discovery is not able to profitably grow Max, this could be disastrous for its bottom line. Leverage could increase, while all free cash flow would need to be used to service the debt, leaving little for investors.

Max is also facing stiff competition from other streaming services like Netflix and Disney+. Today, there are more than 200 streaming services available worldwide. Warner Bros. Discovery will need to invest in high-quality, original content to attract and retain subscribers. High quality content can be incredibly expensive to produce, making it more difficult for Max to become profitable.

Near term catalysts

1. Advertising recovery

Advertising spend is expected to bounce back in 2024 according to S&P Global. There are 2 main drivers of this: the US presidential elections and the Paris Summer Olympics.

Political ad spending is expected to stay strong on linear TV, while local stations are projected to earn even more compared to 2020, according to S&P.

To quote Zaslav in the 2023 Annual report: “We expect the Paris Olympics this summer to be a ratings juggernaut across Europe.”

2. Subscriber growth

With the international rollout of max, be on the lookout for significant growth in subscribers. As subscriber growth is vital for the long-term prospects of Warner Bros. Discovery, a quarterly uptrend in subscribers could trigger a significant revaluation of the stock.

3. Industry consolidation

At current depressed prices, Warner Bros. Discovery is an attractive acquisition target. Take for example Amazon (AMZN). Warner Bros. Discovery’s huge content library would significantly enhance Amazon Prime Video to the point it would be able to compete with Netflix and Disney+.

Another company that might consider acquiring Warner Bros. Discovery could be Apple (AAPL). An acquisition would effectively give Apple all the content it needs for Apple TV+.

4. Deleveraging

Warner Bros. Discovery has the ability to pay down an additional $10B in the next 2 years. If results remain the exact same, and this value is added to the equity, this would increase the share price by 50%.

Warner Bros. Discovery will be in the target leverage ratio of 2.5 – 3.0 times by this point in 2026. At this time, Warner Bros. Discovery might also consider buying back its own shares.

Conclusion

Warner Bros. Discovery is at an inflection point. The success of Max will be key in determining the ultimate value of the stock.

A solid subscriber increase for Max could unlock substantial upside potential. A relatively conservative EV/EBITDA multiple of 8 would imply a share price north of $20 by 2026.

Were subscribers to increase more significantly and were the EV/EBITDA multiple to expand to a more reasonable 10 times, Warner Bros. Discovery stock could be closing in on $30 by 2026.

Even without any bottom-line growth, Warner Bros. Discovery still has a free cash flow yield of 25%, which should provide a good margin of safety.

Warner Bros. Discovery’s current valuation of ~$20b provides an incredibly attractive entry point. The risk is relatively low, while the potential reward is huge.

To quote Warren Buffett:

The beauty of stocks is they do sell at silly prices from time to time.