Warner Bros. Discovery: The Worst Has Been Avoided

Warner Bros. Discovery (NASDAQ:WBD) is one of the world's largest media and entertainment conglomerates headquartered in New York. The company operates through three business segments: Networks, the Studios segment, which produces feature films and television programs, and direct-to-consumer (DTC) businesses, primarily focused on providing entertainment content through streaming services such as Discovery+ and HBO Max.

At the same time, the company's diversified portfolio consists of such world-famous brands as CNN, WBD Sports, HBO, HGTV, DC Comics, and more. On the other hand, WBD's Studios business has produced and distributed through an extensive network of partners world-famous films and TV shows such as Friends, Harry Potter, Fantastic Beasts: The Secrets of Dumbledore, Game of Thrones, and more.

At the end of July 2023, Barbie was shown for the first time on American movie theater screens. According to Box Office Mojo, the Hollywood blockbuster featuring actors such as Margot Robbie and Ryan Gosling took first place at the box office during its opening weekend, bringing in approximately $162 million in ticket sales. Moreover, as of October 23, 2023, its global sales continued to grow and amounted to just over $1.44 billion, delighting WBD management and its investors.

Despite a significant decline in WBD's gross margin in recent years, the company's top five shareholders, comprising Wall Street giants such as Vanguard Group, BlackRock, State Street, Harris Associates, and Geode Capital Management, continue to hold a total ownership stake of 26.07%.

At the same time, the second quarter of 2023 showed unfavorable results since not only WBD's revenue was unable to exceed analysts' expectations, but at the same time, its EPS remained in the negative zone for several quarters. Moreover, rising US household debt is creating additional challenges for the industry, making investors even more nervous about the company's financial position.

On November 8, Warner Bros. Discovery will publish its financial report for the third quarter of 2023. According to Seeking Alpha, WBD's revenue for the third quarter of 2023 is expected to be $9.49-$10.68 billion, up 2.49% year-over-year and down 3.5% from analysts' expectations for the previous quarter. At the same time, under our model, the company's total revenue will be slightly below the median of this range and will reach $9.95 billion.

The decline in WBD's revenue on a quarterly and annual basis will be due to increased competition in the global video streaming market, a decrease in advertising revenue, and the continued strengthening of the US dollar relative to other currencies.

On the other hand, WBD's operating profit margin in Q2 2023 was -7.42%, down from the previous quarter. This decline raises concerns about the company's management capabilities, especially when compared to its competitors in the communication services sector. So, despite the slowdown in the growth rate of consumer spending in the world, the operating profit of the two leaders in the industry, such as Paramount (PARA) and Netflix (NFLX), remains positive.

We forecast that WBD's operating income margin will reach -7.1% by 2023. At the same time, in 2024, this financial metric will increase to -5.4%, thanks to the launch of new films and TV series, growth in advertising revenue, and the synergistic effect from the merger with Discovery, which partially minimizes the increase in theatrical marketing expenses and wage increases for writers and actors after the end of the Writers Guild of America and SAG-AFTRA strikes.

According to Seeking Alpha, WBD's Q3 EPS is expected to be in the range of -$0.22 to $0.87, which is significantly higher than the consensus estimate for Q2 2023. Moreover, according to our model, WBD's EPS will be in this range and reach $0.12.

On the other hand, the company's Non-GAAP P/E [FWD] is 14.21x, 0.76% lower than the sector average and 1.93% lower than the average over the past five years. As a result, this is one of many factors indicating its slight underestimation by Mr. Market during a period of slowdown in US consumer spending growth.

However, one of the main challenges facing the company's management is WBD's excessively high level of debt, which also negatively affects its net income. At the end of the second quarter of 2023, WBD's total debt was about $47.29 billion, down $5.41 billion from the end of December 2022. On the other hand, even though EBITDA for Q2 2023 was lower than the previous quarter, its total debt/EBITDA ratio decreased from 10.67x to 7.7x.

While we expect WBD's free cash flow to improve in 2024, partly thanks to the recovery of the global advertising market, it will have to resort to refinancing some of its debt. Another negative point to note is the extremely high total debt/EBITDA ratio, making it impossible to use the company's cash flow to buy back its shares, thereby making it more vulnerable to short sellers.

Conclusion

Warner Bros. Discovery is one of the world's largest media and entertainment conglomerates headquartered in New York.

In addition to theatrical marketing expenses and the potential damage from wage increases for writers and actors after the strikes end, WBD's revenue continues to decline year over year, which not only negatively affects its margins but has also caused its share price to fall by more than 20% since the start of 2023.

On the other hand, despite all the difficulties the company has encountered in recent years, it is expanding its range of TV series and films at a rapid pace. We believe 2023 will be a transition year for WBD as its management continues to work to improve its margins and reduce its total debt.

At the same time, the expected reduction in interest rates in 2024 will accelerate the growth of consumer spending worldwide, which will ultimately positively impact the company's financial position. Meanwhile, we believe the price level at which the risk/reward profile will be attractive is $9.5-9.6 per share.

We initiate our coverage of Warner Bros. Discovery with a "hold" rating for the next 12 months.