Warner Bros. Discovery (WBD -0.35%), formed earlier this year when telecom giant AT&T spun off WarnerMedia and merged it with Discovery, has all the makings of a media giant. The company's stable of intellectual property and assets is formidable: HBO, DC Comics, Warner Bros.' films, linear TV channels including CNN, TBS, TNT, Cartoon Network, HGTV, TLC, Discovery, and many more, and rights to broadcast NBA games all fall under the company's umbrella.
Warner Bros. Discovery is also already a major player in streaming. Combined, its direct-to-consumer business, which includes HBO, HBO Max, and Discovery+, had 94.9 million subscribers at the end of the third quarter. HBO Max recently got a boost with the release of Game of Thrones spinoff House of the Dragon, with each episode drawing an average of 29 million viewers in the U.S.
While Warner Bros. Discover has great assets, there are two things working against it. First, CEO David Zaslav has the unenviable task of combining Discovery, which he has led since 2006, with WarnerMedia. As reported by CNBC, Zaslav stepped into a giant mess. Spending at WarnerMedia when AT&T owned it was out of control, and Zaslav concluded that the business had been mismanaged.
Second, Warner Bros. Discovery's balance sheet is downright frightening. The company has a total debt of $50.4 billion, with just $2.5 billion of cash on hand. Interest payments in the third quarter alone totaled $555 million. This would be less of a problem if the company was churning out cash, but it's not. Elevated costs and a tough advertising environment led to a free cash flow loss in the third quarter.
Shares of Warner. Bros Discovery have tumbled 65% from their peak, reached soon after it debuted earlier this year. The company's market value is just $26 billion. With pessimism running extremely high, should bargain-hunting investors plug their noses and buy?
A risky turnaround play
Warner Bros. Discovery's balance sheet is the biggest risk facing the company. The company needs to start generating free cash flow as quickly as possible, not only to service that debt but also to pay it down. Any debt that Warner Bros. Discovery needs to refinance is likely to result in higher interest payments, given how much interest rates have risen this year.
More than $13.6 billion of senior notes mature within five years, and those notes carry a weighted average interest rate of 3.6%. The company also has $4 billion of term loans that mature in less than three years. Any debt that ends up being refinanced is likely to be more expensive, so there's a strong incentive for the company to pay down some of this debt as it comes due.
While the balance sheet puts the company in a race against time to turn itself around and get its cash flow situation in order, Warner Bros. Discovery has no shortage of long-term potential. Managed correctly, the combined streaming app the company is working on -- rumored to be called "Max" -- could be a cash machine. But that will require discipline when it comes to content costs, which is not all that common in the world of streaming.
DC Comics also represents a big opportunity. While some movies based on DC characters have been successful, that success pales in comparison to the blockbuster factory that is Disney's Marvel. The company has hired filmmaker James Gunn, known for directing Marvel's Guardians of the Galaxy franchise and DC Comics' The Suicide Squad, to co-lead DC Comic's film and TV unit and attempt to turn the business into something closer to Disney's Marvel.
A lot to prove
Warner Bros. Discovery expects to produce around $12 billion of adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) in 2023, although there's plenty of uncertainty around that number. It expects to convert between 33% and 50% of that total into free cash flow. If the company's forecast bears out, it's looking at between $4 billion and $6 billion of free cash flow next year.
Whether the company hits these forecasts depends on its success in cutting costs without hurting the performance of its various business units, as well as how the economy and advertising industry evolve over the next year. The streaming business is losing money, so for now, the networks segment will be responsible for churning out profits. Given the ongoing decline of linear TV and the chance of a recession next year, that's not a comfortable place to be.
Anyone considering investing in Warner Bros. Discovery or deciding whether to hold onto shares received from AT&T's spinoff should understand that this is a high-risk, high-reward investment. If the company can prove that it can consistently and sustainably generate billions in free cash flow each year, the current market cap will look like a steal in a few years.
On the flip side, the number of things that need to go wrong for the stock to be a long-term dud is small. Even if the company does everything right, a bad economy combined with a lousy balance sheet is enough to derail the turnaround effort.
One thing is clear: Investing in Warner Bros. Discovery is not for the faint of heart.
