Investors have trashed the media giant’s stock, but through the lens of one of Warren Buffett’s favored metrics the baby might have gotten thrown out with the bathwater.
By Brandon Kochkodin, Forbes Staff
There are plenty of reasons to doubt Warner Bros. Discovery.
The media giant was formed in 2022, born from a $43 billion merger between AT&T’s WarnerMedia and Discovery. The marriage brought together a trove of content, ranging from the Barbie movie and Looney Tunes to Harry Potter, HGTV, and HBO, and initially boasted a market capitalization matching the deal’s $43 billion price tag. So far, that’s proven to be the high watermark. Its shares have languished since, with market capitalization plunging to just $18 billion, largely due to what Wells Fargo analyst Steven Cahall called “post-merger growing pains” after its second-quarter earnings announcement last year.
If the situation described by Cahall was painful almost a year ago, things have gotten even worse.
In the first four months of this year, Warner Bros. Discovery shares are down 30% falling from $11 to under $8. Like other traditional media and entertainment companies, WBD is facing a weak advertising market, the rise of so-called cord cutting and the high costs of making new shows and movies. There are also concerns over Warner’s ability to retain NBA broadcasting rights. At the end of April NBCUniversal offered to pay $2.5 billion a year for the contract, twice what Warner Bros. Discovery was paying. The threat of losing the NBA contract alone caused WBD’s stock to fall by 10% in a single day. On top of all of that, investors are upset about CEO David Zaslav’s lavish pay; he was awarded a 27% raise in 2023 bringing his annual compensation to $49.7 million –the second highest among major media execs behind Netflix’s Ted Sarandos.
But cut through the negative chatter, and you will find that Warner Bros. Discovery’s financial statements are stronger than they’ve been in years. Its free cash flow—defined as the amount of cash a company has left after paying for operating expenses and capital expenditures —has soared from $2.4 billion the year before the merger to more than $6 billion in 2023. With the stock languishing, its free cash flow yield per share of 30% is now the highest among S&P 500 companies, topping American Airlines 20%. In fact, only 32 companies in the index have free cash flow yields over 10%, while the average and median yields hover around 4%. It is no coincidence that a large part of Zaslav’s lavish 2023 payout was tied to free cash flow targets in his bonus plan, which he far exceeded thanks to heavy cost cutting.
“I’m scratching my head about why the market is so nervous about this,” Seaport Research Partners senior analyst David Joyce says. “The market isn’t giving companies still exposed to the linear network model any credit. I think that’s throwing the baby out with the bathwater.”
SUFFERING SHAREHOLDERS!
Despite a 40% one year decline in Warner Bros. Discovery’s stock, CEO Zazlav’s bonus, which is tied to WBD’s growing cash flow, has ballooned.
Joyce and others think investors should consider Warner Discovery’s cash flow in addition to its earnings per share. This less followed metric tells investors how much cash a company has left for paying down debt, buying back shares, or paying out dividends without having to borrow more money or dip into reserves.
In fact a 2017 study in the Financial Analysts Journal found that cash flows are more predictive of future stock returns than earnings. The researchers concluded, “from an investment perspective, investors may be able to obtain better information about investment prospects—and thus future stock returns—by relying on cash flows that disaggregate operating cash flows from financing, tax, investing, nonoperating, and nonrecurring activities rather than relying on income statement profitability measures.”
Free cash flow and its derivative, free cash flow yield, are also favorites of value investors like Warren Buffett known for using discounted cash flow analysis, which calculates the present value of a company’s future income streams. Buffett has referred to free cash flow as “owner earnings.” In 2000, he detailed his preference for this measure relative to other commonly used fundamentals in Berkshire Hathaway’s annual letter to shareholders:
“Common yardsticks such as dividend yield, the ratio of price to earnings or to book value, and even growth rates have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business,” Buffett wrote. “Indeed, growth can destroy value if it requires cash inputs in the early years of a project or enterprise that exceed the discounted value of the cash that those assets will generate in later years.”
STREAMING SNAPSHOT
Based on its most recently available filings, Warner Bros. Discovery’s Max streaming service is closing in on 100 million subscribers.
One billionaire investor already keen on Warner Brothers Discovery’s prospects is hedge fund manager Seth Klarman of Boston’s Baupost Group, with $27.4 billion of assets under management. Similar to Buffett Klarman is a dyed in the wool Benjamin Graham acolyte. His out-of-print 1991 book “Margin of Safety” is so prized by value investors that used copies sell for as much as $6,000 today.
Klarman took a big stake in WBD during the second quarter of 2022, when the stock was selling at more than double its current price, and according to its December 2023 13-F filing, the stock constituted over 6% of Baupost’s portfolio. Baupost is required to report its first-quarter holdings by May 15th, which will reveal whether they have increased or decreased their position since the last filing.
What has Warner Bros Discovery been doing with its ample cash flow? Paying down debt. Post merger, Warner Bros. Discovery’s debt ballooned to more than $56 billion—up from Discovery’s $16 billion prior to the merger. However, by the end of the last fiscal year, this amount was reduced to $47.29 billion, a reduction that CEO David Zaslav highlighted during the company’s most recent earnings call in February.
“Our top priority this year was to get this company on solid footing and on a pathway to growth, and we’ve done that,” said Zaslav. “We said we would be less than 4 times levered, and we are. We paid down $5.4 billion in debt for the year for a total of more than $12.4 billion since the deal closed. We’re now at 3.9 times and expect to continue to de-lever in 2024.”
Debt reduction may not be the only priority for Zaslav, a former corporate lawyer, known for his grand ambitions and reviled by many in Hollywood. At the end of last year, there were reports that Warner Bros. Discovery was considering a merger with Paramount Global, which owns Paramount Pictures, CBS, and Nickelodeon, among other assets. However, those discussions reportedly stalled in February after two months of negotiations.
For now, Warner Bros. Discovery must rely on organic growth. Seaport Research Partner’s analyst Joyce is eagerly watching for signs of improving advertising growth across the company’s various platforms, particularly on Max, its streaming service. As the company prepares to announce its earnings on May 9th, FactSet analysts predict that advertising revenue will be around $2.2 billion for the first quarter, roughly in line with the $2.3 billion reported in the same period last year.
“I do think they’re going to generate more than $4 billion in free cash flow this year, which will help them de-lever,” Joyce says. “They’re executing on their Max streaming strategy by starting to layer ads on, but it’s too early to see that in the results. For now, the market has been overly fearful and pessimistic.”
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