By Ee Hsin Kok. Edited by Swastik Patel
In April of 2022, AT&T marked the end of its 4 year relationship with WarnerMedia. The telecommunications giant had acquired the media company for over 85 Billion dollars in 2018, only to sell it to Discovery in a $43 Billion merger this year. This merger meant the formation of Warner Brothers Discovery, which trades on the nasdaq as ticker symbol WBD.
A Gigantic Library
With Discovery and WarnerMedia joining forces, the result is a company that controls an extremely deep library of popular shows and franchises. The likes of which include HBO, DC, Harry Potter, TNT, TLC, Animal Planet, Discovery Channel, and so much more.
Source: AT&T and Discovery Joint Investor Presentation May 17, 2021
HBO Max, Discovery+ and TV Prospects
Another important aspect to this merger is that the company will be able to combine its streaming services. HBO Max and Discovery+ have around 77 and 24 million subscribers respectively. When combined, it would form a powerhouse of a streaming service with over 100 million subscribers. In addition to that, the large portfolio of TV channels in this deal means that the company can put itself in a stronger position to negotiate with advertising and distribution counterparts, as well as cut costs on overlapping expenses.
According to WBD’s investor presentation, the company expects to generate $52 Billion in revenue, as well as $14 Billion of EBITDA in 2023. WBD also took on $43 Billion in debt from AT&T as a result of the merger, which when added to Discovery’s $15 Billion of debt pre-merger, means that WBD has $58 Billion in debt. This high amount of debt is the riskiest part of the business, especially in an era of rising interest rates and with only $3.9 Billion of cash on hand. The good news is that management has acknowledged this, and has said the company will be focused on paying down that debt with the cash the business generates.
Discovery alone generated $12 Billion of Revenue and $7 Billion of EBITDA in 2021. However, as it’s essentially a newly formed business post-merger, we will have to rely on analysts’ expectations to predict how well the business will do this year.
According to most analysts, they forecast this new business doing $49 Billion in revenue and $10.7 Billion in EBITDA for 2022. They also expect $51 Billion in revenue and $13 Billion in EBITDA for 2023 (slightly below management’s expectations of $52 and $14 Billion for 2023). And finally $54 and $14 Billion of Revenue and EBITDA by 2024.
If we combine the net debt ($53 Billion) with the current market cap as of 2nd July ($34.5 Billion), we get an enterprise value(EV) of $87.5 Billion. With EBITDA expected to be $10.7 Billion this year, that gives us a current EV/EBITDA of 8.2. This ratio means that even if WBD’s EBITDA doesn’t grow, it will be able to pay off its net debt as well as return your principal investment in just 8.2 years. For context, an EV/EBITDA ratio below 10 is considered great, and this is less than half of the S&P 500’s EV/EBITDA ratio of 17 at the end of 2021. Additionally, if the business does grow (and it could as much as 30% over 3 years), the EV/EBITDA will be even lower, meaning investors get even better returns.
Looking at it from a Free Cash Flow (FCF) point of view, we can also use a Discounted Cash Flow model to value the business. Analysts expect FCFs of $5.0,$ 7.2, and $8.9 Billion for 2022,2023, and 2024 respectively. Let’s be even more conservative, and write off the ENTIRE first 2 years of FCFs, as it will all go to rapidly deleveraging the debt. After the first 2 years, instead of FCF being at $8.9 Billion, we’ll set the base at only $6.5 Billion, and project 3% growth from there. Even with this extremely conservative forecast, a 10% discount rate (meaning you can expect 10% returns at that price) would mean an Intrinsic Value of $23.54. For context, the share is currently trading at $14.25 a share, which is the intrinsic value at a 15% discount rate. In other words, you can achieve a 15% return on this stock even under extremely conservative forecasts. If we were to be slightly less conservative, we’ll still write off the first 2 years to deleveraging, but forecast from $7.3 Billion in FCF (still well under analysts expectations of $8.9), and then give the stock a 5% growth rate from there, we would get an intrinsic value of $27.89 at a 10% discount rate, and can expect a 17% annual return from the current price.
Like all investments, WBD comes with risks, and it’s quite obvious that the $53 Billion in Net Debt is a big one. With the forecasted EBITDA of $10.7 Billion this year, that puts our Debt/EBITDA ratio at 5. Typically we want Debt/EBITDA to be under 3, as that’s what most banks consider to be a safe ratio. Fortunately, WBD’s management’s goal is exactly that – to rapidly deleverage and reach a long term ratio of 2.5x to 3.0x in the next 24 months. If we do the math, with forecasted EBITDA of $10.7 and then $13 Billion over the next 2 years, rapid deleveraging is certainly possible. $13 Billion multiplied by 3 is $39 Billion. That means $14 Billion in debt (excluding interest) to be paid down with $23.7 Billion in EBITDA, which is very reasonable. Assuming interest rates on the debt goes up to 5% (pretty high and unlikely, corporate debt usually has a grace period), that’s an extra $4.5 Billion in interest. Even then, it would require $19 Billion in debt to be paid down, which is possible at $23.7 Billion in EBITDA, albeit quite close.
Why It’s So undervalued
We’ve done the math and shown that the company is likely considerably undervalued. However, could this be a value trap? Maybe there’s something people on Wall Street know that we don’t, and that’s why they’ve stayed away from the stock. In fact, Institutional Ownership for this stock is only 8.20%. Compared to WarnerMedia’s previous parent company which is at 54.30%, that’s extremely low. However, the market isn’t efficient, and there are plenty of reasons why this stock has been so mispriced.
Firstly, a big part of the mispricing is due to irrational selling from AT&T shareholders who got this stock as a part of the spinoff deal. AT&T stock is mostly held for its dividends, and since WBD doesn’t give out a dividend (and likely won’t for a few years until it pays off its debt), this stock would be quite unattractive to those dividend shareholders. In other words, most AT&T shareholders who got this stock during the spinoff would have sold it for alternative income-generating assets instead.
Secondly, this stock is a media business, of which its streaming service is a big part of its earnings and future. With the massive negative sentiment toward streaming businesses due to the stagnating user growth with Netflix, that gives even more reason for the irrational selling. Fear not though, the stagnation in user growth was already factored in by the valuation model we used, where we assumed an extremely conservative 3% growth on FCF. If the business outperforms that, the returns we calculated could very well be significantly higher.
Lastly, this stock’s depressed price is also part of the broader market sentiment. A recession is looming, there’s rising interest rates, and the S&P 500 is in a bear market. It’s hard for investors and Wall Street to justify owning a company with high debt, a lack of historical earnings to project from, zero dividends, and a sharply declining stock price.
Even More Reasons To Buy
In Peter Lynch’s One Up On Wall Street, he makes two important points about stocks that are quite applicable to WBD. Firstly, that low institutional ownership is a good thing. According to Peter Lynch, stocks with low institutional onwership levels are great as when the big money does come rushing in, the stock price is likely to multiply many times over. On the contrary, high institutional ownership doesn’t leave much room for massive price appreciation. Secondly, Peter Lynch says that insiders sell for all kinds of reasons, but there’s only one reason they buy: the stock’s going to go up. And it just so happens that WBD has quite a number of its Board buying.
Conclusion – Should you Buy WBD?
WBD is a beaten down stock that spun off during a major market crash, and has all the characteristics of a stock nobody wants to own today (declining stock price, high debt, no dividends or share buybacks, and in a stagnating industry). A perfect storm of bad luck has hit this stock, but that’s exactly why it’s such a great value play today. It’s definitely a great opportunity, with a massive potential reward of 15%+ returns on extremely conservative forecasts. However, it’s still not a good idea to put 50% of your portfolio into it, as you need to be okay with losing it all should the company default on its debt. Therefore, invest only what you can afford to lose, and keep dollar cost averaging in a safe position as prices fall.