What happened?
Today the market finally gave long overdue credit to Discovery (NASDAQ:DISCA) (NASDAQ:DISCK) as BofA upgraded them to a buy rating. Discovery has been well covered on SA and I believe it still remains one of the best risk/reward opportunities available to investors.
However rather than regurgitate the obvious valuation potential of WBD, I want to talk about why this has happened (16% intraday rally) and what it demonstrates for individual investors.
Discovery historically has been a flat business (not accounting for the Scripps acquisition) for several years as it struggled with its slowly declining broadcast business. Stock price performance has been very poor over the last number of years for Discovery.
Source: Seeking Alpha
The valuation has largely been flat for the last 5 years. In 2020 management launched a new direct to consumer platform (Discovery Plus – currently 20M+ subs) in order to help steer to the company in a new direction away from broadcasting. Management also announced their intentions to merge with AT&T’s (T) WarnerMedia for $43 billion. Even though AT&T bought WarnerMedia for $85 billion, they are selling at a huge loss as they have been unable to fully utilise the asset.
By merging with Discovery (29% equity for DISCK shareholders), management can repackage the content and push HBO Max internationally. It’s still unclear how management will utilise the content, whether the platforms will be separate at first or be bundled together before being pushed on consumers. However Discovery management are significantly better suited than AT&T to integrate WarnerMedia in their business. Management have guided $3 billion in cost synergies which are likely to be closer to $4 billion according to John Malone.
Based on the post-merger financials ($14 Billion EBITDA in 2025 / 60% FCF conversion) and growth prospects thereafter as the new media company spends $20 billion on new content. Discovery looks like a turnaround play as they roll out a more profitable and consumer-friendly DTC platform. I say consumer friendly as management intend on using a hybrid pricing strategy different to Netflix (NASDAQ:NFLX) and Disney+ (NYSE: DIS).
Users have the option of paying two different prices – one with a lower rate that includes adverts and second more expensive monthly plan that is completely ad free. The lost revenue from the lower priced plan is expected to be offset by selling advertising space which Discovery management are very well experienced in. The idea being Discovery will be able to appeal to more users by offering a hybrid pricing plan.
To successfully attract consumers to a DTC platform, content must be top quality and appeal to consumers, secondly the content library must be large and growing, and lastly it must have attractive pricing. WBD will have all of this to a degree and the benefit Discovery get is a highly scalable streaming platform that can be pushed internationally.
Furthermore the valuation has been (still is) completely irrational. A previous SA author has done a piece with an initial DCF based on S-4 forecasts which I believe are conservative.
So Why Is the Market Ignoring Discovery
Price action influences sentiment even on Wall Street:
In markets we see sentiment change as price moves. Discovery fell victim to the Archegos Capital blowout in March 2021, as banks raced to reduce exposure. After we saw several quarters of downward pressure on the stock. Many banks maintained a neutral rating after May when the potential merger was initially announced; even now Wall Street still has 14 hold ratings on Discovery. Why aren’t most analysts giving Discovery a buy rating, what estimates are they using or are they valuing Discovery as a standalone business?
Wall Street doesn’t benefit from providing forward thinking stock picks, and Discovery is an example of that. Rather Wall Street benefits by convincing clients to trade whether that means buying or selling a particular security. Therefore an idea has to be convincing to the client – largely recent price action has a part in that. If the above isn’t true, then Wall Street is too slow.
Worries of debt without research:
One argument from the bears that tends to come up is the merged business will have excessive leverage with a debt pile of $58 billion. However management have been very clear on their plans to deleverage the balance sheet. For FY23 and FY24 management claim around 50% of FCF will be used to pay down debt. Additionally management said their target leverage was 5x at the time of merging; however, this is now expected to be between 4 and 4.5x with a long term target of 2.5x-3x (net debt / EBITDA).
This information was always available and leverage estimates improved as time went on. The efficient market hypothesis that argues all known information is used to correctly price a stock is clearly false. Market Wizards (Jack D. Schwager) discussed how in chess everyone knows the same rules and has access to the same historical game-based statistics yet only a small few excel. This is simply because they are more skilled. This is the same in markets to a degree but with more importance on emotional intelligence.
Key Takeaways
If macro indicates a fair environment, bottom up analysis works for retail investors.
Discovery is an example of a stock – many smart retailer investors have been bullish on since the summer of 2021. The fact a ratings change is able to push up Discovery 16% in one day demonstrates that markets aren’t efficient and not all known information is correctly accounted for.
Also risk/reward cannot be perfectly measured; however, it can suggest favourable opportunities through conservative modelling.
Lastly, the way I view Discovery is the following – management need 2 years of execution to transform the business which should double equity value from what Discovery is valued at today. Post-merger WBD will see temporary ugly financials with high debt, low earnings, high costs for pushing the new IP and merger transaction costs. Additionally, the synergies will take time to reflect into earnings. But after that, fundamentals such as increasing cash flow and growing subscriber numbers should translate into higher valuations.