Warner Bros. (NASDAQ:WBD) seems to be struggling to convince the markets that it can grow. Despite strong free cash flow generation and significant debt reduction, the company's share price is continuing its downward trajectory.
As can be seen from the quantitative factor grades of Seeking Alpha, the most attractive features of WBD stock seem to be valuation and profitability, while growth is ranked "D- ", down from "A" 6 months ago. The stock price is down ~40% over this period.
The main drivers behind this worsening sentiment seem to be rather lacklustre subscriber growth numbers at the company's "Direct-To-Consumer" division, as well as potentially accelerating "Networks" business decline. The Hollywood writer's strike also contributed to reduced financial performance as well as negative sentiment towards the industry.
The adjusted earnings of WBD were ~$4.7 billion for FY2023, which we calculated by adding back restructuring and acquisition-related amortization expenses to reported operating earnings and deducting interest and tax expenses.
WBD is therefore trading at an adjusted underlying PE of ~2.7X. During FY2023, the business generated $6.2 billion of Free Cash Flow, boosted by ~$1 billion due to reduced content production amid writers' strikes. WBD is therefore trading at a 30% past-year's underlying FCF yield, excluding strike impact.
The market now seems to be assuming that WBD will crater, as these valuation multiples are very unusual, even for structurally challenged and leveraged businesses.
We believe that WBD can actually grow EPS if all goes according to plan.
The Networks division is by far the largest earnings contributor to the group, it will continue declining
Networks and Studios are the largest business segments of WBD. The profit contribution of DTC is still marginal as the business was investing heavily to drive scale, up till now.
Networks is the largest operating segment of the business and consist primarily of cable TV networks including TNT, Discovery and CNN. The fortunes of this business are closely tight to the declining pay-tv industry. While distribution revenues have been resilient as pricing increases have largely compensated for subscriber losses, advertising revenues have been in decline, especially for non-prime slots. The cord-cutting trend is expected to continue as DTC streaming offerings are improving and increasingly include sports. Networks business will continue declining. On the other hand, content spending cuts as well as network integrations, will enable the division to produce Free Cash Flow even as it declines.
Studios division produces feature films for initial exhibition in theatres as well as film and television content for owned and third-party TV networks as well as DTC platforms. Declining linear network audiences is a negative for the business, on the other hand, DTC distribution is a key driver of growth. Overall, video content consumption seems to be increasing though there are hard limits on how much it can grow. This is a strong, albeit slow-growth business.
Direct-to-consumer is the main growth driver of the group. The segment includes the premium cable TV channel HBO and the DTC streaming platforms such as HBO Max, Max and discovery+. DTC now has about 100 million subscribers globally; this number includes linear HBO subscribers who get complimentary access to Max. WBD is now planning an international expansion of its streaming services.
Subscriber growth at DTC has been held back by linear losses, but the Latin American and European launches will break the trend
The growth of the DTC division is dragged down by its exposure to linear TV. WBD does not break out streaming-only subscribers only the overall number, which includes linear losses and streaming gains. For this reason, overall subscriber growth has been rather muted.
At the end of Q1 FY2024, DTC had close to 100 million subscribers up from 92 million in Q2 FY2022, the first period when consolidated subscriber numbers started being reported. The 8% global subscriber growth over the last 2 years has failed to impress the markets.
Subscriber numbers domestically are actually down as compared to Q2 2022, and growth was primarily driven by low ARPU affiliate distribution deals in international markets. Pricing increases in the US have been offset by the growing share of international and overall ARPU has been stagnant over the last couple of years.
We are not surprised that markets are not impressed by DTC's performance. It is also hard to blame management for this underperformance given the content spending frenzy that has driven most of the streaming industry into deep losses. It was not easy to gain or even maintain market share in this hotly contested industry.
Having said it, market share wars in the US seem to be behind us as most of the streamers are now focussing on improving pricing, reducing churn and scaling down original content spending. Since it is becoming more difficult to gain new customers the industry is maturing and refocussing on profitability.
WBD is no exception. In the US, bundling is a top priority at the moment, as it is expected to reduce churn and enable the business to scale down marketing as well as original content spending. Additional subscriber gains are also likely through bundling, though overall ARPU might be negatively affected.
DTC business has been operating close to break-even due to strong content investment and marketing spending aimed at driving subscriber growth at the streaming-only platforms. The division incurred a ~$6.1 billion content (amortization) expense in FY2023, equating to 60% of revenues. This ratio is closer to ~40% for Netflix (NFLX), the streaming industry scale leader. A reduction in this ratio, paired with lower marketing spending, could improve the profitability of WBD considerably.
Even though the US is maturing, WBD does have a lot of untapped growth potential in the international markets. This year the company is launching Max in Latin America and Europe. The European launch is set to coincide with the Summer Olympics to leverage the broadcasting rights owned by Eurosport.
The roll-out will be gradual as in some markets WBD already has distribution deals with third parties. These deals will have to expire before the company can scoop up customers directly with its Max service. For example, MAX will only launch in Britain in 2026, after the current Sky distribution deal expires.
We expect Max to generate international subscriber growth and also increase ARPU as the company moves towards direct distribution. We expect international to be a very significant revenue growth driver for the DTC segment. Having said that, we do expect the company to incur elevated sales and marketing expenses during the launch period.
WBD is targeting a ~$1 billion EBITDA for the DTC for FY2025. We see this target as quite realistic and rather conservative as potential pricing increases in the US should further improve the profitability of the business.
Max leverages the deep Warner Bros. and HBO back catalogues and can utilise the franchise content rights to produce popular originals. Live sports offering is also included in the service. Max is a strong contender, and the addressable international market is huge.
The DTC growth prospects are overshadowed by the Networks decline
The $1+ billion profit would be a quite significant achievement for DTC, on the other hand, the Networks business profits are considerably larger. Continuing high single-digit Networks EBITDA decline could eat up all DTC profit gains, limiting the WBD growth potential.
So far this year, "Networks" adjusted EBITDA is trending down by 8%. During Q1 2024, distribution revenue decreased 3% ex-FX excluding the impact from the AT&T SportsNet exit. This revenue category is supported by increases in affiliate rates as subscriber numbers fall. Advertising revenues, on the other hand, are facing stronger negative trends.
"Networks" revenues are most likely to continue declining at mid-to-high single-digit rates as pay-TV subscriptions as well as linear TV viewing hours continue declining. The business will have to continue to cut costs just to maintain profit margins.
The largest cost category of the business is content. If topline trends deteriorate, the company has the option to respond by cutting content spending to maintain EBITDA margins. On the flip side, reduced content quality can lead to further viewer losses, therefore, the management has to cut costs only gradually.
We would expect the Network business EBITDA to decline by high single digits going forward. Given that last year, the segment delivered ~$9 billion of EBITDA, a ~8% annual decline would reduce the profit by ~$1.4 billion by the end of FY2025. This decline would offset all the expected profit growth in the DTC business.
Studios are positioned to grow in FY2025 as negative effects of Hollywood writers' strikes are cycled out
The last major business segment of the group is the Studios. The content revenue of the division decreased by 13% in 2023, due to the timing of TV production, including the impact of the WGA and SAG-AFTRA strike. Paired with S, G&A cost increases, the EBITDA of the division has declined by 21%.
The strike lasted from May 2, 2023, until September 27, 2023, affecting the reported results for FY2023. However, the financial effects extend beyond the initial strike period as the whole content pipeline was disrupted. As the studios could not produce content last year, they have less new content to licence and sell this year. It will take some time before Studios can make up for the lost production time. The reported FY2024 results will also include a negative strike impact due to continuing production delays.
Assuming that during FY2025 the business can catch up on content production and build back the pipeline, the profitability of the Studios division should recover. If the division returns to the Pro Forma EBITDA level of FY2022, Studios could contribute further towards compensating for the loss of Networks EBITDA.
Warner Bros. Discovery is capable of growing Earnings Per Share, due to low-cost buybacks
We believe the Networks division of the business does face structural decline. Streaming platforms as well as Studios, on the other hand, are very likely to deliver profit growth over the next two years, compensating for the Networks decline. The strong FCF generation is likely to continue, enabling the business to deleverage.
WBD is likely to maintain the ~$4.7 billion adjusted earnings level until FY2025 and at that point will most likely have a debt of about $30 billion. Going into FY2026, the business will reach its leverage targets and will be able to start buying back stock.
Earnings of the business will likely continue declining at a mid-to-high single-digit rate, due to continuing Networks contraction, even after FY2025.
As EBITDA declines by say 8%, the 3X leverage ratio will have to be maintained and therefore debt will also have to be reduced by at least 8%, or ~2.4 billion per annum. After debt reduction, ~$2 billion will be left for buybacks.
The ~$2 billion would enable WBD to buy back 12% of the stock outstanding, based on the current share price. High single-digit earnings decline, paired with low double-digit share buybacks would enable WBD to grow Earnings Per Share by low single digits.
WBD is a potentially growing business trading at a 3X PE and businesses with a stable, or slightly growing EPS do not usually trade at these low levels. We believe that WBD is very likely to trade up to higher levels of adjusted earnings over the next 2 years as the company deleverages and starts buybacks.
WBD is a Buy.
We need to be mindful of the risks
Having said that, it is a risky situation with many moving parts. It's up to everyone individually to decide if the risks involved are appropriately compensated for by the price upside.
A rapid decline in advertising revenues has created a lot of problems for traditional radio and newspaper operators and leverage has only accelerated the headwind. WBD, unlike most of them, does own a strong differentiated content portfolio and has a credible DTC distribution strategy. We believe WBD is a lot more likely to prevail.
We are interested in WBD at these price levels but intend to follow the development of advertising revenues and cost-cutting efforts in Networks closely. We will also keep a close eye on the DTC business efforts to improve profitability. Significant negative deviations from the current expectations should be a sell signal as financial leverage can magnify the downside.
We must note that this is a high-risk investment situation as WBD is leveraged and faces structural decline trends. Management performance will largely determine if the described scenario can be accomplished.
Buying and holding stocks of this type is never a smooth ride, but a diversified portfolio of deep-value situations can indeed produce attractive results.
Bottom Line
Warner Bros. is out of favour with the markets. The business generates the majority of the profits from declining linear TV Networks, and the DTC division, the main growth driver for the group, has not yet turned a profit.
The markets are assuming that WBD is in a perpetual decline, additionally weighted down by its debt burden. The current valuation seems to assume that the business will use the declining cash flows of Networks business to pay down debt, leaving little to equity holders.
We believe that WBD is not in permanent decline. The size of the business is contracting, no doubt, but at its core WBD owns a world-leading portfolio of content franchises which will enable them to reach customers directly.
WBD is a cash-generative business with a high level of control over cost. It is currently deleveraging and as debt targets are reached, the business will be able to buy back its stock. At the current depressed price levels, the buybacks would create considerable shareholder value.
After considering the risks involved, we believe that WBD stock price is too low today. We intend to Buy WBD.
This is a risky bet with a good upside potential.
Curonian Research
Long-Term Focussed In-Depth Fundamental Analysis.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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