More than a month after saying it would combine with WarnerMedia, creating a streaming and linear content giant called Warner Bros. Discovery with annual revenue of more than $43 billion, market reaction to Discovery Inc. has been tepid at best, with its stock dropping 26% from a high of $39.70 each on May 17 to $29.51 on June 23. At the same time, AT&T stock, which was up about 11% since the Feb. 25 plan to spin off DirecTV -- has fallen 15% from a high of $33.81 on May 17 to $28.65 on June 23.
Not exactly the stock performance dreams are made of.
In a research note Thursday (June 24), Bernstein media analyst Todd Juenger deconstructed the merger, cited by countless screaming headlines as the creation of a “streaming powerhouse” that would combine the best content assets with the best management during the best time ever to be a content company. But according to Juenger, just like in the movies, the reality is a lot different.
First, Juenger took issue with calling the merger the creation of a streaming powerhouse. That, he said, couldn’t be further from the truth because despite their streaming offerings -- Discovery Plus and HBO Max -- both companies “are almost entirely cable network companies.” And that, he said, isn’t any better either.
Juenger noted that all of the funds to support their streaming efforts come from traditional linear network affiliate fees and advertising revenue, both segments which are in sharp decline. And he added any unanticipated disruption to that side of the business -- accelerated cord cutting, a drop in ad revenue, a recession -- would put the entire streaming strategy at risk.
“Ironically, the more successful the streaming service becomes in the market – the more pressure is put on the linear networks,” Juenger wrote. “Which is the tyranny of the innovator's dilemma. (And also important to investor expectations about earnings and multiple. The more bullish one is on streaming, the more bearish one must be on legacy. And vice-versa). “
Adding to the potential injury is that both companies have networks with their own specific risks. Discovery’s networks, according to Juenger, have the highest operating margins in the industry (60%), but the risk is that any downturn in revenue would fall directly to the cash flow line at a very high rate.
WarnerMedia’s Turner networks like TNT and TBS, as general entertainment channels have “no specific content proposition, differentiation, or reason to exist in an increasingly on-demand world,” according to Juenger and rely on a handful of sports rights to keep distribution and pricing. Its news networks like CNN , he added, aren’t in control of their content cycle, adding to volatility.
“With all these structural and specific risks to the linear networks, the new company will emerge with roughly 5x financial leverage (and a promise of using excess FCF to de-lever),” Juenger wrote. “We think this puts the company in a very difficult box to start from: promises to both invest in streaming and invest in de-levering. It also greatly amplifies risk to equity value. Any downturn in either EBITDA/FCF, or the valuation multiple of the stock, will fall entirely and sharply on the equity holders.”
Adding to the pressure is the longer the merger takes to complete, the higher the risk of entropy at the operating companies, especially HBO Max, Juenger wrote, adding that HBO and Discovery were late to the streaming game as it is.
By the time this deal closes, another year will have passed, and Netflix, Disney, Amazon, Apple, Paramount, et al are not going to stand still,” Juenger wrote. “Additionally, there is a risk of entropy during the next year as the deal works its way towards closing.”
And there is precedent for that. Juenger pointed to the Disney Fox merger. In months between the Dec. 14, 2017 announcement of the deal to its close on March 20, 2019, Fox lost much of its key management talent and according to Juenger, those that remained were “in a state of paralysis.”
“All momentum had been lost, and Disney was left with a big operational turnaround project,” Juenger continued. “We think it is highly likely this same dynamic sets in, particularly at HBO.”
Over the past several years HBO has had multiple owners, multiple leaders, and multiple strategies, the analyst said. While returning to the hands of a media owner -- Discovery -- should put some smiles on employee faces, Juenger wrote they may not last for long.
“[I[t's not fertile ground for stability when your company has been treated like a foster child being shopped from one temporary home to another over the past many years,” he wrote, adding that the combined entity’s plans to extract $3 billion in synergies from the union over time will add to the malaise.
“The employees will see that $3 billion synergy number and wonder who is going to lose their jobs (and if they keep their job, how it will change),” Juenger wrote. ”One couldn't blame any of these employees for considering other employment options. The best talent will be ripe for the picking by other entertainment companies.”
Aside from the operational issues, how the combined company plans to price its streaming services will be a key to their success. Juenger has touched on this notion before, and with HBO Max priced at about $14.99 per month ($9.99 for an ad-supported version) and Discovery Plus priced at $6.99 per month for its ad-free version and $4.99 for an ad-supported offering, he doubts it will be a simple mash-up of prices.
Neither Discovery or WarnerMedia has commented on potential pricing, but Juenger estimated it will likely be about $15 per month for a combined offering.
Juenger was quick to admit that the market will forgive pretty much any operational shortfalls if the streaming service exceeds expectations, especially on the subscriber front. And so far he said history points to streaming products -- ranging from majors like Netflix and Disney Plus and smaller operations like CBS All Access and Starz to niche players like Shudder and Acorn -- outperforming predictions.
“Of course, all this recent streaming adoption came in the middle of a stay-at-home pandemic,” Juenger wrote. “Which, we think, did accelerate the overall consumer adoption of streaming in a meaningful and lasting way. But we also expect some shakeout as the world settles back down.”
Earlier this month, researcher Parks Associates said that 46% of U.S. broadband homes subscribe to four or more streaming services, a number that Juenger predicts will be whittled down to three, with the services offering the most content value for the lowest prices the obvious winners.
“The bullish view of Warner Bros Discovery is either that they will be among those top three global services, or that consumers on average will subscribe to more than three,” Juenger wrote, adding that HBO’s history of introducing compelling series every year, coupled with Discovery’s reality content and international presence could be enough to move the bull case forward. Or he wrote, the legacy pay TV service could last longer than expected, or subscribers could have a higher tolerance for price increases than originally perceived.
Or better yet, Warner Bros. Discovery, as the new company is called, will become the streaming powerhouse its new owners believe it is destined to be.
