Mike Coppola
Warner Bros. Discovery’s (NASDAQ:WBD) stock has lost more than 60% of its value since completing one of the highest profile mergers in media and entertainment earlier this year. In addition to surging interest rates and weakening macroeconomic conditions that are adverse for WBD’s inherently cyclical advertising and consumer-centric media and entertainment businesses, the market’s misunderstanding that the company would become a direct-to-consumer (“D2C”) focused effort – which did not come to fruition post-merger – was another setback for the stock. Specifically, much of the optimism surrounding the WBD spinoff earlier in the year was primarily focused on not only the opportunities for growth and cost synergies, but also the valuation re-rate potential that exists as the company transitions from a legacy media and entertainment giant to a potential market leader in the tech-centric streaming business:
The unveiling of WBD’s post-merger direct-to-consumer (“D2C”) strategy also highlights management’s focus on profitability over growth. While we were slightly disappointed that D2C growth is not the primary focus – considering this was a core factor to our bullish thesis that WBD is in for a post-merger valuation reset upwards to levels similar to those of high-growth streaming and tech peers like Netflix (NFLX) – the strategic emphasis on profitability would support the continued build-out of stronger fundamentals needed for deleveraging and greater returns, ultimately driving better valuation prospects either way.
Source: “Warner Bros. Discovery: A Long-Term Play With Generous Returns”
And we’re not so sure if management’s recent comment that WBD “did not position the company as a D2C platform with a conveyor belt of mass content flowing”, which effectively punts the responsibility of investors’ disappointment back to themselves, did much to help salvage market confidence in the stock:
Ben Swinburne
So, when – I guess it was, I guess May of last year when you guys announced this transaction. I think at the time, at least my perspective was this was very much about direct to consumer and streaming and sort of the combined scale and winning in D2C…
Gunnar Wiedenfels
Ben, I would say more so, the market has changed the lens because I would describe it a little more – in a little more nuanced way. Clearly the D2C area for this combined company is going to be the most important growth driver going forward, but what’s already differentiated the way we have looked at Warner Brothers Discovery when we announced the deal from everyone else, is that we did not position the company as a D2C platform with a conveyor belt of mass content flowing and to drive that platform. But we have seen the opportunity of Warner Brothers Discovery as one integrated media platform, being able to use all the revenue streams and cash registers across an entire ecosystem.
Nonetheless, WBD’s recognition of D2C as the key longer-term growth driver as consumers’ preference shift away from traditional linear TV, alongside its focus on pushing related economics into a positive inflection within the foreseeable future remain favourable developments. The following analysis will zero in on WBD’s D2C business – specifically, the segment’s growth strategy, and near- and longer-term economic targets – as well as their implications on the broader company’s valuation prospects.
As previously discussed, the stock continues to face stiff headwinds due to ongoing restructuring challenges and ensuing costs, which have only been made worse by rapidly deteriorating macroeconomic conditions. But continued market volatility could create a compelling opportunity for upside potential on a long-view perspective as WBD exhibits strengths in righting the ship and capitalizing on key growth trends in digital media and entertainment over the coming years. Admittedly, it is going to be a bumpy ride for the stock as WBD’s restructuring efforts continue. But once annualized cost synergies and free cash flow generation normalizes – which WBD continues to progress favourably towards, in our opinion – the company would make a competitive market leader with potential to capitalize on further industry consolidation and bolster its share prospects over the longer-term.
Pursuing Renewed Growth Via D2C
The advent of connectivity and mobility has spurred digital data consumption in recent years, with internet access becoming a “form of utility” if anything. There are currently more than 1 billion household broadband connections, and an installed base of more than 5 billion smartphones worldwide, fuelling global data consumption growth at a five-year CAGR of close to 30%. The accelerating penetration rate of high-speed connectivity in recent years has also altered consumer preference in how they choose to consume media and entertainment, with demand shifting towards digital formats like video streaming – especially during the pandemic when people “spent more time at home and more time online”.
Source: “Top 3 Streaming Face-Off: Disney, Warner Bros. Discovery, Netflix”
Today, on-demand streaming accounts for almost 40% of Americans’ total TV screen time, with the number still eating into shares of broadcast and cable. As linear TV continues on a structural downturn on shifting consumer preferences, D2C will inevitably become the key growth driver in media and entertainment going forward.
While that is not to say efforts in maintaining traditional cable and broadcasting should be abandoned altogether, given they remain key drivers for funding growth investments (e.g., D2C), the focus for the two legacy media and entertainment segments should shift from growth to profit retention. And it appears that is exactly the strategy WBD is pursuing – maintaining free cash flows generated from its studios and networks segments by prioritizing profitability, while focusing on capturing growth opportunities in D2C – which is a welcomed sight:
But we have seen the opportunity of Warner Brothers Discovery as one integrated media platform, being able to use all the revenue streams and cash registers across an entire ecosystem… We are going to be able to much more efficiently and effectively market that D2C product, and all our products with the combined company footprint, but not the end all, be all purpose of the company that exists.
Source: Warner Bros. Discovery, Inc. Presents at Morgan Stanley European Technology, Media & Telecom Conference Transcript
Although D2C streaming remains a largely unprofitable business, with the exception of Netflix, it is undoubtedly where the future of consumer TV consumption is headed. And WBD continues to exhibit strengths in facilitating that transition without losing its market leadership in media and entertainment. Sticking with today’s focus on WBD’s D2C streaming opportunities and their implications for the stock’s longer-term outlook, we will assess the segment’s two key growth drivers: 1) subscriptions, and 2) digital ads.
Subscription
The company remains fixed on acquiring 130 million D2C subscribers by mid-decade, which will be crucial to supporting “breakeven in the U.S. in 2024 and $1 billion in profit globally in 2025”. But having only gained 1.7 million and 2.8 million subscribers in the second and third quarter, respectively, to bring the total count to 94.9 million as of September 30, questions are pouring in on if and how the 130 million target could be achieved. Another concern is whether WBD’s D2C business can garner sufficient market share compared to Disney (DIS) and Netflix’s 221+ million and 223+ million subscribers, respectively, to remain financially and economically competitive.
On achieving its 130 million subscriber target, key supporting initiatives include the upcoming roll-out of a brand-new streaming service that combines the content libraries of HBO Max and Discovery+, as well as continued expansion into international markets. Specifically, the long-awaited U.S. launch for the combined platform is scheduled for the coming spring, which will turn WBD’s D2C streaming content library into one of the biggest – if not the biggest – on the market today. As discussed in our previous coverages on the stock, one of the key advantages of combining both services from a growth perspective is that it enables price discrimination within the highly competitive on-demand video streaming market:
While both HBO Max and Discovery+ currently generate dual revenue streams by offering “ad-lite” and “ad-free” options for their respective global subscribers, the combination of both streaming platforms is expected to enable additional tier options – such as films only, sports only, or a premium all-in package – that can cater to different user [preferences], needs and budgets, and maximize WBD’s global share of on-demand video streaming subscription volumes.
Source: “Warner Bros. Discovery: Big Media Energy”
Price discrimination via different tier offerings will be critical for catching churn, especially in the near-term as consumer budgets get squeezed ahead of persistent inflation and a looming recession. The combined service will also improve user experience by offering a wide array of content, ranging from scripted to non-scripted titles that both Warner Brothers and Discovery are reputable for. To some extent, the sprawling portfolio of both non-scripted and scripted titles made available through the combined service would play a positive role in ensuring subscriber retention. Essentially, both genres can mutually reinforce demand for one another among varying consumer preferences.
Given subscriptions can be cancelled at any time, streaming services often see a spike in both sign-ups and churn within weeks from releasing top scripted hits as viewers reach the end of the season. Acknowledging the difficulty in subscriber retention, especially ahead of growing macro weakness and increasing competition, non-scripted content contributed by Discovery in the combined streaming service could potentially help reduce “end-of-season” churn by giving subscribers another reason to stay on the platform. This is also corroborated by the typically low churn rate observed in Discovery+.
Admittedly, non-scripted content has historically appealed to a lower volume of audience appetite though, which is evident based on the larger library of scripted content produced – out of “more than 16,000 TV shows available across 140 U.S. streaming platforms”, more than two-thirds are scripted to enable better capitalization of audience appetite. This means low churn rate historically observed at Discovery+ is primarily reflective of more purposeful, and price-inelastic sign-ups. In this sense, award-winning scripted titles contributed by Warner Brothers within the combined streaming service would be complementary to expanding non-scripted content’s reach and draw additional audience to shows they otherwise would not have watched. It would also effectively improve returns “for every dollar of content spend”, which aligns with WBD’s recent efforts in reallocating low-view titles on its streaming platforms to free ad-supported television (“FAST”) services offered by rivals like Amazon’s FreeVee (AMZN) to optimize D2C content licensing revenues.
Expanding across international markets is another key initiative that is already in WBD’s game plan towards 130 million subscribers by mid-decade. While WBD continues to prioritize growth within the higher ARPU domestic market in the near-term, the company also acknowledges that much of the newly expanded addressable market for streaming will come from outside of the U.S. over the longer-term. This is consistent with management’s go-to-market strategy for its international D2C offerings, which includes relaunching the newly combined streaming service in markets that currently already offer HBO Max and Discovery+ separately, and penetrating new markets thereafter.
Meanwhile, on the market share front, WBD’s goal of acquiring 130 million subscribers by mid-decade does appear to be mediocre when compared to rivals Disney and Netflix, which both already boast subscription counts in the 220 million range. But as discussed in a previous coverage on the stock and in the earlier section, WBD continues to exhibit robust share gains in higher ARPU regions, which implies it is effectively eroding the competition’s market share while carving out a pathway to profitability globally by 2025:
For instance, Disney may have been demonstrating rapid DTC subscription growth in recent quarters, but a deeper dive would reveal that much of it comes from Disney+ Hotstar, its streaming service provided to the less profitable India market. Meanwhile, Netflix continues to struggle with recovering subscriptions lost earlier in the year within its most profitable North American and European markets, despite its recent return to growth.
Source: “Warner Bros. Discovery’s Q3’22 Double Miss: Have We Been Wrong?”
As discussed in the earlier section, striking a balance between its structurally declining yet profitable pay TV business and growing yet unprofitable D2C business remains key in WBD’s execution of its post-merger plan. And WBD’s priority on bringing its D2C streaming business to profitability by mid-decade is welcomed, as it implies the company acknowledges the increasing urgency to transform its next growth driver into a self-funded business without over-reliance on free cash flows generated from a legacy business that is undergoing rapid transition. As such, we view the upcoming debut of the newly combined streaming platform as a positive catalyst for bolstering WBD’s longer-term prospects as the media and entertainment industry undergoes transformation.
Digital Advertising
Digital advertising currently accounts for more than two-thirds of total annual global ad spending. And there is no turning around as ad dollars continue to flow from traditional formats like linear TV, radio and paper to digital formats as viewers in “the 18-49 segment [move] online”. Despite the recent slowdown in ad spending due to the industry’s inherently macro-sensitive nature, advertising-based video on demand (“AVOD”) is expected to see 22% y/y growth in ad revenues this year and 33% y/y in the next, driven by “additional non-cyclical ad spend [such as] mid-term elections and the World Cup”:
…political forecasts remain strong and, unlike other verticals, appear to be fully funded and not price-sensitive. In an analysis of the data from the Federal Election Commission, spending was up 47% in the third quarter compared to the 2018 mid-terms while overall fundraising is 74% higher, leaving roughly 89% more funds available at the end of September than in 2018.
Source: RBC Capital Markets Ad-Tech Recap
AVOD is also expected to emerge as one of the fastest growing digital advertising platforms over the longer-term, which makes strong tailwinds for WBD’s ongoing efforts in turning a profit in its growing D2C business:
AVOD: AVOD is another emerging high-demand ad format that follows the secular transition in consumer preference from linear TV to on-demand video streaming. Demand in the ad format is expected to accelerate over the longer-term as the increasingly saturated video streaming sector consolidates and improves monetization of their respective subscriber bases with advertising. This is further corroborated by the upcoming roll-out of ad-supported options across Netflix and Disney+, which follows the footsteps of Hulu and HBO Max where more than half of their respective subscriber bases are signed up on an ad-lite tier…The format is expected to benefit from further demand acceleration as performance measurability and ROAS (return on ad spending) metrics improve for advertisers, and ad format operators offer improved cost and pricing structures enabled by greater adoption and scale over the longer-term.
Source: “Ad-Tech Round-Up: Why We Think Google and Amazon Will Rise On Top”
Specifically, WBD’s D2C advertising CPMs, or cost per mille, which measures the price advertisers pay for “every 1,000 impressions an ad receives”, are already on par with its linear business’. WBD’s implementation of a weekly content release strategy is also well-liked by advertisers, given a lengthened programming schedule “provides visibility on viewership and engagement levels” to optimize ad placements. This accordingly checks off advertisers’ demand for better performance measurability and ROAS metrics in the emerging AVOD advertising format.
With continued scale as the upcoming roll-out of a combined streaming service extends subscriber reach and engagement, WBD’s D2C segment is well-poised to experience “incremental exponential benefit in digital marketing”. This is already corroborated by almost doubling ad revenues generated by WBD’s D2C segment in the third quarter. And anticipated acceleration in subscription growth is expected to bolster D2C ad sales, which boast higher profit margins compared to subscription revenue.
Enabling a Self-Funded D2C Business
As discussed in the earlier section, only Netflix has achieved profitability in D2C streaming while legacy incumbents including WBD continue to struggle with generating positive free cash flows from the business. But paving ground for D2C towards profitability will be critical to ensuring a sustainable business for WBD over the longer-term given the secular shift in consumer preference on TV viewership.
And “balance” is of the essence in WBD’s continued execution of its D2C approach – growing its streaming offerings too quickly to capitalize on secular growth trends, or unwinding its larger and more profitable studios and networks segments too slowly ahead of a structural decline in linear TV could result in an adverse impact on WBD’s profitability prospects. Slashing costs too aggressively could also risk stifling creativity – a core driver of success in the media and entertainment industry. And investor angst is growing on whether WBD could execute the balanced approach required, especially as restructuring efforts and related costs have time and again turned out to be worse than expected.
Although WBD has undergone significant – and sometimes disheartening – changes since the completion of its merger in April, with high profile projects and divisions within the company being repeatedly taken apart and put back together under CEO David Zaslav’s direction to optimize returns on content investments, the developments underscore commitment to turning D2C into a self-sufficient business within the targeted timeline. Specific to D2C, the upcoming combination of HBO Max and Discovery+ may require upfront ramp-up and deployment costs, which could weigh on profit margins. But over the longer-term, the combined offering would not only benefit from economies of scale in both subscription and ad sales, but also additional cost efficiencies stemming from a shared technology stack, and reduction in overlapping spending among other savings. This will effectively chip away at the sprawling “$6 billion non-content D2C spend” that WBD incurs today, and contribute favourably to the company’s goal of achieving breakeven for the segment in the U.S. by 2024 and $1 billion in profitability globally for the segment by 2025, alongside $3.5 billion in annualized consolidated cost synergies once restructuring efforts wrap up by the end of 2024.
D2C remains a capital-intensive business that requires significant content investments to upkeep competition. Paired with WBD’s substantially leveraged balance sheet – a key sore spot for investors – the sooner D2C becomes profitable, the better, especially as the addressable market for linear TV diminishes and growth funding that comes from the company’s legacy studios and networks business become increasingly at risk.
Risks to the Long-Term Bullish Thesis
In addition to macroeconomic headwinds and the secular decline in demand for linear TV which we have already touched on throughout the foregoing analysis, WBD’s highly leveraged balance sheet is a top sore spot for investors. The company currently operates at a whopping five times leverage, with outstanding debt topping $50 billion over a 14.5-year average maturity timeline. While the bulk of which is “attractively priced debt” at a fixed rate of about 4%, which provides some mitigation against today’s surging interest rates, deteriorating macroeconomic conditions are drawing concerns over the company’s ability in generating sufficient free cash flows to meet its payment obligations.
But considering the company’s approach for D2C, which will compensate for declining free cash flows generated from legacy parts of the business that are facing a structural downturn over the longer-term, WBD does not exhibit immediate liquidity issues. The company has no debt obligations coming due until at least next year ($1.3 billion) and 2024 (about $4 billion), which its guided free cash flows of $3 billion for the current year that is inclusive of “peak losses for direct to consumer”, and anticipated fundamental improvements in the following year could satisfy with ease. This is further corroborated by the $6 billion in debt that WBD has paid off since completing the blockbuster merger, underscoring management’s commitment to deleveraging towards the 2.5x to 3x target range within 24 months post-close, and bolstering financial flexibility to support longer-term growth.
Final Thoughts
Times are tough for WBD currently as it’s working through peak challenges stemming from both deteriorating macroeconomic conditions and company-specific post-merger inefficiencies. The near-term outlook has undoubtedly soured, with WBD’s fundamental performance having almost completely deviated from pre-merger forecasts, especially after management confirmed restructuring efforts would prove more challenging than expected. Paired with the expectation for continued market volatility over coming months as the likely impending recession propels risk-off sentiment, WBD shares are positioned for further turbulence ahead. But despite near-term execution risks on righting its ship, the stock continues to exhibit favourable upside potential on the long-view in our opinion, especially at current levels which have priced in incremental near-term macroeconomic headwinds that will ultimately subside.
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