Warner Bros. Discovery: Significant Upside Potential (DISCA) (DISCB) (DISCK)

A very exciting first quarter of 2022 saw many interesting developments in the markets, many of which were not favorable for the vast majority of investors of today. However, one of the rare positive developments was the performance of Discovery (DISCK) (DISCA) (DISCB) which is up almost 28% since the last time I’ve had a chance to cover the stock, as my investment thesis has slowly started to play itself out.

As the deal is expected to finally close in Q2, the shares of the soon-to-be Warner Bros. Discovery have been selling for close to around the $30 per share level for some time now. If the investment thesis that I’ve outlined in last month’s article holds, shareholders can be expecting some more good news down the road. The upcoming deal should unlock the deep value behind Warner Bros. Discovery, which I see trading in the $45-55 range after the deal closes.

Warner Bros. Discovery remains one of the best investment opportunities of the year and one of my highest conviction plays. It is a brilliant example of deep value being hidden in plain sight, as the emerging giant is on a path of becoming a streaming and media powerhouse that is ready to make its claim to the top of the streaming world.

The exchange offer falls apart

In the November prospectus filed with the SEC, management of both companies outlined a brilliant suggestion that had the idea to generate additional value for both AT&T (T) and Discovery shareholders alike. The company planned to hold an “exchange offer” in which it would allow its shareholders to elect to either keep more “pure AT&T” shares or elect to exchange a part or all of the existing shares for new WBD shares.

In the Exchange Offer, AT&T will offer to AT&T stockholders the option to exchange all or a portion of their shares of AT&T common stock for shares of Spinco common stock. Immediately following the Exchange Offer, the shares of Spinco common stock remaining if the Exchange Offer is not fully subscribed (because the number of shares of AT&T common stock tendered and accepted in the Exchange Offer results in fewer than all of the shares of Spinco common stock being exchanged) will be distributed in a Clean-Up Spin-Off on a pro rata basis to AT&T stockholders as of the Distribution record date, other than in respect of any shares tendered and accepted in the Exchange Offer. Any AT&T stockholder who validly tenders (and does not properly withdraw) shares of AT&T common stock for shares of Spinco common stock and whose shares are accepted in the Exchange Offer will waive their rights with respect to such shares to receive, and forfeit any rights to, shares of Spinco common stock distributed on a pro rata basis to AT&T stockholders in a potential Clean-Up Spin-Off.

Page 161, S-4 Prospectus

The reasoning behind this is that since the time of the Warner acquisition, a good portion of AT&T investors consisted of investors who were at least partially drawn to HBO and its growth prospects. This creates somewhat of an offset to the traditional AT&T income-oriented investors. In other words, AT&T’s shareholder base is consisting of two different groups, the dividend-oriented investors on one end and the HBO-oriented investors on the other end. Seeing the exchange offer become a reality would vastly benefit both groups.

This is the reason why I personally wanted to see the exchange offer become a reality, which unfortunately didn’t come to fruition. At the beginning of this month, AT&T has announced that the distribution of WBD shares to its shareholders will be done on a “pro-rata” basis. On the closing date of the transaction, each AT&T shareholder is expected to receive an estimated 0.24 shares of the new WBD stock for each share of AT&T common stock held as of the record date for the pro-rata distribution. It would not be unreasonable to expect that a good part of the income-oriented investors will seek to dispose of what many would see as little more than a “special dividend”. This is most likely going to create a strong downforce on the WDB stock post-merger.

As a result of this, even though I take a liking to the idea of a “pure AT&T”, I have decided to close my AT&T positions and move everything into Warner Bros Discovery, seeing it as the obvious way to play this merger. Due to the cut dividend combined with the exchange offer failing, it made little sense for me to own the telecom giant any further, especially considering the dividend withholding taxes that I was subject to due to my non-US tax resident status. I will seek to expand on my AT&T thoughts further in a separate article in the following months. In short, I see the company and its shareholders benefit greatly from this deal.

The deal is closing sooner than expected

A couple of days ago, some good news came as little of a surprise for AT&T and Discovery shareholders as a significant regulatory hurdle was passed. The deal is now one step closer to happening as it successfully cleared an antitrust review from US government agencies.

As a comparison, AT&T has faced intense government scrutiny when over its previously mentioned Time Warner acquisition back in 2016. That acquisition was fiercely contested by the Justice Department and in limbo for 20 months before finally closing in June 2018.

As of February 9, 2022, Discovery, Inc. (“Discovery”) and AT&T Inc. (“AT&T”) have satisfied the closing condition in Section 9.1(NYSE:D)(i) of the Agreement and Plan of Merger (the “Merger Agreement”), dated as of May 17, 2021, by and among Discovery, AT&T, Drake Subsidiary, Inc. and Magallanes, Inc. (“Spinco”) relating to the Hart-Scott-Rodino Antitrust Improvements Act of 1976, as amended (“HSR Act”). The HSR Act statutory waiting period has expired or otherwise been terminated, and any agreement not to consummate the transaction between the parties and the Federal Trade Commission or the Antitrust Division of the United States Department of Justice or any other applicable governmental entity, has also expired or otherwise been terminated.

8-K filling, SEC

The deal was initially announced all the way back in May of 2021 when John Stankey and David Zaslav surprised investors around the world, announcing that AT&T’s Warner Media assets are set to merge with Discovery in a Reverse Morris Trust transaction.

The initial announcement came as a huge surprise considering the telecom fought hand over fist to acquire Time Warner only years before. Now it was supposed to unwind AT&T’s $85 billion purchase of Time Warner.

Major takeaways:

• The new company will be called “Warner Bros Discovery” and David Zaslav will be taking the helm as their first CEO.
• AT&T shareholders are getting 71% of the new company, while Discovery’s shareholders get the remaining 29%. The merger is supposed to complete in the second quarter of 2022.
• The deal creates a content library that can be qualitatively and quantitatively measured against any of the competitors in the industry.
• The new company will become an FCF machine expected to produce $52 billion in revenues, $14 billion in Adj. EBITDA, accompanied by a 60% FCF conversion already in 2023.
• Debt is going to play a part since the new company should have close to $60 billion in gross debt at the point of the merger, creating an estimated x5.0 gross leverage.

However, the latest news tells us that we can expect to see the merger close sometime during the second quarter of this year, somewhat sooner than was initially expected. Initial projections have seen the deal closing sometimes “mid-year”, but many investors were afraid that regulatory hurdles could prolong the merger for months if not years. Perhaps the biggest takeaway from all of this is that any and all major regulator struggle seems to have been successfully avoided.

Discovery shareholders are expected to meet on the 11th of March in order to hold a vote on the proposed merger. The “meet” part is a bit of a stretch, considering that the special meeting will take place online via webcast. Still, there is not a single person doubting the outcome of that vote. Discovery shareholders have everything to gain and not much to lose from this deal, and most of it was already decided as soon as John Malone gave the green light. AT&T shareholders on the other end will not need to vote on this particular deal, due to the nature of the transaction.

Considering that the merger cleared both the US Justice Department and an antitrust review by the European Commission, it is highly likely that the next big news to expect is the final announcement of the merger itself. Personally, I would not be terribly surprised if the deal itself closes in late April or early May. If that happens, it would mean that the entire deal took less than 12 months to execute. Given its size and impact, this would be a great feat by the management of both companies.

Content is king

Warner Bros. Discovery’s content library can be easily compared to its main competitors in both quality and quantity. In fact, it brings so much to the table that some of them might grow increasingly displeased with this merger over time. The merger itself creates a worthy competitor that is designed to trade blows with the likes of Netflix (NFLX), Disney (DIS), or Amazon (AMZN).

All the streaming services have started relying on original content to grow their subscribers. Slowly, as deals are running out, all the platforms are moving their IP exclusively over to their platform. For example, Netflix, which was a one-place stop for almost any movies or TV shows only years ago, has lost almost all of its major IPs over to HBOMax and Disney+.

It is not difficult to see how a company with such a deep content portfolio as WBD would be becoming more successful as the year’s progress. The content portfolio as shown in the infographic below displays the true potential and the meaning of this merger. The portfolio covers a very wide selection of content, ranging from some of the greatest cinematic achievements on one end (LoTR, HP, GoT, etc.) to some of the “low intensity” content suitable for your average Sunday family gathering (TLC, Food Network, Discovery, etc.).

Quantitatively speaking, WBD’s portfolio will consist of about 200,000 hours of programming, which would already cement it at the very top of the pyramid of streaming wars. The content covers all major categories of scripted, unscripted, news, and sports. Furthermore, the new company will carry an extremely good brand recognition internationally. WBD is already present in 220 different countries in 50 different languages. The deal will also provide significant synergies savings up to $3 billion/year that can be reinvested back into new content.

Stankey and Zaslav pointed out that the two companies already spend a combined $20 billion per year on content. To put things into perspective, Netflix is spending $17 billion per year doing the same while Disney’s (DIS) spending is in the area of $10 billion per year.

“After over 30 years of being involved in developing Discovery as a global information and entertainment company, the opportunity to combine with WarnerMedia to create the ultimate consumer offering in its space is compelling. The industrial logic of this investment grade, synergistic combination, under the leadership of David Zaslav, is appealing. I am delighted to fully support this transaction, without asking for or receiving a premium for my high vote shares. I believe we are creating real value for shareholders and a legacy investment for my grandkids.”

John Malone, Chairman of Liberty Global – Statement

The billionaire media mogul John Malone has agreed to relinquish his 25% controlling interest in Discovery, a move widely regarded as a huge stamp of approval for the deal.

To summarize the potential of WBD:

• Deepest library in the industry with more than 200,000 hours of content.
• Most diverse library containing both scripted, non-scripted, news and sports content alike.
• Will arguably have the best library in the industry quality-wise.
• Will head the industry in terms of spending.
• Extremely good international brand recognition.
• Is present already in 220+ countries in 50 different languages.

The major downside of the deal

The deal creates huge value and potential for WBD shareholders, however, not everything remains perfect. The new company is expected to come out of the deal as a debt-laden company with more than $57 billion in debt. It was initially planned that AT&T would be contributing $43 billion, while Discovery was supposed to retain the total of its $15 billion debt. However, more recent reports suggested that synergies that are playing out would see this number somewhat lower.

Still, to put matters in perspective, Warner Bros. Discovery is supposed to be close to a $70 billion market cap. That amount of debt is almost surely going to way down on the company as it tries to compete in a cut-throat competitive streaming business.

Management has estimated that WBD will have about 5.0x gross leverage (gross debt/EBITDA) at the time of the merger. WBD’s management has already expressed confidence that they will be able to significantly reduce the company’s gross debt in just a couple of years. They expect that they will be able to lower their leverage to around 3.0x in two years.

With a bit of a back of the paper math, if 60B gross debt / 12B Adj. EBITDA gives us a 5.0x gross leverage, and if estimates for 2023 are a drop to 3.0x gross leverage, it would mean that management expects that the company will have about $42 billion of gross debt in 2023, that is if the estimated $14 billion Adj. EBITDA for 2023 is achievable. In other words, the management believes that in 2 years’ time they can cut down about $18 billion of debt.

Discovery’s Q3 earnings call gives us some further reason to believe that this is achievable. CFO Gunnar Wiedenfels’ opening statements tell us that Discovery expects to bring less than the initially discussed $15 billion of debt into Warner Bros. Discovery.

And to expand on the point that David made earlier, we now expect our net leverage to be at or below 4.5x by the time we close the WarnerMedia merger. Over the past few months, having had the opportunity to dig further into WarnerMedia’s draft carve-out financials and with better visibility on estimated working capital in conjunction with our better P&L and free cash flow performance, we now believe that we will have a healthy amount less net debt at closing than originally anticipated. While naturally, these metrics are preliminary and a function of working capital at close, we now do expect to be in a position to reduce leverage to 3x meaningfully sooner than what we stated in May. Our long-term target net leverage range for Warner Bros. Discovery remains at 2.5 to 3x.

Dr. Gunnar Wiedenfels – CFO, Discovery Q3 Earnings Call

What is often overlooked is that Discovery’s management already delivered on a similar promise back in 2017. Zaslav and Wiedenfels already excelled in this back in 2017 when Discovery took on a significant amount of debt in order to acquire Scripps. Back then, Discovery ended 2017 with a 5.77x gross leverage, only to have had it already cut down to 3.55x in 2019. Zaslav was right to point this out during the Q3 earnings call:

On the integration side, we’re really lucky. We got 2 big tent poles here. One is Gunnar will be the CFO of this company. He did – he’s done an exceptional job. He led the initiative with Scripps, where we said we’d be less than 3.5x levered 2 years later, and we did it in less than a year. And we said we’d deliver $350 million, and we delivered over $1 billion. And all of that was just cost not revenue synergy. He came up with these targets and he’s quite confident in those targets. And so Gunnar will be kind of the lead horse. He’ll talk to it.

David Zaslav – CEO, Discovery Q3 Earnings Call

An additional thing to point out here is that a rising interest world is becoming a reality by the day. The upcoming rate hikes and the subsequent more costly access to capital should root out companies with limited access to free cash flow. Some in the streaming world should be slightly worried. However, Warner Bros. is most definitely not one of those companies, as it expects north of $8 billion in FCF this year alone.

Being a free cash flow machine is definitely going to make the deleveraging process much easier. It remains to be seen to what degree of success will Zaslav navigate the heavy debt load. This downside remains one of the major issues with the deal that keeps analysts and investors worried alike.

Unlocking the value

As both Stankey and Zaslav have pointed out multiple times, this deal simply put unlocks value. The basic investment thesis here is that the current intrinsic value of WBD is buried beneath the rubble of AT&T’s poor decision-making and Discovery’s lack of a high-quality content library. Once Warner Bros. Discovery starts trading on the market as a stand-alone company, more and more investors are going to realize the obvious. A streaming and media behemoth that is on par with the likes of Netflix and Disney will not be able to trade at telecom and cable-TV multiples for much longer.

The streaming services competition is getting denser by the day, as more companies are deciding to try themselves out in the space. Still, as outlined before, I see Netflix, Amazon, and Disney as the major competitors to the new company. Amazon, even though a worthy competitor, is not the best comparison given that streaming is only a part of its huge empire. However, Netflix and Disney are excellent comparisons in this regard. Now let us take a look at how the market is pricing those stocks. Netflix, after having a very bad run as of late, still manages to pull a forward EV/EBITDA of 26.19x, while Disney remains constant at 19.92x FW EV/EBITDA.

Considering that we already know that WBD’s projected EBITDA for 2023 is $14 billion, as well as that the estimated Enterprise Value is set at around $120 billion at this point, we can conclude the company is selling for an EV/EBITDA multiple of 8.57x. That, as we can see, is nowhere close to what the competition is trading for. Would it be a far stretch claiming that WBD should warrant an identical or even similar to EV/EBITDA multiple such as the one Netflix commands? Would it be unreasonable to assume that WBD could make it at least halfway through to Disney’s 19.92x multiple? Let us take a look at what would happen with today’s DISCK market price of $30.20 if we are to assign a couple of different EV/EBITDA multiples to the company.

As we can see, this would indicate a huge upside potential for the company. However, let us take a look at the valuation from a different angle. We know that Warner Bros. Discovery is expected to generate around $14 billion in EBITDA with an estimated 60% Free Cash Flow conversion. That would mean the company would generate $8.4 billion in free cash flow. It would mean that considering the 2.404 million shares, the FCF per share would land at $3.50.

In comparison, Disney has $0.84 in FCF per share. Considering the $151.88 per share stock price, it would result in a 180x FCF/share multiple. Netflix on the other hand continued to operate with negative FCF. However, if we are to take 2020 which is the last FCF positive year, they had $4.38 in FCF per share. Considering today’s price, they would be trading at a 34.73x FCF/share multiple.

If we take a look at the EV/REV of the competitors, we encounter a pretty much similar situation. The forward EV/Revenue multiple for Netflix is 5.76x, while Disney stands at an EV/Revenue multiple of 3.75x. WBD is expected to generate $52 billion in 2023. With some back of the paper math, we can see that the EV/Revenue multiple is 2.30x. No matter which way I take a look at the company, it remains severely undervalued to me and more upside action is to be reasonably expected after the deal closes.

Final thoughts and conclusions

Warner Bros Discovery is a behemoth that is going to hit the streaming industry seemingly overnight. WBD can utilize its strong brand recognition, international exposure, as well as the quality, quantity, and depth of its content library to compete with the likes of Disney, Amazon, and Netflix. As the market is beginning to appreciate the pure value proposition of the deal, my investment thesis has started to play itself out to a certain extent. Still, with the shares trading at only $30, there is much more to be made on the upside.

With the exchange offer falling apart, a chance to generate pure value for shareholders of both companies has been missed. However as it stands now, with AT&T shareholders getting a flat distribution of the WBD shares, it is likely that most income-oriented investors will sell their stake as soon as they get their shares assigned to them. This will in turn cause a strong temporary downforce on the stock. Even if bad, the temporary nature of the sell-off could be well exploited by more opportunistic long-term-oriented investors. From a personal standpoint, Warner Bros. Discovery remains to be one of the best investment opportunities of the year and one of my highest conviction plays.