Warner Bros. Discovery's Streaming Business Is Almost Profitable

Some of the biggest recent hits in the world of streaming TV have been on Warner Bros. Discovery's (WBD 4.33%) platforms. The White Lotus, Succession, House of the Dragon, and The Last of Us are all massively popular.

The company has had no issues creating hit shows and must-watch TV. HBO has a long legacy of creating some of the best shows on television, and that legacy lives on as the age of streaming radically changes consumers' viewing habits.

The problem for Warner Bros. Discovery is translating its knack for creating quality programming into profits. The company took a big step forward on that front in the second quarter.

New sources of revenue

The flagship HBO Max streaming service was rebranded as Max in the second quarter. The service contains content from both HBO and Discovery, mixing the quality of HBO with the reality-focused programming of Discovery.

While the company gained subscribers on a year-over-year basis, the subscriber base shrunk by about 1.8 million in the second quarter. Warner Bros. Discovery ended the quarter with 95.8 million subscribers, 54 million of which are in the United States. It should be noted that the company includes the non-streaming version of HBO in its direct-to-consumer segment, so the number of pure streaming subscribers is lower.

Despite the decline in subscribers, direct-to-consumer revenue rose 13% year over year and 11% sequentially. Higher average revenue per subscriber helped the situation, with global ARPU jumping 3% from the first quarter to $7.71. The biggest factor, though, was an increase in content revenue.

Warner Bros. Discovery generated $410 million in revenue from content within the direct-to-consumer segment in the second quarter, more than double what it generated in the first quarter. The company has stopped the strategy of locking up shows within its own platforms.

Some shows, including the canceled Westworld, have been licensed out to third-party ad-supported services. These shows likely hold little value in terms of attracting new subscribers and retaining existing subscribers, so it makes sense for the company to try to wring as much revenue as possible from them.

In July, Warner Bros. Discovery took a more audacious step of licensing a selection of shows to streaming rival Netflix. The company's back catalog of once-popular shows has the potential to grow licensing revenue significantly, but bringing some of its shows to Netflix certainly isn't going to help with subscriber growth.

Higher direct-to-consumer revenue pushed adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA) for the segment to a loss of just $3 million, compared to a loss of more than $500 million in the prior-year period. The company's goal is for the U.S. direct-to-consumer business to be profitable on an adjusted EBITDA basis this year and the global direct-to-consumer business to generate at least $1 billion in adjusted EBITDA by 2025. With content licensing growing, Warner Bros. Discovery is well on its way.

An uncertain future

Warner Bros. Discovery stock looks extremely inexpensive. The company expects to generate free cash flow as high as $5 billion this year, which puts the price-to-free-cash-flow ratio at just 6. But there are two things investors need to be worried about.

First, Warner Bros. Discovery has a lot of debt. The company made progress paying down that debt in the second quarter, but net debt still stood at $44.7 billion. About 37% of this debt comes due within the next five years. The average interest rate stands at 4.6%, but that number could rise as debt is refinanced at higher rates.

Second, most of the company's profit comes from its networks business. Streaming profits may not grow quickly enough to offset declines in networks profit, which means that once the company's cost-cutting efforts are complete, the bottom line may be in for a prolonged decline.

Investing in Warner Bros. Discovery is a risky proposition, although the valuation is so low that the stock could soar if the networks segment can pump out profits long enough for the streaming business to catch up. That's far from a guarantee, although the new strategy of licensing content should help the cause.