Summary
- Warner Bros. Discovery is considering a bifurcation into two standalone entities, one for linear assets and one for direct-to-consumer assets.
- The potential spinoff could result in significant gains for shareholders but also poses risks and challenges, including legal battles with bondholders.
- Despite the possibility of a spinoff, Warner Discovery faces operational challenges, including declining box office performance and pressure on its studio segment.
- The likely loss of the NBA, or the much higher costs to keep it, will further pressure the Networks segment, which is Warner's largest cash generator by far.
- The potential of the new spinoff plan for shareholders is real, but the company seems to lack a plan B if the spinoff is blocked or otherwise foiled. A Warner investment remains a major risk. I rate Avoid.
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Warner Bros. Discovery (NASDAQ:WBD) is one of the most interesting stocks in the market right now, and I mean that in ways both good and bad. In fact, the sheer quantity of different news developments engulfing the company all at once right now almost defies counting.
However, there is now another story developing, and this one might trump all the others: according to reports, Warner management is seriously considering a bifurcation of the company itself into two different standalone entities, one for linear assets and one for direct-to-consumer assets; the latter would presumably include the Warner Bros. studio.
Is this even feasible? And what are the implications for shareholders if it happens? The short answer is, quite possibly yes and probably very good. However, the fact that such an act is even being contemplated is an indication of just how far the two-year-old conglomerate's once lofty ambitions have fallen.
What's more, the necessity of the maneuver speaks to the tremendous risk to shareholders if such a gambit is tried and fails, as risks and headwinds to its existing business continue to strengthen.
Spinoffs And Blastoffs
The reports come courtesy of the Financial Times, but frankly, they're almost certainly just a middleman for a message that management wants to see put out there. The report came a single day after the disclosure of a new research note written by noted media industry analyst Jessica Ehrlich that Warner's existing business model "is not working" and suggesting "exploring strategic alternatives." Ehrlich went through a few possibilities, but a prime position was given to the suggestion of a linear/streaming spinoff. One day later, management is signaling that it is open to her suggestion.
The short-term effect of the reports alone has been positive. Warner stock is up 15% in the last two days on Ehrlich's note and management's exploration of options. It's a welcome reprieve for a ticker that has fallen 75% in the nine quarters since the merger was closed. But that won't last if it can't actually happen.
So, can it?
The Rise Of The "Cov-Lite" Deal
Ordinarily, I would say that something like this had no chance. The reason is that under the proposal as it currently seems to be percolating, veritably all or almost all of Warner's crippling $40 billion in debt would be left behind with the linear assets, while the growth assets of tomorrow went off debt-free in a new company, owned by the same shareholders. Such a move would represent a massive transfer of wealth from bondholders to shareholders; there is almost no chance that the linear assets could pay off the debt before they expired completely, for reasons I've already covered well elsewhere.
Usually, bondholders have covenants up the wazoo on their debt to prevent just these sorts of shenanigans from occurring. However, these are not normal times. Or more specifically, they are normal times, but the lingering effects of less-normal times are still with us.
During the COVID lockdown, and to a lesser extent ever since the Great Financial Crisis, Quantitative Easing has left bondholders ever more desperate to find any sort of yield in debt markets, to the point that by the end of 2021, so-called "covenant-lite" bonds had become more or less par for the course.
Now, as times normalize - in some ways to the most normal they've been since 2007, with the federal funds rate back at the 5.25% it peaked at before the housing bubble burst - more and more companies whose stocks have been hammered by rate hikes and technological disruption are seeing ways to use those "cov-lite" openings to their advantage.
Hollywood is already no exception, even before this latest report came out. Lions Gate (LGF.A) (LGF.B) swept its most valuable assets into a new subsidiary and took about half of its 2029 tranche of senior debt with it, leaving the other half and the rest of the bondholders out in the cold with recourse only to the other, far less valuable assets such as Starz. EchoStar (SATS) is trying to stave off bankruptcy a little longer by finding loopholes in its bond covenants to eliminate encumbrances on assets to procure new, secured financing. It's not a surprise a failing company would try that; it's surprising how many loopholes they're finding.
Running The Numbers
So yes, as hard as it is to believe that those responsible for $40 billion of investors' bond money could have left the door open to this, it does appear that Warner could very well get away with this. And if they did, the results for shareholders would probably be stupendous.
Currently, Warner Discovery is trading at an Enterprise Value of around $60 billion, with roughly two-thirds of that in debt and the last third in equity. It does this despite finances that can only be characterized as challenged, to say the least. When he was selling the merger to Wall Street, Zaslav promised that Warner Bros. Discovery would close out 2023 with $52 billion in revenue and $14 billion in EBITDA. When Warner reported its 2023 10-K numbers, the actual EBITDA number was $10.2 billion and revenue was almost $10 billion below the projection.
I'm not such a fan of EBITDA as a metric, either. Reporting what earnings the company would have if you ignored its capital expenditures (the Depreciation and Amortization expenses) is a little like reporting how much credit card debt you could clear if you didn't have to pay rent. Warner's 2023 operating income was negative $1.5 billion.
"GoodCo" Profits For Shareholders
If indeed the company did take all its non-linear assets and run, leaving bondholders and linear rightsholders to fight over the carcass, it would only need to generate $1 billion a year in profit from those assets to break even on the trade at a 20 P/E ratio. Anything above that would be gravy. Essentially, this would entail moving the DTC and Studios segments to a new company, while Networks stayed behind.
Considering that HBO alone was generating $2.5 billion a year in operating income five years ago, such a bar doesn't seem hard to clear. Just returning to that level, without a debt burden to service, could well push the stock up 50% even if all the Corporate segment negative EBITDA followed to the new company. If only half of it did, a doubling of the share price could not be ruled out.
Crashing Back To Earth
But before shareholders start celebrating, there are a couple of headwinds to keep in mind.
"BadCo" Losses For Bondholders
The first is simply that while a maneuver like this might (or then again, might not) be legally permissible, it does not follow that it would be legally wise. Just because bondholders might not be able to stop it doesn't mean they wouldn't try. EchoStar's bondholders are already suing; Lionsgate's may well follow suit. And a trial could cripple the company for months or even years, freezing it in place and not only stopping the spinoff but preventing them from pursuing any other opportunities that might develop in the interim as courts tried to get to the bottom of the issue.
The bondholders would, in fact, have little reason not to pursue such a strategy. The downside of such a windfall for shareholders is that it is coming straight out of bondholders' pockets; with only the linear assets to secure their debts an eventual haircut in bankruptcy of as much as 50% or more doesn't seem unreasonable. This is because even if Networks' 2023 operating income of $3.3 billion went entirely unimpaired and flowed entirely to the bottom line, and even if linear survived until the end of the decade before collapsing, it would only generate $19.8 billion. And then there's the fact that those are some incredibly generous assumptions.
It seems highly unlikely that bondholders would take that kind of a loss without a knockdown, drag-out fight.
Market Multiplier Risks
There is also the issue of multiple expansion, or lack thereof. Markets price stocks not only according to what they generate today but how sustainable that generation is. And lately, Warner's studio and streaming assets just haven't felt the love.
I thought it was particularly instructive to watch the stock's behavior during the pivotal showdown between Disney (DIS) and Charter (CHTR) cable last year. Disney shares fell 2.2% the day the blackout went public and Charter held its famous investor conference call. However, Warner Discovery shares fell 10.2% the same day.
Investors have proven time and again that they see Warner Discovery as a linear TV company. That's not so surprising considering that of its $10.2 billion in Adjusted EBITDA that Warner bulls and management put so much stock in, over $9 billion of it was generated by the Networks segment.
So it's easy to see why investors get extremely antsy when told that linear's time of death estimate is (again) moving up. How much more nervous would they get if they were told that the linear cash cows were leaving the nest entirely? Warner might find its new spinoff creation strengthening its balance sheet, only to fail to be rewarded for it by the market.
Confessions Of Weakness; Operational Challenges
There is one final consideration: this kind of bondholder shafting is not the kind of risk a company takes if its underlying operations are performing well. This is the kind of maneuver you make when you are distributing losses, not profits. Regardless of whether you think it can work or not, just the fact that this is being considered speaks to the ongoing operational challenges Warner Discovery faces.
This article is getting so long already that I need to do this part condensed style. But Warner is beset by new and growing challenges on a wide variety of fronts. A lot of these I've covered before and won't repeat. Just in the past few weeks alone, however, the bad news has continued to pile up. Warner has had a rather dismal summer at the box office; multiple titles have not only fallen below expectations but almost certainly will fail to recoup their budgets.
Cracks have perhaps begun to emerge in Warner's new Venu troika with Fox (FOX) and Disney, as Zaslav described a substantially different app architecture and product access rules than the leaked Venu beta that Fox, which is leading the technological development of the service, has already admitted is genuine. Warner's position in Venu is already tenuous since it lacks NFL and, soon, NBA content, which I'll come back to.
Meanwhile, Warner's pending streaming bundle with Disney remains without an official price, and a long-expected hike in price for in-house service Max has yet to materialize, as evidence grows that consumer backlash against price hikes may be sufficiently severe to put the revenue gains of price increases in question.
Merger Shutdown?
Even before the latest reports, it was already expected that Warner would seek to use (yet another) merger to address these issues. Hence, CEO David Zaslav's pleas for antitrust leniency, so that he can merge his company with another studio and increase his pricing leverage over consumers.
But these are increasingly in question as President Biden's handpicked FTC Chairwoman continues to challenge mergers across American industry and President Trump selected perhaps the most anti-merger Republican in the Senate as his running mate.
In short, it is not clear that Warner can bundle or merge its way out of trouble.
Operational Analysis: No Spinoff
That leaves growing its way out, as a single company, which is what any competent operator should always seek to do first, anyway. And because Networks is such a predominant source of cash, any operational analysis of a Warner Discovery that remains intact and whole has to begin with its increasingly single-track approach to profit.
Networks
It was recently announced that truTV, Turner's old reality TV flagship, is being converted to a full-time sports network. None of its games will be exclusive; Warner is seeking to tap into ESPN's trick of having alternate broadcast options for the same NBA and NHL games. The fact that management would rather do that than broadcast even the relatively inexpensive reality-TV fare that truTV was created for speaks to not just the centrality, but the single-minded devotion to sports in Turner today. Increasingly, to the exclusion of all else.
But the scary thing is that even this strategy may not carry Turner much further. We have (finally!!) reached the conclusion of the far too drawn-out NBA contract saga, with official contracts being delivered to Disney, Amazon (AMZN), and Comcast's (CMCSA) NBCUniversal, who are threatening to usurp Warner's place in the NBA hierarchy and end the company's four-decade-long relationship with the league. More than threatening, in fact; the NBA has made clear that it considers the matter closed.
But Warner is signaling not so fast. It has a series of vaguely defined matching rights, which it has said it will use to essentially Shanghai Amazon's portion of the deal for itself.
I could write a whole article just about this climactic showdown between two of the biggest players in media, and in fact, I hope to do so. But for the moment, suffice to say that the most optimistic Wall Street analyst I've seen thinks it would cost Warner $600 million in lost annual profit to forego the NBA entirely.
I have explained before that these estimates are, to my mind, far, far too low. The real hit probably starts with a 'B' not an 'M'. I have estimated the hit to Warner at anywhere from $1.2 to $2.2 billion per year…and Networks only generates $3.3 billion in operating income.
And this is only from the NBA hike/loss. Cord cutting also continues unabated, which is putting additional pressure on the linear networks.
Studios
Pressure on Studios, the only other segment reporting major EBITDA, also will likely continue. As rough as Warner has had it at the box office, its peers haven't had it much better. A few weeks ago, I said that the industry as a whole would be lucky if the Q2 2024 box office tally reached 70% of 2023's, which would only be about half of 2019's.
As it turned out, the industry wasn't so lucky. As I've explained before, Warner and Disney are the principal beneficiaries of the existing theater system, but that system depends on what is effectively a cross-subsidy system from the other studios. If those studios decide that they no longer wish to participate in such a scheme, there isn't really much Warner can do about it. And since theaters themselves are largely a fixed-cost operation whose costs need to be covered, box office underperformance usually winds up not being split evenly, but falling hardest on the studios.
Investment Summary
Simply put, the merger Zaslav sold as a boon has turned into a complete bust. Almost immediately after these reports began leaking, the business community began the recriminations; as Business Insider put it, this is basically Zaslav's white flag that he probably doesn't know how to make his media conglomerate - all but custom-built to his specifications - work.
And before shareholders buy in with the expectation of a quick, financial engineering style payday, they should consider that if that does not come to fruition there very well may not be a plan B; Zaslav may not have a plan to fix the operational problems that ail Warner Discovery.
While I think there is a very real possibility that Warner could pull off such a spinoff as has been reported, the danger that it cannot would still be very real, and then there is the fact that it's not clear what shareholders can look forward to if such a spinoff plan does not come to fruition.
I am maintaining my Avoid on Warner Discovery.
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