Warner Bros. Discovery: Long The Stock, Short The ‘Batgirl’ Strategy

Stock Market

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Warner Bros. Discovery (NASDAQ:WBD) is getting no respect for its recent August 4 earnings report and conference call. The Q2 numbers may have been subpar, but hey, the company is just getting settled into its new corporate life as a combination of the old Time Warner media assets with Discovery’s cable-based IP. The stock closed down over 16% on the trading day following the news on heavy volume, landing within a couple bucks of the 52-week low.

The numbers are the numbers, and they will be that way for a little while as we cruise toward fresh comps when the company is a year old (remember shares began their trading life back on April 11). More importantly, we have to consider recent news about the overall strategy that CEO David Zaslav is plotting.

There are good points and not-so-good ones to the story behind the stock. The good outweighs the bad, and the stock is a buy on dips.

Here are some more thoughts on this company…

The Quarter – All About The Debt

Probably the biggest standout in the quarter, and not a good one, is the debt. Mergers like this always come with a debt transfer, and the question for the company is, what will it do about that line on the balance sheet? $51 billion in long-term debt ($53 billion total) against a market capitalization of $35 billion (at the moment) does tend to stick out.

As you might imagine, the large sum owed was a topic in the earnings call. Management clearly knows that Wall Street wants that leverage scaled back, the quicker the better. The motivation is there, and while I’m sure some quarters will disappoint in terms of expectations as to where the company should be at, two main points were emphasized: $6 billion will be paid back by the end of August, and whatever free cash flow is generated will be plowed back into the debt levels. That is going to incentivize profitability and positive cash generation, so the next few years may not see much in the way of experimentation with the business model (definitely not as much as I would like to see, certainly, in terms of different release paradigms, content approaches, et cetera).

Before we get to more on that, let me point out that the company did generate roughly $1 billion in free cash during the six-month frame (CFO Gunnar Wiedenfels pegged the quarter at a little under $800 million in free cash, with some adjustments related to the merger), a mostly flat performance against the comparable period last year. Investors will want to see that number grow, and the free cash comes against a reported GAAP net loss, again within the context of this new start to the combined media businesses. This article mentions free-cash guidance of between $4 billion and $6 billion for the fiscal 2023 period, which represents a downgrade from $8 billion, but the author believes there may be some under-promising going on since consensus estimates are more near the top part of the range at $6 billion. Obviously the economy and recession threats will affect performance, so managing investor outlook is warranted; still, I believe the company should be able to get cash-generation going as it begins its IP/streaming strategies.

I believe the company may look at ways to accelerate deleveraging. Any assets that can be safely sold (safe as in non-core in any significant way) will most likely be identified. One asset in particular that would be a controversial disposal would be the video-game unit. I agree that this would be a good asset to keep from one angle, but from another, since the company wants to get debt down and it could always follow the approach of licensing IP instead of developing/publishing, the company could always look at it in case cash flow becomes more variable because of challenges of content slates (i.e., Hollywood is a great industry in which to invest, but studios can go through down times based on slate popularity). AT&T (T) thought about selling out of video games back when it owned Warner; it is a dynamic to watch as CEO David Zaslav considers all his options with further strategy evolutions.

Beyond The Quarter

Looking beyond EPS and debt at this young stage in the company’s life is more productive than short-term thinking, for the long-term planning will have more effect on the success of the stock than these early results.

Which brings me to the big news everyone is talking about – the cancellation of a DC project.

By now, most people who follow Warner know that a Batgirl film has been sidelined, mostly because of tax-strategy rationale. Zaslav is looking to be very careful about money, so any tax advantages he can harvest makes sense.

However, is this particular tax strategy inappropriate?

I do think this is the wrong move. DC is an important component of the overall Warner long-term model for shareholder value, and if you take a look at some comments, the reasoning behind the sacrifice of this particular silver-screen asset is because it either didn’t fit within the new scheme of the cinematic franchise (i.e., where the storylines are going) or it didn’t rise high enough in the quality department to warrant a theatrical release with an expensive campaign behind it. On that last point, it’s been said that the previous administration’s intention to place it on HBO Max is a non-starter for Zaslav and company, as they are determined to ride the new theatrical wave that seems to be coming now that tentpoles such as Spider-Man and Top Gun are brushing off SARS worries and multiplexes are once again full with popcorn-buying consumers.

But that might not be the greatest explanation for shareholders. Hollywood is like any business – there are strong personalities present that want to reinvent previous corporate wheels so as to map out a unique legacy that will remain in the industry’s archives of admiration; Zaslav is no different. Yet, if an investment was made in a previous corporate regime of $90 million on a film that is part of an iconic intellectual property, it would make more sense to do something with it instead of merely exploiting an accounting inefficiency with it. If the company was opposed to releasing the project to the multiplex because it felt the final product wasn’t worthy of a profligate marketing campaign, then it simply could have placed it on TBS or TNT (maybe both, a simultaneous premiere?) and work some synergy with it. Or, it could have done a direct-to-physical-media release (remember those?) backed by a limited run, followed by H-Max. Or, why not offload it to Netflix (NFLX) or another streamer in a cost-plus sale? Sure, that’s a competitor… but if you want to save money, sometimes that’s an option; plus, the film would still have a purpose as an advertisement to competitor viewers for the DC brand. Zaslav can still make his mark without unraveling all of the previous investments, and they would serve as content placeholders until his multiyear DC strategy is put in place (not to mention the combination of HBO and Discovery direct-to-consumer). It’s understandable – and commonplace – for new management teams not to validate previous investment theses – but as it concerns a film in the Batman universe, it would seem that the interests would be aligned.

I’m not sure if the movie can eventually be released after some time has passed, but I don’t necessarily believe that the negative is gone forever. All of the content write-downs and other aspects of the merger obviously are creating opportunities for the company to look for ways to save money, but using a superhero film and a Scooby-Doo cartoon as tax strategies wouldn’t seem to be as important as perhaps looking at other things. I’ve mentioned before the issue with overall deals and ROI… there is more news on that front.

Deadline published a very useful perspective on Zaslav’s strategy. My main takeaway is that there is, as I foreshadowed earlier, good and bad to the strategy – the good outweighs the bad, as I will briefly explain – and that investors must look at everything in an overall context that goes beyond the somewhat chaotic reboot that is taking place. At its basic core, the tenet Zaslav is following centers on not being other people’s money. That is an extremely good side to the strategy, it’s a great attitude to have. As the trade article intimated, talent such as J.J. Abrams and Clint Eastwood are more than welcome to produce product for Warner – it just has to be done at the correct level of compensation. For me – and I hope the CEO feels the same as I do, and I would argue that he won’t really win the fight not to be other people’s money unless he does this – that would imply a flat fee for services with no backend participations. This should allow for reduction of sweetheart-deal lawsuits, a horrible legal plague that hurts vertical media companies.

The bad side to all this is obvious: sometimes you need the services of certain star talent, and you have to pay up, or you have to show respect. Abrams’s deal is not popular to Warner’s new brass because it hasn’t really produced the kind of slate the company was anticipating; I’m heartened by the fact that someone is questioning multimillion-dollar outlays (and I say multimillion as in hundreds of millions) for overall deals if product isn’t coming to market. And it can’t be just product; I’ve argued this before, and I’ll argue again here: as a shareholder, I want to see not just product, but commercial product. It has to sell tickets or capture eyeballs monetized by premium subscriptions or advertising support. Again, if you’ve got a project you absolutely need to see on some species of screen, a big one or a small one, lower your fee and we can talk. However, I do recognize this is a significant risk; my solution is to take the risk, sacrifice some revenue that might be lost because of using newer talent, and focus on quality of story and spectacle of special effect.

There was a very interesting point covered in the trade piece about director Christopher Nolan perhaps moving to Comcast’s (CMCSA) Universal studio. WBD shareholders obviously would rather Warner be in business with Nolan, but I have a different philosophy as an investor who owns multiple media businesses. As a Comcast shareholder, if Nolan moves there, then I will potentially see a benefit, very small though it will be, if his projects turn out to be hits. If he hypothetically moved to Netflix, same outcome. I mention this because oftentimes a talent exodus might seem like a bad thing for a single company or a sector, but for those who own multiple equities linked to Hollywood, I would argue that letting talent move over to another part of your portfolio is a positive development as it allows one company to evolve its strategy – in this case, WBD – while the other one hedges the bet. In the end, it’s nothing to fear, although as I stated in the previous paragraph, it does come with downside risk for a slate. The key with talent is: don’t overdo it on the compensation side.

One weird contradiction with the Batgirl thing is that it does send a bit of a mixed message: Zaslav clearly stated that he is firmly in on theatrical distribution. It’s odd that such a statement needs to be made, but the death of the multiplex was constantly broadcast around the world as the SARS-CoV-2 virus sent Warner’s entire film slate over to H-Max, so reassurances to exhibitors as the industry bounces back probably does help, especially in the new world of the forty-five-day window. Batgirl could have played a part in proving the theatrical pledge, but going beyond that, long-term shareholders will benefit from Warner’s intention on making significant investments for the silver screen. Not only is theatrical essentially a value-adding window that beneficially impacts all ancillary revenue streams – physical release sales, for instance, obviously will be higher if a movie hits theaters first – but it is, itself, an important revenue stream that has diversification value in relation to the rest of the company’s businesses. In other words, I always want a tentpole picture to be profitable before it exits the first window. Granted, that oftentimes is not possible given the usual Hollywood model of what is usually known as ultimate profit – the net surplus (or deficit) generated after all ancillary revenue streams are considered. It should be the goal, though, and it starts with rational talent compensation practices, which I’ve already mentioned.

Conclusion/Thinking On The Stock

So, taking all of this together, the bullet points are clear: cut costs as much as possible, even if it means jettisoning some in-the-can negatives such as Batgirl. Go all-in on theatrical and forget the day/date stuff. Watch the cash flow, and pay off the debt.

Sounds good (except for the not-releasing-a-DC-film part). And the valuation on the stock is currently rated highly by SA. Add to that a bad rating on momentum – i.e., the stock is currently out of favor – and you’ve got an attractive situation: in other words, the stock is a buy at these levels. Not only because of the metrics, but mostly because of the promise of the IP, the newness of the merger, and the motivation of management. With WBD, an investor gets a different approach from some of the other media companies – first look at the money available, then price out the cost of content.

At least, that’s what Zaslav is preaching today. Tomorrow, yes, Zaslav might find that Hollywood – the scripted side of Hollywood, as opposed to reality shenanigans – is going to push back against his bid.

But I have a good feeling at the moment. I have read comments that criticize his performance over at Discovery, and while there are solid points to them, I see the current situation with the merger as transformative to his leadership – meaning that he knows the challenges of cost versus content and will act accordingly. There will be missteps – cancelling completed cinematic assets is not something I would have done – but given the valuation and the portfolio, and catalysts such as more films to feed a rejuvenated multiplex and a combined streaming platform with an advertising option for inflation-weary consumers, I find Warner Bros. Discovery to be a buy, and I have recently added to my own position to improve cost basis.

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