Warner Bros. Discovery stock - Catching a falling knife
Update on one of the most exciting investment cases for me at the moment.
In a previous article I have described the investment case for Warner Bros. Discovery (WBD) shares on this substack. WBD 0.00%↑ was one of my top picks then, as it is now. And at the end of 2023 I saw a triple-digit upside potential in the share price over the medium term.
That has not been a good call so far. Currently, WBD shares have hit new lows following the announcement of Q4 2023 results, and with a 25% book loss, I am sad to say that I have a new problem child in my investable model portfolio.
Here is a quick update on the WBD investment case and why I added to the position during the post Q4 weakness. What has caused the recent price drop?
WBD Quarterly Figures for Q4 2023
As was the case in the previous quarter, the headlines in the Q4 reporting were poor for WBD. Most of the headlines related to the net loss of 400 million USD in Q4 on a 7% decline in revenues.
Few observers were interested in the fact that this loss was caused by a further 1.7 billion USD writedown of excessive intangible assets in 4Q. I still see this as a necessary clean-up of the Warner Bros. balance sheet inherited in the acquisition. For the full year 2023, a net loss of 3.1 billion USD was reported after a loss of 7.4 billion USD in the acquisition year 2022.
Given the disappointing revenue and profit figures, most investors were apparently not very interested in the cash flow, which paints a very different picture both in Q4 and for 2023 as a whole. In fact, WBD generated free cash flow of 3.3 billion USD in Q4 alone and a total cash inflow of almost 6.2 billion USD for 2023.
This extremely positive free cash flow has enabled the company to reduce its debt significantly by 5.4 billion USD during 2023. The remaining debt of 44.2 billion USD represents 3.9 times EBITDA and is all fixed rate (average interest rate 4.6%). Relatively little debt comes due in the next 3 years. In my opinion, less than two years after the takeover of Goliath (Warner Bros.) by David (Discovery), WBD no longer has a threatening debt situation.
The management team led by CEO David Zaslav and CEO Gunnar Wiedenfels has thus achieved its main goals for 2023. However, the capital market did not reward this and WBD shares were sold off after the results were announced.
The main reason was probably that management refused to give analysts a specific cash flow target for 2024. Instead, they simply reiterated their intention to reduce debt to less than 3 times EBITDA by the end of 2025. And with regard to the current Q1, they reported on the current recovery in the advertising market and, in this context, held out the prospect of a significant improvement in Q1 cash flow compared to the same quarter last year. None of this was very concrete.
On the global streaming business, they reiterated their goal of generating more than 1 billion USD of EBITDA from the direct-to-consumer segment by the end of 2025. Analysts continue to question whether WBD can succeed in the long term with its own streaming service MAX (currently 98 million subscribers) in the face of seemingly overwhelming competition from Netflix and Disney+ (260 million and 150 million subscribers respectively).
I don't think it makes sense to compare subscriber numbers at this stage, as MAX is not yet available in half the households that can be reached and will only be launched in many key markets over the next two years. It seems more important to me that MAX has already reached profitability in the US in 2023 (much earlier than originally planned).
Why I remain invested in WBD shares
From a business perspective, I think the refusal to give specific guidance was a very wise move by WBD's management. Even if it angered some investors and put further pressure on the share price.
This is because it gives WBD's management the flexibility to respond to the opportunities presented by a media landscape in turmoil in 2024, without having to consider short-term targets.
Unlike faltering rivals such as Paramount, WBD's strong cash flow generation has returned it to a position of enormous financial strength. Not only can WBD continue to reduce its own debt, but it can also invest billions when the opportunity arises. Be it in the further development of its own franchises or in the acquisition of assets.
I am happy to admit it: I am a fan of this polarising management team. Since the merger, Zaslav and Wiedenfels have delivered to their shareholders pretty much what they promised at the time, despite an adverse market environment: They have significantly cleaned up Warner's balance sheet after years of mismanagement at AT&T, and have had to take unpopular measures and lay off many people to make the company fit for the future with strong cash flow.
In my view, WBD is now well positioned to emerge as one of the winners from the forthcoming market consolidation. However, the financial markets clearly see things differently.
Although WBD's balance sheet should have been largely cleaned up by now (i.e. excess content assets and goodwill have been written off), at 8.50 USD the stock is trading at half its own book value. The ratio of enterprise value to free cash flow (EV/FCF, explained in simple terms here) is around 10, compared with 30 to 40 for other media stocks such as Netflix or Disney.
The EV/sales ratio of 1.5 is also at an all-time low and suggests an undervaluation. In my view, a market capitalisation of just 21 billion USD (enterprise value of 65 billion USD) is clearly too low for one of the world's leading media groups.
I now have an overweight position in WBD in my portfolio. And I remain convinced of the investment case. Am I right? We will probably not know for another two or three years.
If you would like to follow the Warner Bros. Discovery share together with me in the future, you can
*Disclaimer:
The author and/or associated persons or companies own shares in Warner Bros. Discovery. This article is an expression of opinion and does not constitute any investment or financial advice.