A Leveraged Opportunity in Warner Bros. Discovery (WBD)

The past months have seen some big selloffs in the stock market. Netflix Inc., for example, is down -71.7% from it’s ATH of $690 in November 2021 and is now priced at $195. In the first quarter of 2022, the streaming giant reported losing 200,000 subscribers, marking the first time it lost subscribers in over 10 years. On top of that, Netflix expects to lose another 2 million more subscribers in the second quarter of 2022. The bad news got investors fearful and worried that the entire industry might be affected and would experience less growth, as Netflix brought down several other streaming companies with it. There is, however, a frequent tendency on the part of the stock market to exaggerate the significance of changes in earnings in unfavorable direction. Warner Bros. Discovery, a recent spinoff by AT&T is down -42.31% in 1 year, while clearly improving their fundamentals. Oversold and undervalued stocks in beaten down industries create the perfect investment opportunity for the observant investor and in the investment analysis below, I will argue and show why there is value to be found in Warner Bros. Discovery (WBD).

.

1. INTRODUCTION

Warner Bros. Discovery is a premier global media and entertainment company, offers audiences the world’s most differentiated and complete portfolio of content, brands and franchises across television, film, streaming and gaming. The new company combines WarnerMedia’s premium entertainment, sports and news assets with Discovery’s leading non-fiction and international entertainment and sports businesses (i.e. the company is a merger from WarnerMedia and Discovery). Furthermore, we notice that WBD was spinoff entirely from AT&T, as shown in this announcement. So while readers that are familiar with my work notice that I have recently discussed two partial spinoffs in my blog posts about Harley-Davidson and Fidelity National Financial, we now encounter a company that is 100% spun off towards their initial shareholders (i.e. AT&T shareholders). Although there are plenty of reasons why a company might choose to unload or otherwise separate itself from the fortunes of the business to be spun off, there is really only one reason to pay attention when they do: you can make a pile of money investing in spinoffs. Stocks of spinoff companies on average significantly and consistently outperform the market average. But what happens if you’re willing to do a little of your own work? What if you could pick your spots within the spinoff universe? You could potentially make returns even better than the average spinoff, which is already outperforming the market. Here is why spinoffs are particularly interesting investment opportunities:

• The new spinoff stock isn’t sold, it is given to the shareholders who were investing in the parent company business. This means that once the shares are distributed they are typically sold immediately without regard to price or fundamental value. In our example, many investors perhaps bought AT&T stock for their great dividend of 5.21%, not for an exposure towards the streaming industry.
• Many institutional investors join the selling spree; whether it is because they are only allowed to own large caps funds (spinoffs are mostly only 10% the size of the parent company) or because they are allowed to only own shares of companies that are in the SP500 index. It may, however, well take a full year for the initial selling pressure to wear off.
• This selling pressure is in sharp contrast to the initial thought of the spinoff by management, which mostly comes down to creating additional shareholder value. This is in line with the comments by FNF management in our previous blog post on Fidelity National Financal: ”While this has played out much better than we had expected, the market has not recognized the value creation that has taken place at F&G. We believe that the best way to unlock this value is to publicly list F&G through a dividend to our shareholders.”
• In their Q1 2022 earnings we noticed that the results presented, cover the period from January 1, 2022 through March 31, 2022 for Discovery, Inc., and do not include the first-quarter performance for the WarnerMedia business which was acquired on April 8, 2022. We would therefore expect the Q2 results to differ significantly from the Q1 results. This could present a further opportunity when the financial numbers are finally presented together in Q2 and therefore significantly improving the results.

So how has does our story relate to our real life example of Warner Bros. Discovery? On April 11th, 2022 AT&T completed a spin-off of its media business, Warner Brothers Discovery and Warner Brothers Discovery stock has been trading separately from AT&T’s stock since the spin-off completed. On April 11th, the share price was $24.78 and went even down to $16.62 on May 11th, or a -32.92% return in 1 month while the SP500 experienced -10.81% return. WBD reported their Q1 2022 earnings which saw revenue increase by 13%, free cash flows increase by 33% and cash provided by operating activities increase by 20%. So even though the business fundamentals strongly improved, the stock went down by -32.92%, which seems in line with the explanation above that spinoff companies are directly sold by the shareholders of the parent company without any regard to price or fundamental value.

.

2. WARNER BROS. DISCOVERY

The fact that Warner Bros. Discovery is a spinoff company is in and off by itself not enough reason to go out and immediately buy the stock. We therefore notice several more interesting key points regarding the stock/business:

General

• The stock trades at a current p/e ratio of 10.39, with a share price of $18.76 (as of 28-05-2022). For comparion, Netflix trades at a current p/e ratio of 17.72 and The Walt Disney company at a current p/e ratio of 75.39.
• The stock trades at a forward p/e ratio of 8.41 showing that analysists expect the earnings of the company to increase in the coming period. For comparison, Netflix trades at a forward p/e ratio of 17.21 while The Walt Disney company trades at a forward p/e ratio of 25.06. This shows Warner Bros. Discovery is undervalued relative to their direct competitors.
• The stock trades at a p/s ratio of 0.94, meaning that the investor pays $0.94 for every $1 in sales.
• The stock furthermore trades at an EV/EBITDA ratio of 6.74. EV calculates a company’s total value or assessed worth, while EBITDA measures a company’s overall financial performance and profitability. Typically, when evaluating a company, an EV/EBITDA value below 10 is seen as healthy. For comparison, The Walt Disney company trades at a EV/EBITDA multiple of 21.19.
• WBD has an operating margin of 16.75% and profit margin of 10.53%.
• The CEO bought shares in the company worth $1 million while the CFO bought shares worth $500k, showing that management believes the stock to be a good investment opportunity and showing confidence in the company.
• In the past 4 years, the company has increased their revenues by 15.52%, has increased their earnings by 134% and their profit margin by 159%.
• For the FY21, we notice a depreciaton and amortization expense of $1.582 billion. This is a non-cash bookkeeping expense, pulling down the net earnings without affecting the business operations.

Cash Flow

• For FY21 the company earned $2.798 billion in operating cash flow. For the past 4 years, the company earned an average of $2.878 billion operating cash flow.
• For FY21 the company earned $2.425 billion free cash flows, or $3.64 free cash flow per share leading to a p/fcf ratio of 5.144 (665 million shares outstanding) which is 50% lower than their p/e ratio.
• For the past 4 years, the company earned an average of $2.575 billion in free cash flow. These FCF numbers are after deducting the company repaid an average of $2.118 billion in debt for the 4 year period.
• The company has $4.162 billion in cash on their balance sheet as of Q1 2022, or $6.25 cash per share.

Balance Sheet

• Total Assets have increased from $32.550 billion on 31/12/2018 towards $33.799 billion on 31/12/2021. This means that there is $50.82 of assets per share ($33.799 billion divided by 665 million).
• Total Liabilities have decreased from $22.033 billion on 31/12/2018 towards $20.327 billion on 30/3/2022, with gross debt of $15 billion. This means that there is $30.56 of liabilities per share.
• This means that Total Equity has increased from 12.575 billion on 31/12/2018 towards $13.562 billion on 30/3/2022. This means that there is $20.39 of equity per share.
• The company has a rather large part of their total assets in the form of Goodwill of $22.611 billion on on 30/3/2022.
• Current ratio = 2.01
• Debt / Equity ratio = 1.49, indicating that the company is getting more of its financing by borrowing money. A debt-to-equity ratio of 1.5 would indicate that the company in question has $1.50 of debt for every $1 of equity.

.

3. LEVERAGE OPPORTUNITY

We therefore notice that the company has a different kind of opportunity: tremendous leverage because of the debt/equity ratio of 1.49. We must remember, however, that Warner Bros. Discovery is a spinoff company from AT&T, a company with total assets of $550 billion. Peter Lynch in ”One Up on Wallstreet” notes that:

”Large parent companies do not want to spin off divisions and then see those spinoffs get into trouble, because that would bring embarrassing publicity that would reflect back on the parents. And once these companies are granted their independence, the new management, free to run its own show, can cut costs and take creative measures that improve the near-term and long-term earnings. A month or two after the spinoff is completed, you can check to see if there is heavy insider buying, among the new officers and directors. This will confirm that they, too, believe in the company’s prospects.”

Furthermore, David Zaslav, President and CEO of Warner Bros. Discovery has said the following in their Q1 earnings:

‘’With Warner Bros. Discovery, we are creating a pure-play media company with diversified revenues and the most compelling IP ownership, franchises, and brand portfolio in our industry. Importantly, we also have an unrivaled global footprint of touchpoints to get our content into the hands of consumers on every screen. We are putting together the strategic framework and organization to drive our balanced approach to growing our businesses and maximizing the value of our storytelling, news and sports. To do this, we have brought together a strong leadership team in a streamlined structure to foster better command and control and strategic clarity across the entire company. I could not be more excited about the massive opportunity ahead.”

We notice that Warner Bros. Discovery is backed by the giant company AT&T and that management has a clear vision and direction on how to create and unlock value in the company, so we see the leverage as an investment opportunity, as explained below in Table 1:

.

Ofcourse Total Liabilities + Total Equity = Total Assets. So the above Table 1 clearly shows that a 10% increase in assets (i.e. a value of $55.90 per share) leads to an $5.08 increase, or a 27.07% return. This is in line with the net leverage of 2.7 in the Q1 2022 earnings reported by the company. A 15% increase in assets (i.e. a value of $58.44 per share) leads to an increase of $7.62, or a staggering 40.61% return. Though the market may value the equity in the spinoff company at $1 for every $1.63 in debt, $1 is also the amount of our maximum loss. The potential reward of sound reasoning and some research are vastly multiplied when applied in these leveraged circumstances.

.

4. CONCLUSION

In conclusion, we note that there is value to be found in Warner Bros. Discovery. Warner Bros. Discovery is a underfollowed, misunderstood and oversold spinoff stock that shows a leveraged investment opportunity. Upon distribution, most retail and institutional investors sold their WBD stock without any regard to price or fundamental value, pushing the stock down by nearly 40% in one month. Key insiders such as the CEO, however, appear to be buying shares in the company, some even for significant sums upwards to $1 million. This shows that management sees potential in the companys prospects. If management, when freed from a large corporate parent, can unleash their entrepreneurial forces and show that capitalism actually works, our returns would be magnified by tremendous leverage of 2.7.

In addition, we notice that the stock is even undervalued relative to its own price history, its industry and direct competitors. The company has furthermore increased their revenues, their earnings, their margins and show great free cash flows of on average $2 billion per year. I wonder how their fundamentals turn out when the numbers of Warnermedia are added to the financial statements in the Q2 2022 earnings report. According to Benjamin Graham, ”There are two requirements for success in Wall Street. One, you have to think correctly; and secondly, you have to think independently.”

For me, it means that if I’ve thought an issue through, I try to follow my own research and opinion even when the crowd thinks differently. In the case of Warner Bros. Discovery, if the stock turns out to be more attractive than it is valued at the moment by Mr. Market, we can expect some decent returns due to the net leverage of 2.7.

DISCLAIMER

Eurykleia Investments is not a registered investment, legal or tax advisor or a broker/dealer. All investment/ financial opinions expressed by Eurykleia Investments are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that the all information is accurate and up to date, occassionally unintended error and misprints may occur.