Warner Bros. Discovery: a leveraged bet on streaming can backfire


When Discovery closed the AT&T‘s (T) WarnerMedia in the second week of April, predictions of a strong U.S. ad market, along with rapid growth in eyeball subscribers and streaming service revenue, were the conventional wisdom on Wall Street. Of course, a lower interest rate backdrop was also part of the merger equation, when the deal closed in 2021. In my view, two issues now exist for the whole Discovery of Warner Bros. (NASDAQ: WBD) that were not fully anticipated last year: (1) lower subscription rates and a declining economics of the advertising market for online entertainment, and (2) an increase in interest charges on the debt. Ultimately, I’m very worried that a prolonged recession and too much debt will mean equity gains won’t happen until 2023, at the earliest.

A critical warning sign for investors is the current market capitalization of $35 billion which dwarfs $52 billion in debt and $89 billion in total liabilities. Wall Street rightly fears that leverage will crush property values ​​over time. A liability setup of nearly 3 to 1 to shareholder market value leaves little room for error. Successful blue chips typically trade the opposite, with the total value of the share far exceeding the underlying trading liabilities.

We still don’t have a bunch of financials to work with, but based on the first quarter of the combined operations, the second quarter of June generated estimated annualized rates of $4.3 billion in cash flow from operating costs (which are expected to improve) against $2.3 billion in interest charges . 2021 pro forma results published in beginning of april herefixed $6 billion in combined cash flow for the calendar year versus $2.5 billion in interest expense.

In terms of debt as a concept, it will take 9-13 years to devote ALL operating cash flow to repaying its debt in theory, and up to 12-17 years to eliminate total liabilities (minus current assets), particularly if cost reduction and continued growth do not meet management’s optimistic forecasts. Remember, that’s without investing a dime in new capital expenditures, stock buybacks, or expansion plans.

Below is a chart of total financial debt to tangible assets, measured against the largest US video and audio streaming peers and competitors. The new company Warner Bros. Discovery is by far the most exploited compared to owned content providers netflix (NFLX), World Paramount (PARA) (PARAA), waltz disney (SAY), Fox (FOX) (FOXA), Google/Alphabet (GOOG) (GOOGL), Warner Music Group (WMG), and Spotify (PLACE). WBD’s debt to hard assets is three times the ratio of peers to competitors.

Streaming Industry – Financial Debt vs. Tangible Book Value

Author’s Creation, Financial Debt to Tangible Book Value, Latest Quarterly Statements – August 8, 2022

Debt on sales is no better. Using trailing 12 month earnings for Warner Bros. peer group and pro forma sales. Discovery, interest charges as a percentage of sales could explode with higher interest rates in the US (squeezing profit margins and making the business uncompetitive over time). The debt-to-sales ratio is roughly double the mega-cap streaming average.

Diffusion of industry debt on annual sales

Author’s creation, debt on annual sales, 12 consecutive months – August 8, 2022

Ultimately, massive leverage in a slowing economy has had a major negative impact on shareholder earnings in 2022. Below is a graph of total returns achieved over the past 52 weeks, relative to the peer group. Believe it or not, Warner Bros. Discovery performed just as poorly during this period as the full bust in Netflix’s quote!

Streaming Industry Peer 1-Year Total Returns

YCharts, peer 1-year total returns

When we look at current operating estimates, the good news is that analysts expect 2023-24 to deliver strong cash flow and cash income (GAAP losses are expected through 2024). However, the projections are all over the place, with a rather murky interest rate picture (affecting interest charges on all WBD debt) and a heated debate regarding the future of the US economy raging in mid-2022. My opinion is 5%. Year-over-year hourly wage earnings gains to 9% CPI are a horrifying setup for US consumer confidence and spending on things like discretionary streaming entertainment.

EPS WBD estimates

Seeking Alpha, EPS Estimates 2022-23 Analyst, Warner Bros. Discovery – August 8, 2022

When we look at basic cash benefit tracking valuations [EBITDA], and counts towards the debt holdings of each peer company, Warner Bros. Discovery can be considered cheap (using mostly pre-merge calculations). But you have to assume borrowing costs are done rising and consumer spending won’t be hit by the stealthy stagflation recession this year. My forecast calls for both higher interest rates and much weaker consumer spending by the end of the year. If so, current Wall Street estimates will turn out to be a mile too optimistic for WBD.

Streaming industry peers EV rolling vs 12-month EBITDA

YCharts, EV to EBITDA over 12 months, August 8, 2022

I would note that I prefer the low EBITDA and more sustainable debt structures of Netflix and Paramount Global. I wrote bullish articles months ago on Netflix here and Paramount here, if you want to read the positive stories for either investment idea.

Weak commercial momentum

Due to the debt bomb that weighs on its balance sheet, shares of Warner Bros. Discovery have been under massive and steady selling pressure for months. The momentum trend is down impressively and will need some sort of catalyst to stabilize.

On the weekly chart of trade action below, shown over the past five years, we can see what I call the “trifecta” of bearish action in the Accumulation/distribution line, Negative volume indexand On balance volume indicators. When all three fall sharply in unison, the price finds it difficult, if not impossible, to rise. Further examples of this technical warning of deep and significant selling momentum are highlighted by the green arrows, amid the pandemic panic of March 2020 and after the meme surge in early 2021. Discovery (now WBD) today is at a 5-year low, while ADL, NVI and OBV numbers could be on the verge of even bigger outages and failures this week.

WBD stock - similar big sell times, weekly 5-year chart

StockCharts.com, Author’s Benchmarks, 5 Years

Final Thoughts

The highest rating I can give Warner Bros. Discovery is a Hold Where Neutral setting. If you own stocks and think the overall economy will survive 2023-24 very well, WBD could rise $14 per share (perhaps to a target price of $20). However, for most investors, I would simply avoid that name and buy other streaming giants using less debt and leverage on the balance sheet. In the event of a severe prolonged recession, the price of common stock could theoretically fall to zero. Too much debt is never a good thing for a company’s investors. A weaker ad market and declining interest in subscriptions Discovery+ and HBO Max could drive the stock down significantly as rising interest costs eventually reduce profitability (cash generation margins) in an ultra-competitive streaming environment. Although much of the $52 billion in debt is long-term funded, every 1% increase in interest costs could potentially add $520 million to the company’s annual costs, in the absence of funding. real debt reduction efforts.

In other words, the current risks seem to outweigh the potential rewards for investors. Once the economic destruction of the 2022 inflation spike passes, I might become more bullish on Warner Bros. Discovery. However, I think the first trough in the US economy is the first quarter of 2023. Could the dramatic single-digit drop in WBD quotes catch my eye? It’s possible, but any bullish outlook will depend on a reduction in the debt burden, which may be difficult to achieve in a recession without significant new equity issuance and related dilution for exiting holdings.

Thanks for reading. Please consider this article as a first step in your due diligence process. It is recommended to consult a registered and experienced investment adviser before carrying out any transaction.