Warner Bros Discovery

This post first appeared on 8percentpa.substack.com, as part of a new effort to share investment ideas. 

Why do humans love stories?

Ever since our brains evolved to develop language, we have been telling stories to one another. Stories activate our cognitive brains and bring us into different realities which we believe can be perfect and we escape into them to forget about our not-so-perfect lives.

But stories can also inspire us to become better versions of ourselves. We worship both ancient Greek heroes and Marvel superheroes and aspire to be like them. We empathize with our heroes when they go through their challenges and rejoice with them when they finally overcome their nemeses and live happily ever after.

In recent years, storytelling has reached a whole new level with Hollywood and Netflix throwing billions of dollars into content creation. Disney up its game with the Avenger series and we see its peers following suit. On top of that, big budget television series, reality programs, anime and a slew of alternative content now proliferate our lives and our minds.

As such, our bet today is an overlooked content company created in the midst of the pandemic.

Investment Idea: Warner Bro Discovery

Warner Bros Discovery (WBD) was created with the merger of Warner Brothers Media and Discovery Inc in 2021-22. The stock price has corrected from $24 to $10 since its inception and looks amazingly cheap at teens free cashflow yield (FCF) today.

1. Fundamentals

The company now houses some of best brands and franchises outside of Disney under one roof (see slide from 2Q2022 investor presentation below). These include DC Comic, HBO, Harry Potter, CNN and Cartoon Network, amongst many other franchises. According to CEO David Zaslav, WBD probably has 35% market share of the best content on Earth, as much as Disney does. There is so much room to extract value but the market is not appreciating WBD’s value and not valuing the company as such.

As a result of the various past mergers, including the final mega combination between Discovery and Warner, one can also expect that a lot of duplicated costs can be reduced. Cost synergies is estimated to be USD3.5bn and while sales synergies are not factored in, it should also be significant. Just think about how Harry Potter and DC can now go on HBO and Cartoon Network or how they can further milk the Game of Thrones franchise as they already did with the House of Dragons.

The following is a set of simple financials projects WBD’s financial prowess in 2023. In the base case scenario, the company can create USD4bn on free cashflow (FCF) on its market cap of USD25bn:

Simple financials (estimated for Dec 2023, USD)

Sales: 48bn

EBITDA: 11bn

Net income: 500m

FCF: 4bn (current FCF in 2022 is 3bn)

Debt: 50bn, Mkt Cap: 25bn

Ratios

ROE 9% ROIC 6%

EV/EBITDA 7x

Past margins: OPM 20-30%

By comparison, Disney generated USD5-8bn of free cashflow pre-pandemic and achieved teens ROE which should be the levels that WBD can aspire to reach in the next 2-3 years. That said, the next few years does not bode well for Disney as it struggles with management succession and its streaming business. The same key risk can be said for WBD.

Risks

WBD faces the possibility of not being able to turnaround streaming losses (USD500m per quarter) and continued hiccups in execution, will mean that the abovementioned potential will continue to be unrealized. The mitigating factor is that with its lucrative content library, WBD might be taken over by another operator to achieve its potential. So by investing today, we should not lose money.

The second smaller risk is WBD’s balance sheet. With USD50bn of debt (against market cap of USD25bn) and rising interest rates, things could spiral out of hand if this debt and its interest expenses are not managed well. The mitigating factor is its strong FCF generation. At the current estimated range of USD3-6bn FCF annually, WBD could pay down its debt in c.8-16 years.

2. Technicals

WBD traded to $80 as a mime stock when it was still Discovery Inc (the deal was already announced). and it is not a stretch to imagine it can be valued as such given the strong FCF, franchise and leadership under David Zaslav, who was under the tutelage of John Malone, one of the best business leaders of our times.

David Zaslav alluded to this target in a recent podcast. He also shared that his stock options only make good money when the share price hit USD30 and beyond. We are also seeing insiders buying at current levels. These “technical” signals bodes well.

After it started trading as WBD in Apr 2022, the share price dropped from USD24 to its current USD10, a 60% drop reflecting the weakness in the markets. Its highest point was above USD30 shortly after the launch of its new ticker and it traded as low as USD8.8 recently. Thus, on many counts, the current share price presents a good risk reward profile.

3. Valuations

Warner Bros Discovery measures FCF and EBITDA closely and therefore we can use FCF yield and EV/EBITDA as the appropriate valuation metrics to triangulate its intrinsic value. Starting with FCF, WBD currently has a market cap of USD25bn and management expects free cashflow to hit USD3bn in 2022 and somewhere between USD4-6bn in the future, calculated from its EBITDA to FCF conversion ratio of 33-50%.

This implies its FCF yield is 12% using the USD3bn number and a whopping 24% if we believe WBD can make USD6bn in FCF. As a rule of thumb, an intact business (i.e. not declining business) with FCF 10% yield is what investors will kill for because we do not have to sell. We can technically hold it forever since this asset is going to give us 10% every year, perpetually.

WBD is trading way beyond this FCF 10% yield benchmark.

Similarly, we can use EV/EBITDA to value WBD. Management is guiding USD12bn in EBITDA next year but we have conservatively estimated that it will miss by a billion, achieving USD11bn. Using its current EV of USD75bn (market cap of 25bn + debt 50bn, WBD is trading at 6.8x EV/EBITDA, which is considerably cheaper than most of its peers (Disney at high teens and Netflix at over 20x).

4. Intrinsic Value

Assuming that WBD trades 8x EV/EBITDA on next year's USD11bn of EBITDA, WBD should have an EV of USD88bn and after deducting its USD50bn debt, its market cap should be closer to USD38bn (not the current USD25bn). If we use current EBITDA of USD9.5bn and similarly give it the 8x, then we get to a more conservative EV of USD76bn. After we deduct the USD50bn, we still get USD26bn of market cap, which is still 4% above today’s share price.

WBD is incredibly cheap!

Let's see how it looks like if we use FCF. Assuming FCF is at USD4bn and giving it 15x (or 6.7% FCF yield) which is again at a discount to its peers, WBD should trade at a market cap of USD60bn i.e. 140% above its current market cap. This translates WBD’s intrinsic value to USD24 per share.

If we look at its peers, Disney, Netflix, Comcast, they are trading at USD219bn, USD107bn and USD171bn respectively with EBITDA at USD12bn, USD19bn and USD36bn. The average market cap is USD166bn over an average EBITDA of 22bn. Without doing a full regression analysis, we can intrapolate the above numbers back to WBD's market cap using its current EBITDA of USD9.5bn, it implies that WBD should trade closer to USD72bn.

Taking the average of the four market caps, USD38bn, USD26bn, USD60bn and USD72bn, we get to an intrinsic value (IV) of USD49bn in market cap or USD20 per share. As such, we would put WBD's IV at 20 with over 90% upside from today’s price.

Huat Ah!

Read it at https://8percentpa.substack.com/p/investment-idea-2 and please support by subscribing at substack, thanks!

This post does not constitute investment advice and should not be deemed to be an offer to buy or sell or a solicitation of an offer to buy or sell any securities or other financial instruments.

The Fall and Rise of Disney

In March 2020, when the coronavirus hit the US and everyone panicked and bought all the toilet paper off supermarkets, Disney's share price was flushed into the sewers as well. Its theme parks suffered with catastrophic fall in revenue as visitors number collapsed. Its movie business was similarly hit as people stopped going to the cinemas. Share price fell from USD 150 to USD 85. This stock was labelled as the covid-hit name. Avoid it like the plague!

Fast forward to December 2020, its share price hit USD 175, an all time high. Its market cap at USD 318bn is almost 50% bigger than Netflix and also Comcast, owner of Universal Studios. It has beaten Netflix at its own game with the spectacular success of Disney Plus, its newly launch streaming service. Disney now boasts c.100m subscribers across its various streaming services (Disney, ESPN and Hulu). While this is still smaller than Netflix's 195m subs, Disney has far superior content and should catch up in time. 

The Walt Disney Company (its official name) has always been a unique company. Its larger-than-life eponymous founder/creator built the company by creating a mouse, an animated rehash of a fairy tale about a maiden and a poison apple and then dreamed about theme parks where stars are born. They became huge successes and Walt Disney captured people's hearts and minds as one of the most intriguing rag-to-riches stories in modern times.

About 15 years ago, the company made a few spectacular acquisitions under the watch of Bob Iger, a visionary CEO. In 2005, Disney bought Pixar, the hottest 3D animation studio in town from Steve Jobs. Then in 2009, it bought Marvel Studios for USD 4bn. It was lauded as a crazy move because nobody was reading comics and just a few years ago, Sony paid just USD 10m for Spiderman. Back then (and here's the punchline), the most famous superhero wore underpants on the outside and he wasn't even a Marvel character.

Well, as they say, the rest is history. On hindsight, its success was almost inevitable.

To crown it all, in 2012, Disney bought out George Lucas and acquired all the rights to the Star Wars franchise (again for c.USD 4bn). It then launched the last trilogy in the original Skywalker storyline with a disastrous ending. But fans didn't care, they just couldn't get enough of Star Wars. So Disney created all these spinoffs on the various characters (pic above). The current hit, The Mandalorian propelled the franchise back into people's mind during COVID-19 and Disney racked it all in. This is Disney's way.

As the story unfolds, COVID-19 hit its Park, Experience and Products as well as its Studio Entertainment businesses bad, but its Media Network and Direct-to-Consumer (where Disney Plus and other streaming services are housed) will be picking up the slack and bringing the company's profits back (see table below). In terms of cashflow, the company has also shown its operational prowess by diligently cutting cost and preserving cash. It managed to generated USD 3.5bn of free cashflow in the year ending Oct 2020. 

With its current all time high stock price, this is probably not the time to buy the stock. Today's valuation put Disney at 4.5x 2019 price-to-sales which is based on its pre-COVID historical high revenue and 25x 2018 PER. Again, this was the year it has its highest EPS at c.USD 7. In 2018, it also generated its highest ever annual FCF at c.USD 10bn. Off this high FCF base (who knows when it can do FCF of USD 10bn again, it could be 2022 or 2023 or beyond), it is trading at c.3% FCF yield today. It is not crazy internet valuation but it's just not cheap. We value investors need our margin of safety.

COVID-19 however did present the opportunity to better understand Disney. This is a solid compounder like 3M, Starbucks and Diageo. Compounders just bounce back much faster than mediocre, crappy firms. Disney has the best content and the best platforms: theme parks, stores and now streaming networks leveraging on its valuable first-class franchises, creating value simply by telling stories. Like the heroes in its stories, Disney is also bold, innovative and most importantly resilient. Disney doesn't need vaccine, it has immunity!

In future posts, we hope to dissect its various businesses and better understand this solid compounder. 

This is the way!

The Force Awakens: Thoughts and Takeaways

Star Wars: The Force Awakens opened last weekend and smashed all box office records. This episode, #7 in the franchise, will likely make USD 1-2bn in the cinemas alone. When Disney bought Star Wars for USD 4bn in 2012, everyone thought they were stupid. Why pay so much to George Lucas who did a crap job trying to do the prequels (Episode #1-3)? Also how can a 30 year old dated sci-fi saga be worth so much?

Now, Disney is having the last laugh. Episode #7 alone might rack in enough profits to cover the USD 4bn cost and there's five more in the pipeline. Yes, there will be Episode #8, #9 and all the way to Episode #12. The motto is: don't stop if die-hard fans will keep coming back for more. Based on my very crude Google search estimate, there could be close to a million Star Wars fan globally, counting both die-hard and casual fans. Over 60,000 of them gather for a May 4th Star Wars Celebration in the US every year.

Coming back to the math a bit more, here's some interesting revenue and cost breakdown:

In US dollar terms
2 bn Box office 

1 bn Merchandise

1 bn DVDs, streaming, rental and downloads

0.5bn Synergies from rest of Disney (Theme park rides, derivative cartoons, games etc.)

-0.5bn Marketing and cost of production

4bn Profits for Disney from Episode #7 alone

Gosh, George Lucas might be wondering whether he was underpaid. Should he have asked for USD 8bn instead? Well actually that's not entirely fair because he could not have generated USD 4-8bn if he did not have the Disney marketing machine behind it. Lucasfilm Ltd was making a miserable tens of millions from merchandise and mostly from Lego Star Wars.

Why did Star Wars do so well even after so many years? What about Disney, is it then a super investment? What are some takeaways we can learn from this? This post hopes to answer some of these questions and provide the investment thoughts as well. 

New lead characters in The Force Awakens

Ok why did Star Wars do so well? For one, pretty female leads. This instalment we have the 23 year old Daisy Ridley (that's her in the pic above with the cutesy BB8 droid) as the new protagonist, probably the prettiest amongst all the female stars. Well, Carrie Fisher wasn't too bad some 35 years ago although the bikini definitely helped. Natalie Portman was okay but Ridley really gives a fresh look despite her scavenger outfit. Okay, okay, beauty lies in the eyes of the beholder, yes and if beautiful ladies make good movies, then we won't have flops liao, ever. So it's not just about pretty girls.

Star Wars worked because it combined so many qualities of good movie-making: a popular genre (sci-fi) with a vast expanded universe, adrenaline pumping sequences, plot twists, innovative gadgets (lightsabers!) and of course the love story. Romance bring in the ladies, or at least help convince them to watch with their hubbies. Yes, there is still the luck element. The first Star Wars was really a lucky hit. It had huge production hiccups and back then, an untested plot, genre, storyline based on a Japan cult movie: Akira Kurosawa's Hidden Fortress. But when it became a success, it paved the way to build a franchise. 

We just love familiarity which is why franchises work. Today, 60-70% of the top grossing films are franchises: Harry Potter, Jurassic World, Marvel Super Heroes, Lord of the Rings and the list goes on (see chart below). This is very similar to branding, which is why we go back to the same brand of toothpastes, the same food chains, the same cosmetics and the same phones and computers which we have used before and liked it. Nobody likes to learn how to use a new OS.

Once we built a brand, we can have pricing power and pricing power is one of the most important criteria for a good investment. Strong brands can build in pricing power above inflation which is the way to supernormal profits and margins. Star Wars merchandise can be priced ridiculously and fans will just pay up. This is why Disney make billions off merchandise, not just Star Wars, but think Mickey, Disney Princesses, Marvel Heroes and all its other franchises.

Top 20 box office movies of all time

In fact, Disney has 8 out of the top 20 box office movies of all time from Marvel, Frozen, Pirates of the Caribbean, Toy Story and needless to say, Star Wars. So does it make Disney a super investment? Well it's hard to say, because it's not cheap. Disney generates c.USD 7bn in free cash flow annually but trades at a market cap of USD 180bn, that's a 3-4% FCF yield and a big part of the business deals with sports: they own ESPN which has a different business model and analysts argue that costs to acquire content (rights to live telecast sports games) are rising sharply which hurts Disney.

But in the franchise business, Disney is unbeatable. Essentially, it had become a buyer of choice for franchise creators. Pixar, Marvel, Lucasfilm all chose to be bought out by Disney because they knew their life-works would find a better home and soar to greater heights. It has become an aggregator of good quality content, not unlike Berkshire Hathaway as a good aggregator of high quality businesses. With more and more content, Disney is then able to drive more merchandise sales, more synergies between its various businesses (other than sports). 

I guess this is really one of the important lesson learnt in investing: look for good aggregator stocks. Companies that have built that capability to deliver value add by building on its strength of aggregating businesses. They just become a locus of growth and keeps attracting the good stuff to them like a strong magnet. This has been the model of growth for some US companies for some time. Especially in certain sectors like pharmaceutical and medtech.

Even in our daily lives, we can strive to be an aggregator of good quality stuff. We should aspire to aggregate wisdom in some domain and become a master of sorts (yeah like a Jedi Master). We then build a brand for ourselves and people would come to us. There are many niches that one could fulfill. I am sure we know friends who are good at music, or IT, or art, or food, or finance and we seek them out for their expertise sometimes. We should seek to be an aggregator in a field we are interested in and have established some know-how and expertise. 

Strive to be a Jedi Master

The final point I would like to make for Star Wars is the offline and online argument. This came as a revelation in 2015 as online moved to really dominate our lives after 15 years since the dotcom boom and bust saga of 1999-2000. Online and internet came one full circle in the one and half decade fulfilling the prophecies that drove the bubble then. Now we buy groceries online, pay our bills online, chat with friends online, watch movies online, in fact we can pretty much live our lives online. What does this mean for the offline world?

It means that whatever cannot be done online becomes really, really scarce and people seek to do it and cherish these rare offline moments. Every damn thing has become a commodity when it goes online so offline is left for things that are really so bloody important (or simply a hassle sometimes though if the segment hasn't caught up with the online fever, like government related matters or banking) and we will pay any price to do it offline for that experience (obviously not for the hassles though). Again, as online dominates our lives, for the really important offline events, we will pay any prices for the unique experiences in the real world.

That's watching Star Wars in the theatres. The internet has taken over the world and we can pretty much watch any movie online, paid or pirated. But if there is one movie in 2015 that you would want to watch it live in the cinemas, just like the good old days, there would only be a handful. And Star Wars would rank pretty near the top. In fact for Star Wars fans, it would be at the top. Now these fans would drag their loved ones to go with them. Or better, they would first watch it once themselves on the first day, then drag their loved ones to go with them for a second round. This explains the huge box office sales.

That's what is really happening in the real world. Since everything has gone online, what is left offline has to be really important. People will cherish the remaining offline experiences and will be willing to pay huge premiums to get these experiences. Yes, it's pricing power all over again. Think of live concerts, Michelin star restaurant meals, theme parks, birthday parties, invitation-only events and even shopping. People want to be awed when they do things offline. Hence they are no longer shopping at some local malls. They want to visit flagship stores to discover new things. They want unforgettable experiences. It's not shopping to buy stuff. We can do that on Amazon, it's about creating awesome experiences. They go to the flagship Disney store to see the Princesses or meet Darth Vader. That's shopping in 2015.

Disney understood this and embarked on an ambitious marketing campaign globally with Star Wars. We have the Changi Airport campaign in Singapore which is becoming a huge success and we see families flocked to the airport for the experiences: a photo on a life-size X-wing and another one battling the Dark Side with lightsabers. Then flooding Facebook with Star Wars photos, intriguing more people to go Changi and then go watch the movies. This offline and online loop is really the force awakening the new paradigm shift as we move forward. The winners would be companies that could find the balance well between both offline and online, the light and dark side of consumerism.

May the Force be with you! Merry Christmas and Happy Holidays!