Last year I posted about the Discovery/WarnerBros merger. At the time, I calculated that DISCK was a buy at $23.30. We are still only a year into the merger process, but clearly I’ve been wrong so far. The stock is currently trading at $11.85, a loss of 50%. So what’s happened so far?
The first and obvious elephant in the room is….. Warner Brothers Discovery is not very profitable so far. Net income is deeply negative, but actual cash from operations is at least positive. Management was calling for $8B/yr in free cash flow after the merger, and we certainly aren’t anywhere near that level. At the same time, management did state it would take until the end of 2023, or a year from now, to get there. I still believe if management can generate that level of cash flow, owners will be rewarded.
So perhaps management isn’t doing a great job quite yet. They’ve got to generate cash. But what about my analysis would I change if I could go back? Debt analysis. I wrote that if WBD could get to $6B/yr in net income, they could/should be valued at $90B. However, I no longer view it that way. Management said they could get the debt down to $24B in two years. Even at that seemingly impossible to reach number, the company valuation should be $90B – $24B = $66B. DISCK holders would be entitled to 29% of that, which would be $19.15B. Which means the upside isn’t the 68% I originally calculated, but 23.4%. A decent number, but not for the given risk, and spread out of two years. I’ve updated my processes to do a better job of factoring in debt in my decision making.
Should I sell? Should I hold? Well, the answer lies in valuation to me. I prefer not to sell stock in an iconic company. And for all the bad net income numbers, WBD is cash flow positive. It doesn’t appear to be on its way out just yet. So the question is what is WBD worth today?
The answer is that I simply don’t know. The situation is too cloudy. The company is too new. I will say, HBO streaming is running smoother than ever. I do believe one of my fears has been mitigated and HBO is now using the Discovery tech stack. On the flip side, ad revenues are slipping. That’s bad for a company whose big plans included adding ad based tiers.
What I do think I can estimate is the upside. Let’s assume we do get to that $6B/yr in operating earnings. Let’s assume a PE of 15 and that $90B market cap. But let’s now subtract the current debt, which is $47.5B. That leaves us a company valued at $42.5B, which has 2.428B shares outstanding, or $17.50 a share. From the $11.85 WBD is trading at today, that’s a 47% upside.
What’s the downside? WBD could go to zero. The path is there. They are going to have to pay off $20B in bonds in the next five years, or roll them over at what could be high interest rates. It’ll take a heroic effort, but perhaps David Zaslav can fail to earn more money as a combined company than each entity did when it was separate.
For now, I’m sitting tight. Sure, a 50% drop isn’t very fun. I’m also not adding to my position at these prices. I am taking a wait and see approach. If the stock were to trade at $17.50 tomorrow, I’d probably sell out. The future is too unclear for me. If the stock dropped to $6 tomorrow, I’d be really tempted to double down as the upside would outweigh the down. If a year from now WBD starts earning $6B/yr with $24B in debt, I’ll just hold on to the stock and consider it a good investment even if it was a little volatile.
For now, I think the market is pricing WBD just right. The future is cloudy with large upside and large downsides. I wouldn’t be surprised to see it trade in-between $8 and $15 until we get a better idea of what the unified company is going to look like.