Ahead of the release of its first-quarter earnings later this week, shares of Warner Bros. Discovery Inc. (WBD, Financial) are showing high volatility, having dropped 9% in the last 30 days to reach $7.90. Among the main contributors to this performance is the negative news related to the possibility of losing NBA rights.
This strong retracement, with relevant news and the proximity of earnings, caused me to update the thesis and my discounted cash flow model. I realize that although Warner's shares are still asymmetrical, the drop didn't necessarily increase the margin of safety, given the greater cloudiness involved.
Before we dive into the DCF analysis, let's break down the company's revenue, which can be divided between distribution, advertising and content. As they have very different perspectives, it is worth separating them in the model.
Advertising and distribution prospects
Revenue from distribution is one of the crucial points in Warner Bros. Discovery's thesis and represented around 49% of the total revenue. Most of it comes from networks (approximately 57%), which is a business model threatened by the disruption of streaming and rumors of the loss of NBA rights, which is a partnership that TNT has held for some years and is certainly one of its moats.
The other major part of distribution revenue comes from direct to consumer, which, unlike networks, has interesting growth prospects as the company matures its operations and expands internationally.
This balanced mix between networks and DTC is one of the keys to Warner Bros. Discovery's future. How much will the growth of DTC be able to offset the declining rate of networks?
Being a conservative projection, but with a skeptical bias toward the cable TV model, my assumptions consider an average annual growth of 3% until 2030 in this revenue line, as I understand that DTC revenues still have a lot of room to grow and that even with high network declining rates, I do not believe they will happen abruptly.
Nielsen data corroborates this thesis, broadcasts and cable TV, although they have retreated in recent years, also show a certain resilience, as well as seasonality driven by sports and other events, such as the State of the Union speech, which reached 32 million viewers. Of those, 14 million were on cable TV.
On the other hand, especially given recent rumors and the importance of the NBA (and other sports) for networks, it is prudent to stress the projections in the advertising segment, more than 90% of which comes from networks. In view of the slowdown in this industry and greater competition from new forms of advertising, my projections consider a drop of 8% per year (on average) until 2028, stabilizing at 1% after that period.
Content perspectives
Unlike the other two sources of revenue, content is made up of practically only studios. Even so, it is not trivial to project it; not only because it encompasses different types of content (such as films and games), but also because of its high volatility. In a year when Warner Bros. Discovery hits the nail on the head, this revenue could show strong growth. In the same way, when the company allocates resources to developing bad projects, as was the case with the failure of the "Suicide Squad" live service, we could see some negative results in certain periods.
Looking ahead to the next quarter, I believe the company will be able to maintain a robust level of studios revenue (perhaps with a slight decline given the games side). Although the first quarter of 2023 is a base with a greater number of films and positively impacted by "Hogwarts Legacy," which was a great success, for this quarter we should also see a good contribution from films such as "Dune: Part Two" and "Godzilla x Kong," both of which have raked in more than $500 million worldwide according to Box Office Mojo.
Source: Wikipedia
As a result, my projections for content's revenues are for growth of 0.5% in first quarter, but to return to a better level over the years, with average growth of 3% per year until 2030, reflecting volatility, but recovery to a level above $13 billion as they reach a higher level of maturity, better managing old and new franchises and the like.
Earnings preview
Considering the outlook outlined above, I find the following financials for the first quarter:
- Net sales: $10.35 billion, down 3.20% year over year
- Ebit: -$155 million, negative margin at -1.5%
- Net income: -$440 million, negative margin at -4.3%
Compared to the market consensus, net income is slightly more optimistic, but margins are more conservative.
Consensus estimates:
- Net sales: $10.22 billion, down 4.4% year over year
- Ebit: $148 million, negative margin at -1.44%
- Net income: -$425 million, negative margin at -4.16%
Note that my projections are slightly more conservative, pricing in little short-term progress in terms of margins. However, given my focus on a long-term horizon, this matters little. In my view, the most crucial thing for Warner Bros. Discovery's first-quarter earnings will be the prospects mentioned in the call that touch on factors such as expansion and monetization of streaming worldwide, efficiency capture projections, studio (and streaming) maintenance through new productions and intellectual property exploitation and, last but not least, the prospects for the networks segment and the NBA rights rumors.
DCF updated
As previously mentioned, Warner Bros. Discovery entered my radar again due to negative factors, such as the stock's pre-earnings drop and the news directly affecting networks' declining rate. This made my assumptions mainly pessimistic.
The main adjustment to further stress the projections was the revenue growth that was broken down in the first sections. Combining the outlook, I find a much slower pace of revenue, on average 1.60% per year until 2031. If in the last projection the company reached a revenue of $50 billion in 2030, it now reaches something close to $46 billion, with a major loss of relevance in advertising, offset by a slight growth in distribution (driven by DTC) and a robust level of content (Studio).
Source: Author and Warner Bros. Discovery Trending-Schedules
On the other hand, there is margin gain for the coming years, but maintaining a gradual pace, stabilizing at an Ebitda margin of roughly 16% post-2031.
Source: Author and Warner Bros. Discovery Trending-Schedules
The other DCF assumptions includes:
- Capital expenditure: -3.5% for the next few years, declining to -2.5% post-2027
- Terminal growth: 1%, given the conservative approach and low prospects
- WACC: 8.98%, assumption very stressed, given the ERP of 15% to reach a plausible weighted average cost of capital and the greater risk of the thesis
Even with stressed assumptions, it is possible to find an upside of 30% for Warner Bros. Discovery.
The purpose of the modeling is to stress the company's scenario in order to exercise how cheap the stock might be. This disclaimer is even more valid for Warner Bros. Discovery, which has a diversified business model, with different perspectives on each line of business and complex financials. For example, in cash generation, there is a large volume of content rights amortization and impairment (reduces net income and inflates Ebitda), as well as a large volume for the production of film and television content. Thus, even with a negative net income, the company was able to generate a high volume of cash from operations.
Source: Warner's 10k 2023
Final thoughts
Even though we could still see an upside of 30% in a scenario of lower growth, as well as a relevant drop in the stock, I understand the margin of safety has not increased. In fact, the level of uncertainty has increased, with the news of NBA rights and also regarding Fubo's statements, which mentioned the company insisted on offering "above-market rates for its content" and therefore, Warner Bros. Discovery networks left Fubo in April.
So, with more nebulous prospects regarding the stability of networks, not only in terms of revenue but also profitability, together with some initiatives that did not work out so well, I understand the risk to the thesis may have increased in the short term.
In any case, given that even in a delicate and conservative scenario there is upside, Warner Bros. Discovery's thesis seems asymmetrical to me and I believe the company should be able to maintain strong cash generation to pay its (high) debt and eventually generate shareholder value. Not only that, but its biggest moat remains its quality IPs, which may eventually bring growth to DTC and studio depending on how efficient management can be with its projects, which is also a bit of a question mark as Dune was a big hit, while the Suicide Squad live service was an awful mistake.
