On Friday, April 8, Discovery and WarnerMedia officially closed their long-awaited merger deal, combining into one entertainment giant in order to drive value creation and take advantage of business synergies.
Trading around $24.20 per share on April 12 for a market cap of $12.23 billion, the newly formed joint venture, now trading as Warner Bros. Discovery Inc. (WBD, Financial), promises to offer a vast portfolio of brands and franchises across television, film and streaming. The WarnerMedia addition could be the shot in the arm that Discovery needs to truly make itself competitive with the likes of Netflix (NFLX, Financial) and Disney (DIS, Financial).
Despite the growth prospects that the combination of these media companies offers, though, Discovery handed over $40.4 billion in cash to WarnerMedia’s previous owner, AT&T (T, Financial), to secure the deal. It also retained certain debts, and AT&T shareholders received 0.241917 shares of WBD for each share of AT&T common stock they held at close on Friday.
It total, AT&T shareholders received 1.7 billion shares of the newly combined company, accounting for 71% of its shares outstanding, while former Discovery shareholders hold the remaining 29%.
The sheer size of this deal begs the question: has Discovery bitten off more than it can chew? Can it really make this deal worth it in the highly competitive streaming market?
Transformation plan
The combined company doesn’t plan to lose any time on integrating its brands and beginning its transformation plan to become a streaming giant. CEO David Zaslav had the following to say on the merger announcement:
"With our collective assets and diversified business model, Warner Bros. Discovery offers the most differentiated and complete portfolio of content across film, television and streaming. We are confident that we can bring more choice to consumers around the globe while fostering creativity and creating value for shareholders. I can’t wait for both teams to come together to make Warner Bros. Discovery the best place for impactful storytelling."
As a leader in informational television content, Discovery undeniably has a unique product to offer customers. In the past, it struggled due to being outshone by the glamour of the entertainment streaming industry, but the company hopes the addition of WarnerMedia will not only eliminate this problem but give it an edge over the competition.
At the end of 2021, Discovery had approximately 22 million subscribers across its direct-to-consumer video services, including Discovery+, while WarnerMedia’s HBO Max and HBO had 73.8 million subscribers. For reference, Netflix ended 2021 with 221.8 million subscribers.
Growing in a crowded market
Even though Warner Bros. Discovery has an attractive streaming lineup to offer the market, the streaming market isn’t exactly new. It’s no longer just Netflix waiting around for even a single competitor to show up; there’s also Disney’s Hulu and Disney+, Amazon’s (AMZN, Financial) Prime Video, Apple (AAPL, Financial) TV and more just in the U.S.
As streaming subscriptions become more numerous and expensive, households become less likely to just subscribe to them all and call it a day. Instead, they will need to carefully pick and choose which options they want to go with – not just because of the expense, but also because no one can consume enough content from all of these services at once to make the purchase worthwhile.
The fact of the matter is, it’s not easy to grow in a crowded market. Incumbents have the advantage since people tend to be creatures of habit, especially with the highly sticky subscription model. Less-established competitors will need to try harder and offer significantly more value in order to entice customers.
Even in this uphill struggle, though, WarnerMedia and Discovery could have an edge for three reasons. First is the unique combination of the brands, second is the fact that they plan to offer a cheaper ad-supported tier and third is Netflix’s scramble to increase profitability as it reaches market saturation.
Netflix has recently raised prices yet again, but more worryingly from the customer’s perspective, it is testing measures to prohibit people from sharing their accounts with family members who don’t live under the same roof. Subscribers that don’t think the service is worth the money if they can’t share it with family might look to other options.
Normally, companies like Netflix have an unshakeable advantage due to their existing market leader positions. However, it is possible to lose this advantage if customers overwhelmingly feel like newer competitors offer better value.
Valuation
With a price-earnings ratio of 16.02, a PEG ratio of 1.09 and a GF Value rating of modestly undervalued, Warner Bros. Discovery appears to be trading below its fair value:
However, there are two main uncertainties that could negatively impact the value opportunity going forward: debt and subscriber growth.
Discovery paid an enormous cash price for WarnerMedia. In order to raise enough cash for the deal, the company issued $30 billion in senior unsecured notes in one of the largest debt offerings in corporate history.
How many new subscribers will the combined company need to attract in order to make that price tag worth it? To give some perspective, in 2021, Netflix’s most profitable year ever, the streaming giant brought in net income of $5.1 billion on revenue of $29.6 billion, with an operating margin of 20.8%. Discovery’s pre-merger operating margin was 16.18% for 2021.
If the company’s streaming services were to immediately attract the same subscribers and profits as Netflix, which would require more than doubling the subscriber base and improving profit margins, it would take roughly eight years for the investment to pay itself off. This cost will be somewhat mitigated by merger-related run cost savings and content production scale.
On the positive side, investors tend to assign much higher earnings multiples to the stocks of companies that are growing their earnings quickly, without regard to debt. We can see this clearly with Netflix; when Netflix was posting high subscriber growth, its price-earnings ratios soared into the triple-digit range at times.
If Warner Bros. Discovery can turn out subscriber growth numbers like Netflix in its heyday, there could be room for multiples expansion. Given the debt level and the difficult market conditions, I will be keeping this stock on my watchlist for now, paying attention to merger synergies, subscriber growth, profit margins and consumer sentiment.
