Thoughts On Discovery/WarnerBros Merger

For those that don’t know, Discovery (HGTV, Food, Discovery, etc) is merging with Warner Brothers (Currently owned by AT&T). This merger has the chance to bring about a powerful media company to rival Netflix. It also has the ability to bring about a debt ridden organization with no proven ability to provide delightful user experiences.

I, like many others, view this as an opportunity to potentially buy a great company at a discount. You’ve got three ways to buy into this new company. #1, you can buy DISCK, DISCA or DISCB stock. #2, you can buy AT&T stock. #3, you can wait and buy the merged company stock (WBD).

For me, the choice has to be #1 or #3, as I don’t want to own AT&T. #3 is a great option, and may turn out to be the best one, as you’ll have a better idea of what you are buying. However, waiting for the fully merged company to emerge may not yield the best results. It also doesn’t make for an interesting post. So let’s dive into option #1. Buy DISCK stock.

Right now, DISCK is trading at $23.30 a share and is the cheapest of Discovery’s three classes of stock, all of which will get the same number of shares post merger. So I don’t see any reason to buy DISCA or DISCB unless you are want to own Discovery stock and believe the merger will fall through.

At the $23.30 price, Discovery is valued at $15.45 billion. Yahoo or Google might show a valuation of $12B, but this is incorrect. When the merger happens, all outstanding shares will materialize. All options will be executed. Unfortunately, there are 663 million outstanding shares. Which is 31% more than are currently being traded. That’s a significant amount of dilution that I wish wasn’t present. :-/

The upside is that Discovery will own 29% of the merged company. That puts a current market price on the merged company of 15.45/.29 = $53.3B. Compared to NFLX’s current market price of $270B, the merged company’s valuation seems cheap. I love Netflix, but I wouldn’t pay five times what I’d pay for HBO Max + HGTV + Food + Discovery + TBS + TNT + DC Comics Movies + Warner Brothers. Personally, I think Netflix is overpriced. So let’s look at Discovery + WarnerBros ($WBD) as an independent company and stop the competitor comparisons.

In 2021, Discovery and Warner Brothers should both net about $1.5B in income. Discovery is an open book because of their SEC filings. Warner Brothers is harder, because AT&T doesn’t break it out to the granular level I’d like. But let’s assume they would net out $3B in income this year as a combined company. If they can’t find any way to cut costs when they join forced, then the P/E of this new company would be 17.7. Not too bad and less than the current P/E of the S&P 500. But…. Discovery is paying $43B for Warner Brothers and already has $11.6B of debt. That is $55B in debt for this new company that might only make $3B/yr in income. That is a very, very ugly balance sheet. I don’t want to own that company.

In Discovery’s Q3 earnings call, they state that they believe the synergies between the two companies will result in $3B/yr in cost savings. This, my friends, is where things get interesting. If these savings are real, then we could expect the WBD to make $6B/yr! That is double what the two companies made last year. And it helps solve the debt problem. A company that makes $6B/yr and has $50B in debt is much more attractive. It’s not great, but it’s something a growing company can overcome. Discovery management believes they can get earning to debt down to 3x in two years. That would be fantastic. It really would. That would put them somewhere around $8B free cash flow with $24B in debt two years from now.

The upside: If WBD is making $6B/yr and is valued at a 15 P/E in two years, that’ll be a valuation of $90B, 29% of which is attributable to Discovery, which is $26.1B vs. the $15.5B it currently trades at. That’s a 68% improvement in two years, or something like 30%/yr return AND a position in a company that I believe I will want to hold long term. I want to own a company that makes must watch content and provides good software to do it on.

The downside: If the deal falls through, I’ll be left with some currently overpriced Discovery stock. It’s not a bad company, but the stock trades about 25% higher than I’d pay for it normally, and it has 31% dilution waiting in the wings. Realistically, any Discovery stock I buy could lose 50% of its value.

The middle: If WBD dilutes the stock by 31% like they have Discovery. If WBD can’t find the synergies to reduce costs by $3B. If WBD can’t do a better job of creating a streaming app than the current HBO Max (🤮). If they don’t pay down debt. If they spend $100B on acquiring NFL rights. If HBO’s technology management carries over. Basically, I see the middle as Discovery’s management mis-managing this.

My strategy: I’ve bought some DISCK @ $23.30. I’m watching the price though. If DISCK goes down, I’ll buy more. Somewhere around the $18 mark, I would make DISCK 5% of our holdings. The risk would be worth the potential reward. If DISCK goes up, I’m good with this initial investment that I hope turns into a very long term play. I’d love to own HBO’s great shows for the rest of my life.

My exit: If the merger falls through, I’m probably out. Discovery is overpriced by 25% and has 31% dilution overhanging. If the $3B in cost savings never show up, I’m out. If WBD can’t make a usable streaming service, I’ll bail out. If WBD diversifies out of being a media company, I’ll bail out. If WBD dilutes the shares by 31% like Discovery has, I’ll bail out as they don’t care for the shareholders. If I find myself canceling the streaming service because I’m not watching, I’ll bail out.