After U.S. antitrust clearance, AT&T (NYSE:T) is closer to spinning off its interest in WarnerMedia in a merger with Discovery (NASDAQ:DISCA) (NASDAQ: DISCB) (NASDAQ:DISCK). The merger will create Warner Bros. Discovery (WBD), a formidable player in the streaming wars. But before you invest, keep in mind that the newly formed company faces an uphill battle.
The fine print
The deal is expected to close as soon as April if approved by Discovery shareholders. WBD will assume the $43 billion price of the WarnerMedia spin-out as debt, along with Discovery's $15 billion in debt, creating a total gross debt of $58 billion. Between Discovery Plus and HBO MAX, the new company will inherit roughly 94 million paid subscribers.
AT&T will own 71% of WBD, and shareholders will receive approximately 0.24 shares of the new company for each share of AT&T stock owned. Meanwhile, Discovery currently owns the remaining 29% of the future media giant. Discovery will reclassify its three share classes immediately prior to the merger, before automatically converting into WBD common stock.
Warner Bros. Discovery is expected to have a $50 billion to $60 billion market cap -- but before you decide to invest, take a closer look at the company's many red flags.
The bull case
If Disney (NYSE:DIS) has taught us anything with its acquisitions of Lucasfilm, Marvel, and Pixar, it's that intellectual property is a valuable asset. Warner Media has rights to some of the most popular franchises, including DC Comics, Game of Thrones, and Harry Potter. Furthermore, the company owns several television networks including Adult Swim, Cartoon Network, CNN, TBS, and TNT.
WBD will have optionality in bundling its "Direct-to-Consumer" (DTC) options CNN Plus, Discovery Plus, and HBO Max, similar to what Disney has done with Disney Plus, ESPN Plus, and Hulu. With multiple distribution platforms, Warner Bros. Discovery could be well-positioned to capture new subscribers for its DTC products while maintaining its legacy revenue from advertising and subscriptions via cable.
Moreover, WBD has guided for $52 billion in revenue in 2023 -- $15 billion of which will be DTC revenue. For comparison, Disney produced $50 billion in revenue with its media and distribution arm in its fiscal 2021 year -- $16.3 billion of which was DTC revenue. WBD also claims that it will save $3 billion in synergies and expects to convert an impressive 60% of its revenue into free cash flow. For comparison, Netflix (NASDAQ:NFLX) spent $17 billion in content, yet posted slightly negative free cash flow in 2021.
If WBD's free cash flow projections hold, the company could potentially fund a significant slate of movies and TV shows and still pay down its outsized debt -- but that's a big "if."
The bear case
As highlighted, Warner Bros. Discovery will begin its life as a public company with $58 billion in gross debt. Producing content is an inherently capital-intensive business model. In fact, David Zaslav, CEO of Discovery and soon-to-be CEO of Warner Bros. Discovery, says WBD plans on spending $20 billion on content for 2022. Therefore, with projected revenue of $39 billion in 2022, WBD believes it will make $23.4 in free cash flow, leaving the company only $3.4 billion to pay down debt. At that rate, it would take over a decade for for WBD to pay off what it owes. And even as revenue grows, the new media company's content costs will most likely grow each year. For comparison, Disney is expected to spend $33 billion on streaming content for its fiscal 2022, up from $25 billion in fiscal 2021.
Warner Bros. Discovery has other challenges as well. Warner Media's advertising revenues for its TV networks were down 13% in 2021 "primarily due to lower audiences." By 2021, 55.7 million U.S. households had "cut the cord," or never paid for cable or satellite TV -- a number that has tripled since 2014 -- according to nScreenMedia, a site that analyzes how people watch TV and other entertainment at home. With several major television networks in its portfolio, WBD will be pressed to figure out how to unlock value in declining assets.
Additionally, Warner Bros. Discovery won't have same-day streaming releases for its theatrical movies in 2022 -- a factor that led to an uptick in sign-ups for HBO Max in 2021. For example, HBO Max received nearly 450,000 sign-ups on the day Wonder Woman 1984 was released, according to the Wall Street Journal and Antenna. Furthermore, streaming services are dealing with higher churn rates with increased competition. Antenna's data shows that roughly half of U.S. viewers who signed up within three days of the release of Wonder Woman 1984 had stopped paying for HBO Max within six months.
With a merger imminent, WBD has the potential to be a highflier with offerings that rival the likes of Disney and Netflix. Look to future announcements and earnings to see whether the company can successfully navigate a heavy debt load and declining traditional TV offerings by growing its subscribers for its streaming services. Either way, you may want to wait on the sidelines until WBD's origin story is complete.