Description

Recommendation: Long Warner Bros. Discovery (WBD), paired with short Paramount (PARA).

Thesis: As WBD pivots from a year of restructuring to one of execution, I think WBD will narrow its current valuation spread relative to PARA. Both are close peers making the transition to streaming with their linear video business (accounting for a majority of EBITDA; see Exhibit 1) secularly pressured by deteriorating cord cutting trends and ad environment. However, WBD and PARA stand in stark contrast with each other in terms of growth profile and direction of estimate revisions. Execution on synergies will drive EBITDA and FCF growth for WBD from here even in a worse macro, which differentiates it from PARA which has declining EBITDA and continues to burn meaningful FCF this year, before (hopefully) inflecting to positive FCF only in ’24.

WBD trades at a current 3x turn discount to PARA on NTM EBITDA, which I believe will narrow 2x turns in the near-term with the potential for a complete elimination of the discount given the similarity of the businesses and LT prospective growth algorithms. WBD / PARA trade at 7.5x / 11.1x ’23 EBITDA, and 6.8x / 9.2x ’24 EBITDA. If WBD re-rates to PARA, there is 90% upside to the stock. On FCF, WBD is too cheap relative to PARA at a ~25x turn discount on ’24 FCF (WBD at 7x / PARA at 30x), and there is further upside should WBD re-rate closer to PARA on this basis.

Price Target: I believe WBD can narrow its current valuation spread vs. PARA. WBD trades at a 3x turn NTM EBITDA discount to WBD, and each 1x turn on WBD is worth 30% to WBD’s stock. WBD is trading only ~0.5x turns from the wides vs. PARA, setting up an attractive r/r of 2-3x turns of tightening vs. 0.5x turn of widening (see appendix 2 for a relative valuation chart).  

Situation Overview:

• WBD was formed in April 2022 when AT&T (T) unwound their 2018 acquisition of Time Warner (TWX) by spinning off the asset and merging it into Discovery (DISCA).
• WBD is in its transition to streaming, against the backdrop of ongoing secular pressures in linear video from a challenging ad environment and deteriorating cord cutting trends. In the past year, WBD was also impacted negatively from inheriting unexpectedly worse assets from the merger, setting back some restructuring efforts.
• Moving forward, WBD will continue executing on synergy targets (targeting $4bn+ through ’24) while meaningfully delevering their balance sheet from 5x in ’22. WBD will be relaunching their DTC product that will combine HBO Max and Discovery+ in the US market mid-April, and roll it out to international markets through ’24.

Why the opportunity exists:

• Over the course of ’22, media stocks were hit hard given macro and secular pressures, with most having gone through significant multiple contraction. However, PARA actually saw meaningful multiple expansion vs peers given the sheer magnitude of their ’23 estimates being cut (EBITDA cut by 45%, FCF flipping from $1bn+ to -$100m) in the same time period.
• Moreover, WBD multiples also faced significant idiosyncratic pressure over ‘22 when 1) T management surprised the market with how the mechanics of the merger would be executed (market expected an exchange offer, instead we got a spin-off) which induced technical selling pressure from legacy T shareholders; 2) estimates revised down from management projections filed in an S-4 given harsher macroeconomic conditions that played out over the course of 18 months since the deal was announced; and 3) WBD inheriting unexpectedly worse assets from the merger, setting back some restructuring efforts.
• On FCF, WBD is too cheap relative to PARA at 7x ’24 FCF vs. PARA at 30x. WBD will grow EBITDA 20%+ in ’23 with FCF conversion of 33-50% (guiding to 60% long-term), while PARA will see EBITDA down 20%+ and burn FCF to the tune of -$800m (including $300m of restructuring costs), before growing EBITDA again and inflecting back to positive FCF in ’24.
• The discrepancy in FCF profile is stark as PARA had been lagging peers in their transition to DTC and had to invest aggressively to catch up, with elevated cash content spend pressuring FCF conversion and will see peak DTC losses in ’23. On the other hand, WBD FCF is supported by moderating cash content spend and synergy realization. Even as I look past near-term timing differences in the DTC ramp, I believe part of why WBD FCF conversion is superior to PARA is due to a higher mix of unscripted content from legacy DISCA. Before the transition to DTC and normalized for M&A, legacy DISCA FCF conversion was ~55%+, while PARA was weaker at ~40%.
• The difference in direction of estimate revisions also makes the pair more compelling. FY’23 guidance turned out to be fine for WBD on the Q4 print, with street FY’23 EBITDA / FCF unchanged for the most part. Moving forward, WBD likely will see positive estimate revisions through the year as they are likely to surprise to the upside on their synergy execution, while Hogwarts Legacy / The Last of Us outperformance are also tailwinds to financial results. On the other hand, PARA has just cut ’23 FCF meaningfully and only expect to see FCF inflect back to positive in ’24, essentially kicking the can down the road such that estimate revisions are likely more rangebound until I get more clarity closer to the end of ’23.

Risks:

• M&A risk
  • WBD and PARA are both viable takeout candidates in an industry that will see further consolidation. I think it is unlikely anything is happening in the near-term under the current regulatory regime.
  • However, if either were to be taken out for the sake of argument, over a three-year time frame I would argue that WBD is a more attractive takeout candidate over PARA. In mid ’24, WBD will lap the 2-year moratorium against M&A per RMT tax avoidance rules and be in a better position to be acquired. CMCSA would have been a likely acquiror of WarnerMedia back in ’22 if not for the regulatory risk T recognized in doing a deal with CMCSA. A transaction with PARA on the other hand is more complex given their broadcast exposure, which limits the buyer pool and introduces additional regulatory challenges should potential divestitures be required.
• High financial leverage (5x) creates a wide range of outcomes depending on how EBITDA holds up given worsening cord cutting and advertising trends.
• Both WBD and PARA are consensus shorts, per Bloomberg WBD has 3% short interest / 3x days to cover, PARA has 19% short interest / 6x days to cover, so there is squeeze risk.

Apologies in advance: compliance policy prevents me from responding to questions in the Q&A thread.

Exhibit 1: ’22 Segment Financials

Exhibit 2: Historical EV / EBITDA

Period from April 2022 (regular way trading for WBD) through June 2022 unavailable given noise in estimates due to spin dynamics.

Catalyst

• Achieving deal synergies target, with quarterly earnings validating successful execution.
• Consistent deleveraging of balance sheet with net leverage going down from 5x in ’22 to below 4x by year end ’23, and expected to hit 2.5-3x gross leverage by ’24.
• Hogwarts Legacy headlines and upside to financial results, DTC relaunch mid-April along with further cost containment and opex cuts to DTC.
• Accretive asset sales that will accelerate deleveraging path.