Warner Bros. Discovery: value based on content quality, not distribution issues (NASDAQ:WBD)
Investors in Warner Bros. Discovery, Inc. (NASDAQ: WBD) stock have had a rocky year to say the least. After the company’s merger with Warner Media, they had to persevere all sales of AT&T Inc. (J) shareholders, they then had to deal with the fact that the company would not meet its free cash flow forecast. Add to that an intransigent Federal Reserve, and it’s no wonder the stock is down nearly 45% year-to-date.
The majority of negative comments surrounding the company relate to the ability to navigate the ropes to repay debt (which stands at 5x EBITDA).
Wells Fargo analyst Steven Cahall, for example, said cord cutting was accelerating and would pose a challenge for WBD given that cable accounts for about 20% of revenue.
Moffett Nathanson analyst Robert Fishman said the company’s latest results show how dependent it is on cable revenue. He added that:
The risk is that accelerating cord-cutting and linear ad weakness could put additional pressure on network profitability, which could offset any improvements in DTC after expected loss spikes in 2022.
WBD navigated cast changes before
Just nine years ago, Time Warner (now part of WBD) earned 12% of its revenue from magazine sales. Today, that number is 0% and the company has more revenue. More infamously, much of the company’s revenue in 2000 came from dial-up Internet subscriptions. This company has completely disappeared today as well.
The lesson here is pretty clear; History shows time and time again that valuing media companies based on their distribution capabilities would lead to a serious underestimation of their potential. Imagine if investors in the 1920s thought of Disney (DIS) as just a movie studio, or in the 1970s that DC and Marvel were just comic book publishing companies. Such proposals seem ridiculous today in perfect hindsight, but analysts could be making a similar mistake today when they (correctly) point out that WBD is currently too dependent on cable revenue.
Warner Bros. itself began as a movie business. The company then transformed into a movie studio, and when television came along it started producing TV shows (including mega hits like Friends). He also founded what is now Warner Music Group Corp. (WMG), and this year they released two of the top three best-selling video games. Pinning them as a movie studio would have mislabeled the company, and labeling them today simply as a cable company might be a similar misjudgment.
The question becomes, what makes a media company able to navigate these distribution shifts? Why did Time Inc. become insignificant while Warner Bros. continued to increase its income and cultural significance?
The answer in my opinion is intellectual property. Warner Bros. Discovery is not a cable company, it is an IP company. The problem for most investors is how to value the intellectual property of a given company?
Warner Bros. Discovery is worth much more under the royalty exemption accounting method
Instead of assigning WBD a multiple of cable company (since the majority of its money will come from it), a better method is to try to make an educated guess as to the value of its library and IP address.
The royalty exemption accounting method could be a useful guide for investors in this regard. It tries to value an intangible asset by discounting hypothetical royalty payments in the future to their present value. It’s essentially how much another company like Netflix (NFLX) and Amazon.com Inc. (AMZN) would pay WBD if it bought all of its past and future content net of the cost of production, discounted to the present.
How much would Netflix pay WBD to have The dragon house exclusively on its platform? Investors can use similar license agreements to try to come up with an educated price guess and then repeat the process for the entire WBD library. Then, look at the market offers related to future content, to try to determine how much WBD would earn on these. Recent announcements such as the one made by Netflix on Sony (SONY, OTCPK:SNEJF) film licenses, for example, can be a good starting point for investors. Applying this process is beyond the scope of the article, given the length it would take to do so.
For WBD investors, the question they need to ask is how much can the company earn by licensing past and future content, discounted by an appropriate discount rate?
One of the challenges with using this method is that there isn’t a lot of transparency about the details of licensing agreements.
To try to overcome these complications, we can just ask a simple question; Would Netflix be willing to trade the $17 billion it spends a year on content to get all of WBD’s old library and all of its new shows and movies?
If the answer is yes (which I would lean towards), we can get a rough estimate of what WBD would conservatively report in this scenario. Assuming the company spends $200 million (for production and marketing) on one movie out of the 20 films it plans to release each year, the total spend will be $4 billion per year. As for TV shows, the company is releasing 46 scripted shows in 2022. At a respectable price of $80 million per show, that brings TV spending to $3.7 billion per year and total spending on content to $7.7 billion a year. For context, The Batman and Dragon House cost $200 million and over $150 million respectively.
Subtracting the cost of Netflix’s content spend of $17 billion and movie revenue of $1.75 billion (note that assumed movie revenue implies the company is losing money on its movie business) , WBD’s operating profit would be around $11 billion, or $8.7. billion after tax.
I also assume that the cost paid by Netflix will grow above the inflation target for developed economies of 2% (a growth rate of 4%), given the enduring value of high quality IP . With a discount rate of 10%. The value of the intellectual property based on these factors would be $66.2 per share, or $42.1 per share after subtracting debt. Note that the debt was not really used to fund the library, only to buy Warner Media from AT&T Inc. (T). So it’s not necessarily part of the content creation costs.
The process is clearly subjective, as each investor will end up with their own number to content value. What matters in this case is to have a large margin of safety.
In 2013, Ted Sarandos, then Netflix’s chief operating officer, said the company’s goal was:
Become HBO faster than HBO can become us.
In this respect, the method used in this article could be a useful guide for investors looking to value intellectual property, but it is unlikely to be practical. Netflix would surely like to license the Dragon House stream exclusively on its platform, but companies also realize the financial importance of building their own franchises and might resist the temptation to rely primarily on content from other studios.
Additionally, licensing rates and current levels of content spending could reflect the land grab phase of the streaming market. This means that the supposed value of content could be inflated relative to a more competitively defined oligopolistic streaming market.
And just because a library is valuable today doesn’t mean a management team can’t dilute its value. While I consider this a remote possibility, there’s no guarantee that WBD’s management won’t make missteps that dilute the value of its IP address.
Also, while I consider scripted media intellectual property to be an intangible asset with an indefinite life (meaning it shouldn’t be amortized), there’s no question that parts of that intellectual property depreciate. every year. There is no guarantee that the company’s current creators can add more valuable IP to the library any faster than old properties are degraded, which means that the company’s IP would diminish with the time.
WBD’s woes seem to stem from a concern about the company’s ability to adapt to the new mode of distribution. While history shows that investing in media is not for the faint of heart, it also shows that companies with enduring intellectual property like Warner Bros. Discovery have always been able to pivot when the cast changes. Investors might be better served by thinking about the value of WBD’s intellectual property to others, rather than focusing on short-term cable revenue. But investors should also keep an eye on whether management is striving to enhance the value of the company’s intellectual property or whether it is destroying it, as this will be the primary driver of returns.