AT&T & Discovery Mega-Merger: What's The Outlook For Discovery?

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AT&T & Discovery Mega-Merger: What’s The Outlook For Discovery?


Updated on April 15th, 2022 by Josh Arnold

Mergers and acquisitions occur quite frequently in the capital markets, but in terms of scale, media coverage, and importance for dividend investors, the now-completed transaction between AT&T (T) and Discovery (DISCA) is one of the largest in recent memory. The new, combined company is called Warner Bros. Discovery, and trades with the ticker WBD.

AT&T unwound some of the merger activity it completed in the past decade and trying to refocus its business. Prior to the merger, AT&T was a Dividend Aristocrat thanks to its 30+ years of rising dividends.

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Warner Bros. Discovery isn’t paying a dividend right away, which is typical for such a transaction. This is particularly true given Discovery didn’t pay a dividend as a standalone company to the merger.

In this article, we’ll take a look at the transaction itself, what the addition of WarnerMedia means to Discovery’s outlook, and whether or not we might see the company pay a dividend in the future.

Transaction Overview

Let’s begin with the terms of the deal, and as we can see below, the companies have elected to use a Reverse Morris Trust transaction. Essentially, this type of transaction allows AT&T to create a tax-free spinoff of WarnerMedia by immediately merging it into Discovery.

Source: Investor presentation, slide 5

WarnerMedia was spun off into a new company, which then immediately merged with the existing Discovery business with the latter’s shareholders owning 29% of the new company, and AT&T shareholders taking the remaining 71%.

As a result, AT&T received $43 billion of cash and equivalents as part of the deal, which amounts to compensation for shareholders for the WarnerMedia business.

Related: To see a detailed analysis of the merger from the perspective of AT&T, click here.

The goal of this transaction is to take the content and media portion of AT&T’s current business that doesn’t necessarily fit strategically with the remainder of the business, and allow AT&T to refocus its business on telecom and broadband, while Discovery greatly expands its content library.

We see the move as favorable for both companies, and we think Discovery’s growth prospects are much-improved following completion of the transaction, which closed in early-April 2022.

What Discovery Looks Like Post-Merger

By consummating this transaction, Discovery’s content library moves from what is extremely reliant upon reality and documentary-style content to adding lucrative franchises like Warner’s movie business, HBO, TBS, Harry Potter, Lord of the Rings, and much more.

Source: Investor presentation, slide 8

Discovery immediately moves into the top spot in terms of TV revenue and volume, and become a massive player in scripted content, where it had very little before the merger. Movies are another way Discovery stands to benefit from the merger, as Warner’s movie studio owns lucrative legacy franchises, but also creates new content regularly.

Finally, Discovery picked up a sizable live sports portfolio, and we think the addition of these lines of business could see Discovery with more stable revenue and earnings, and stronger, more diversified growth potential than the legacy Discovery portfolio.

Growth Prospects

We estimated Discovery could grow earnings at about 5% per year prior to the merger, but with the addition of the former WarnerMedia business, we think the combined entity could reach a sustainable double-digit growth rate in the years to come. Discovery+, the company’s relatively new but highly successful streaming service, in addition to licensing deals and popular franchises from Warner Bros. could see the combined company grow quite strongly.

That includes Warner’s huge portfolio of TV properties where it is an industry leader. Discovery now stands to benefit from that steady and growing revenue stream in the years to come.

Warner Bros. Discovery’s revenue is set to jump from $12 billion last year to about $50 billion this year, multiplying the size of the company instantaneously.

Source: Investor presentation, slide 11

We can see that pro-forma revenue for Warner Bros. Discovery would have been about $39 billion in 2020, and that management believes it can be $52 billion by the end of next year, a number that we think has some upside potential. That reflects the massive content library that Discovery is gaining, and it means total revenue could ~4X in the next 18 months or so.

That’s impressive growth, and it implies that the combined entities would see something like low double-digit annual growth in revenue on a pro-forma basis from 2020 to 2023.

The company’s primary platforms for streaming – Discovery+ and HBO Max – have 22 million and 74 million subscribers, respectively. Warner Bros. Discovery is going to work on the next leg of growth in part through bundling.

Adjusted EBITDA is slated to grow at a slower rate, with projections of the combination growing from an estimated $12 billion in 2020 to $14 billion in 2023, but we still see Warner Bros. Discovery’s post-merger earnings growth opportunity as meaningful.

This is particularly true because Warner Bros. Discovery should be able to significantly deleverage post-transaction. The company is set to have a leverage ratio of about 5X at closing, but expects to see it at 3X or less two years after. That will not only provide the company with more financial flexibility, but will also reduce the burden of interest expense on the company’s earnings.

Combined, we see Warner Bros. Discovery’s earnings growth profile as enhanced following this period of deleveraging, which will then allow further content development investment in the company’s various content properties.

In addition to that, Discovery and WarnerMedia are looking to save at least $3 billion annually in currently redundant costs, which will accrue significant benefits over time to the company’s margin profile.

These benefits won’t likely be seen until at least 2023, but we see this as another significant tailwind for not only earnings growth, but free cash flow generation that can be used for content investment or further deleveraging. We see growth as front-loaded for revenue, but with the margin benefits of cost savings and operating expense leverage as accruing a bit later down the road. Both will help drive earnings-per-share growth.

Dividend Prospects & Valuation

Warner Bros. Discovery doesn’t currently pay a dividend, but we believe that could change following the merger. The legacy Discovery produced significant free cash flow, which it used to invest in new content, servicing debt, and buying back its own stock to reduce the float.

While the company hasn’t elected to immediately pay a dividend following the merger, we believe that once the deleveraging process is well underway, which shouldn’t take more than two years, the company will be very well-positioned to begin returning cash to shareholders via dividends.

Given the hesitancy to pay a dividend up to this point, we believe Warner Bros. Discovery would start with a small dividend, but its free cash flow generation post-merger will be more than sufficient to support a meaningful dividend pretty quickly.

At the current market capitalization of $60 billion, Warner Bros. Discovery is trading for less than 5X 2023 EBITDA. Once the market sees that deleveraging and cost savings are accruing and boosting margins, all while revenue rises, there could be valuation upside.

For instance, AT&T traded for just over 8X EBITDA prior to the spin-off, and we see AT&T as a lower-growth proposition than Warner Bros. Discovery. Ultimately, with a brand new stock, one has to wait and see how it is valued by the market. However, early indications are that Warner Bros. Discovery is quite cheaply valued.

Final Thoughts

While the transaction that saw Discovery take over WarnerMedia’s business is somewhat unusual and complicated, we like the deal from the acquirer’s perspective. The WarnerMedia business gives the new company a very strong existing portfolio of lucrative properties, and gives it an instantaneous leadership position in live sports and scripted content, where legacy Discovery was uncompetitive.

Warner Bros. Discovery should have about $50 billion annual revenue to start, and should provide robust cost synergies that will help with earnings growth in the coming years. Finally, the deleveraging that management has committed to will boost the company’s flexibility, and afford it the ability to begin paying a dividend in the years to come.

Given all of these factors, including the attractive valuation, we like the stock as a buy now that the merger is complete and Warner Bros. Discovery is trading on its own.

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