Warner Bros. Discovery (WBD): All eyes on Q3

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Mike Coppola

Thesis

Warner Bros. Discovery’s (NASDAQ: WBD) The Q2 results, published on August 4, clearly disappointed. I have already reviewed the quarter already last month. But given analysts’ low expectations for the third quarter (scheduled for early November), I think further analysis of WBD T2 results may be necessary or useful.

In my opinion, there is no good reason why the T3 should be as disappointing as the T2. In fact, in the context of restructuring efforts following the integration of Warner Bros., I argue that management spending and write-offs were overly aggressive in the second quarter, resulting in unnecessarily low results. As a result, investors may have now lowered their expectations for the third quarter, which I think WBD is likely to easily beat.

For reference, WBD stock is down about 55% since Discovery took over the Warner Bros. business. from AT&T (T).

WBD versus SPX

Looking for Alpha

Accounting for the second quarter deep end

Reflecting on a sharp stock price depreciation and disaster Q2 2022, an analyst could easily argue that Discovery’s merger with Warner Bros. was a disaster (the net loss in the second quarter was $3.4 billion). But the Q2 data point is more complex than the numbers imply. During the June quarter, Warner Bros. Discovery has no doubt taken what is describe as “Big Bath Accounting” (or also called Bloodbath Accounting): I argue that management spending and write-offs were overly aggressive in the second quarter, leading to unnecessarily low results. Such a “technique” seems to be highly appreciated by the management teams of companies after a major merger.

That said, during the period from April to the end of June, the management of Warner Bros. Discovery has delivered a lot of bad news to investors. Here are some considerations:

Management assessed $2.0 billion of intangible asset impairment, $1.0 billion of restructuring expenses and an additional $983 million of transaction and integration expenses.

To see how tightly management acted with its finances, consider the movie Batgirl, which cost the company an estimated $70 million in sunk cost. As a manager who prides himself on being cost-focused and battling the irrationality of the DTC streaming economy, how likely is Zslatav to cut a nearly completed $70 million movie? Unlikely, in my opinion. But the $70 million write-down is very timely for the big bath accounting.

Additionally, WBD lowered investor expectations for DTC streaming activity. The company undertook a substantial downgrade of the company’s subscriber count by around 10 million.

Analyst expectations for the third quarter

Reflecting on the Q3 estimates, I have a feeling that analysts misjudged the “Q2 bloodshed accounting” – they presumably don’t think WBD management anticipated all the bad news.

According to data compiled by Seeking Alpha, as of October 20, 17 analysts have submitted their estimates for WBD’s third quarter earnings. Total sales are expected to be between $9.9 billion and $11.38 billion, with the average estimate being $10.41 billion. So the dispersion is actually very wide – highlighting the disagreement among professional analysts. But, if an investor were to take the average as an anchor, WBD’s third-quarter sales are expected to contract about 3.7% from the June quarter. I think that’s unreasonably pessimistic.

EPS estimates range between $0.51 negative and $0.49 positive. The average is -$0.02. Again, I think the consensus is overly pessimistic. If WBD management really threw everything into the bloodbath in the second quarter (so, assuming my thesis is correct), then I’m having a hard time seeing how the company can push an estimated $3 gross profit $.2 billion into negative territory.

Reflecting on analysts’ expectations for WBD’s September quarter, I argue that it is reasonable to assume that WBD could beat consensus analyst forecasts. And therefore, there could be a nice surprise price appreciation after the third quarter.

Evaluation

At this point, it’s worth considering that WBD is trading pre-Q3 earnings very cheaply. For reference, if you compare WBD’s valuation against its peers, you note that WBD’s forward EV/EBITDA multiple for 2024 is valued at around -45% discount to the industry and that the P/B multiple is valued at a discount of around -60% (Source: Bloomberg Terminal, EQRV October 15).

For reference:

  • Disney (DIS) is trading at EV revenue of 2.8x EV/EBITDA of 18.8x.
  • Netflix (NFLX) is trading at an EV/Sales of 3.6x and EV/EBITDA of 18.2x.

This compares to WBD’s 2024/2025 EV/Sales estimates of x1.4 and EV/EBITDA of x10 (Source: Bloomberg Terminal, EQRV October 15).

As I understand that multiples might not provide an accurate valuation benchmark, here is what I previously calculated for Warner Bros. relative multiple analysis. Discovery (1), the sum of the parts valuation (2) and the residual benefits framework (3).

My previous article on Warner Bros. Discovery included the following evaluation summary:

Warner Bros. Discovery is just too cheap to ignore. In this article, I’ve highlighted three valuation patterns, all of which indicate over 100% upside for WBD.

(1) The relative multiple comparison indicates a $42.9 target price.

(2) Assessing the sum of the parts involves $24.60 as fair.

(3) The residual gains model calculates a $27.51 target.

Debt remains the major risk

All is not perfect for WBD. In my opinion, the major risk factor for shareholders remains the company’s excessive indebtedness. As of June 30, it had gross debt of about $53.0 billion, compared to cash and short-term investments of just $3.9 billion. Compared to the estimated 2024/2025 EBITDA, the leverage effect is x5, which is clearly too much.

However, I would like to emphasize that from 2022 there is little interest rate and/or refinancing risk. WBD’s second quarter results highlighted that the average duration of the company’s outstanding debt is approximately 14 years, with an average cost of 4.2%.

Conclusion

In my view, the market is pricing too much pessimism for WBD stocks. And a disastrous Q2 certainly didn’t help lift sentiment. But going into Q3, I like the negative setup, which I think makes WBD stock vulnerable to an upside surprise.

Given the opportunity for strong near-term price appreciation, coupled with a potential long-term valuation of over 100%, I am confident to reiterate a strong buy recommendation for WBD shares.

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