WBD: Undervalued streaming giant could compete with Netflix

In Peter's Lynch's One up on Wall Street, Lynch argues that spinoffs often result in astoundingly lucrative investments as once they are granted their independence, new management is given free rein to execute on their plans and take creative measures to cut costs and improve company earnings. However, Lynch also states that spinoff companies are often misunderstood by both Wall Street and investors who "dismiss these shares as pocket change or found money". $Warner Bros. Discovery(WBD)$ is an American multinational mass media and entertainment conglomerate formed by the spin-off of WarnerMedia by AT&T, and its merger with Discovery, Inc. Since the merger, WBD shares have been dumped by disinterested AT&T shareholders due to negative sentiment in the streaming sector. At current prices, WBD presents an attractive investment opportunity for investors seeking value in an overvalued market

The Spinoff

In 2021, it was announced that WarnerMedia and Discoer were to combine operations to create a global entertainment leader, with David Zaslav to be the CEO of the new company. The rationale behind the transaction was to unlock significant value for AT&T shareholders and position Discovery shareholders with enhanced long-term growth. Not only will the merger create one of the deepest content libraries in the world, but it is also expected to generate $3B+ in annual synergies that can be reinvested into content and Direct-to-Consumer (DTC).

The transaction was structured as a Reverse Morris Trust transaction (Figure 1) where Discovery contributed 100% of its business and received 29% of common equity and AT&T received $43B in a combination of cash, debt securities and WarnerMedia's retention of certain debt in exchange for 71% of common equity in the merged company.

Figure 1: Structure of newly merged WBD

Investment thesis

1. Strong subscriber growth driven by a diversified content portfolio
2.  Cost-cutting synergies
3. Robust Free-Cash-Flow (FCF) conversion
4.  Strong insider buying

Strong subscriber growth driven by a diversified content portfolio

Unlike $Netflix(NFLX)$ and $Walt Disney(DIS)$ which produce scripted content, WBD's well-diversified content portfolio consists of both scripted and unscripted content. WBD not only produces leading scripted content such as The Sopranos, Harry Potter and Lord of the Rings, but the company also has a network of unscripted channels such as CNN, Animal Planet and TLC. Therefore, Discovery+ provides consumers with access to a variety of media channels which helps to drive interest and subscriptions across the board. While Netflix reported a decline in the number of its subscribers last quarter, WBD experienced a 2 million growth in DTC subscribers from a quarter before. In comparison to Netflix, WBD has stronger IP ownership, franchises and brand portfolio to help it win over customers. Therefore as competition in the streaming space heats up, WBD's moat and stream of diversified revenues should help to protect it from competition and continue driving subscriber growth.

WBD's content library includes lifestyle, sports and entertainment channels

Cost-cutting synergies

In addition to top-line revenue growth, the WBD merger is expected to bring about $3 billion in yearly cost-cutting synergies through an enhanced DTC presence across key criteria. According to Reuters, WBD is looking to cut up to 30% or nearly 1,000 jobs in its global advertising sales team. Management claims that the synergies from the merger will lead to an adjusted EBITDA of $14 billion in 2023, representing a 5.3% CAGR from 2020. Analysts are more prudent on future EBITDA projections, and have estimated EBITDA to reach $13.3 billion in 2023.

Robust FCF conversion

Management is also expecting robust FCF conversion which supports deleveraging, reinvestment and financial flexibility. The company is targeting a decrease in gross leverage from 5x (ttm adjusted EBITDA) to 3x (ttm adjusted EBITDA) 24 months after the merger. This signals that the company is committed to maintaining investment-grade ratings and positioning itself in a healthy financial condition in the long run.

Strong insider buying

Lynch claims that following a spinoff, heavy insider buying could be a signal that the new officers and directors believe in the company's prospects. Guess what WBD's directors and officers have been doing since the merger? Buying shares. 7 out of 7 of WBD's latest insider transactions show that insiders have been scooping up shares of the newly merged company. This supports the view that insiders believe in the long-term prospects of the company and feel that the company is trading below/at fair value

Valuation

Due to the negative sentiment surrounding the streaming industry, coupled with AT&T's shareholders' lack of desire to hold a non-dividend-paying stock, WBD's share price has fallen over 80% since its peak in March 2021 and is currently trading near its all-time low EV/EBITDA multiple of 3.90x. Given WBD's prospects of growth and financial stability, the company should be trading nearer to its mean EV/EBITDA of 8.13x. This means that WBD is roughly undervalued by 100% and its intrinsic value should be around $30 per share. Therefore, I believe that buying WBD stock at current price levels presents an attractive risk-reward opportunity for investors as much of the negative sentiment is already priced into the stock.

Disclaimer: This article is meant solely for informational and educational purposes and does not constitute investment advice. Perform your own due diligence before making any financial decisions.