Warner Bros. Discovery: Sweet-Sour Anniversary Celebration

We’re hold-rated on Warner Bros. Discovery (NASDAQ:WBD) stock. We’re adding WBD to our broader coverage of the media and entertainment space alongside Netflix (NFLX) and Disney (DIS). WBD is ramping up its position in the media and entertainment industry after last year’s $43B merger between WarnerMedia and Discovery Inc. The expensive merger amid weakening consumer spending in the post-pandemic environment was not specifically cheered on by investors; the stock dropped nearly 45% since its creation last April. Our bearish sentiment is driven by our belief that WBD is not done restructuring and doesn’t provide a favorable risk-reward profile toward 2H23. We expect the company to be negatively impacted by the macroeconomic headwinds pressuring Disney and Netflix, especially the pullback on ad spending. We believe things will worsen before they get better, and we see more downside in 1H23. We will continue to cover the stock closely but recommend investors wait on the sidelines for the near-term downside to be priced into the stock fully.

The following graph outlines WBD’s stock performance compared to S&P 500.

Contending with soft ad spending

WBD’s fourth quarter for FY2022 reported the company’s third consecutive miss on top and bottom lines primarily due to the pullback on advertisement spending. The company reported a revenue of $11.01B, missing expectations by $220M, and GAAP EPS of -$0.86, missing by $0.41. We believe WBD stands to take a bigger slice of the streaming market in the mid-to-long run, leveraging HBO, HBO Max, and Discovery+ and an extensive content library. The company successfully narrowed its DTC losses, improved free cash flow this quarter, and reported gaining 1.1M subscribers, bringing the total to 96.1M. Still, we believe these wins cannot offset the larger issue at hand: weaker ad spending. We expect WBD to struggle to find stable footing after a wave of restructuring costs and amid a softer ad spending environment. The company is attempting to paint FY2023 as the “year of rebuilding,” and while it may be a year of rebuilding, we don’t expect it to be a profitable one.

Advertising-dependent companies experienced shrinking ad budgets in the fourth quarter of 2022 as global ad spending pulled back significantly; Alphabet (GOOG), Meta Platforms (META), and Amazon (AMZN) all reported slower ad revenue growth. WBD’s peer group also felt the softer ad spending with Paramount (PARA) reporting an ad revenue slump, Disney reporting softer ad sales, and concerns over Netflix’s ad-tier plans’ profitability amid market uncertainty. Our takeaway from last year was that the advertising industry mirrors the economy; hence, we expect ad firms to continue cutting back on budgets in response to high-inflation rates and a looming recession. Major ad forecasting firms expect global advertising growth to slow in 2023; media investment firm Magna lowered its predictions for ad revenue growth in 2023 from 6.3% to 4.8%. Magna is not alone in its pessimistic outlook on the ad industry in 2023; a separate forecast company, GroupM, also revised its predictions about global ad revenue to 5.9% from 6.4%. We believe WBD will feel the brunt of the weaker ad spending toward 2H23 because the company derives the bulk of its revenues from its Networks segment, including advertising and distribution revenues. In 4Q22, the company’s ad revenues dropped 17%. We see more downside ahead for the company as the economic condition worsens, and WBD already has its hands full with restructuring costs and rebuilding.

Significantly harder to slash debt

WBD wrapped up 4Q22 with $45.5B in debt on its balance sheet; we believe a major focus for the company in FY2023 will be to shrink its hefty debt load and cut costs. We expect it’ll be difficult to reduce debt, cut costs, maneuver macro challenges, and simultaneously grow. The company has $3.9B in cash; hence, it’s no secret that it’ll take several quarters to cut down debt. Since the merger closed in April, the company has repaid $7B in debt. We believe WBD is on the right track, but we don’t expect to see significant returns from the company in the near term.

The following image outlines WBD’s net debt as of 4Q22.

Valuation

WBD is relatively cheap, trading at 1.9x EV/C2023 Sales versus the peer group average of 3.2x. In spite of the cheap valuation, we recommend investors remain on the sidelines as we see more possible downside ahead.

The following table outlines WBD’s valuation.

Word on Wall Street

Wall Street is bullish on WBD stock. Of the 28 analysts covering the stock, 16 are buy-rated, 11 are hold-rated, and the remaining are sell-rated. We attribute Wall Street’s bullish sentiment to WBD’s turnaround outlook for FY2023; we expect the stock’s recovery will not likely materialize before the end of 2023. The stock is currently trading at $14 per share. The median sell-side price target is $20 while the mean is $21, with a potential 36-48% upside.

The following tables outline WBD’s sell-side rating and price targets.

What to do with the stock

We’re hold-rated on WBD. We like the company’s mid-to-long-term prospects in the media and entertainment space and expect it to compete closely in the streaming industry with Netflix and Disney. Still, we expect underlying market trends, namely weaker ad spending, to soften the company’s earnings results through the first half of FY2023. We believe WBD has its hands full with restructuring costs, rebuilding, and weaker ad spending weighing down its revenue. We will continue to cover WBD closely as part of our broader media and entertainment coverage; in the meantime, we recommend investors wait on the sidelines for the stock to drop closer to its 52-week-low of $8.82 before looking for entry points.