A smart strategy when trying to find areas to invest capital in is to look at broad secular trends. One of the most prominent ones over the past decade has been the ongoing shift from traditional cable TV to streaming entertainment. Major companies like Netflix, Walt Disney, and Amazon have spearheaded this movement.
Investors looking to put money to work by buying streaming stocks might also be seriously considering Warner Bros. Discovery (WBD -2.17%), a new entity that was formed last year after the merger of Discovery and AT&T's WarnerMedia unit. But there's something you should know about this business first. Read on to learn what I'm talking about.
Looking at the balance sheet
With 2022 revenue of $33.8 billion, there's no denying that Warner Bros. Discovery is a media and entertainment juggernaut. It has business lines that span traditional cable networks like TNT and CNN, movie studios like Warner Bros. Pictures and DC Studios, and streaming services like HBO Max and Discovery+. The company certainly has well-known intellectual property.
However, the merger last year saddled the business with a huge debt load. At the end of 2022, Warner Bros. Discovery had a whopping $49.5 billion of gross debt on its balance sheet. This is compared to just $3.9 billion of total cash. That debt balance is greater than the company's entire market cap, which is currently $36.8 billion.
In a highly uncertain economic environment like the current one -- characterized by high inflation and rising interest rates -- and at a time when many are expecting a recession, this type of balance sheet is not what investors would like to see from the businesses they own. That's because a high debt balance is like a crutch, taking capital that could be used to reinvest back into the business or to reward shareholders in the form of dividends. It also increases the chances of a default happening.
Last year, Warner Bros. Discovery paid $2.3 billion in interest expenses, which equates to 25% of 2022 pro forma adjusted earnings before interest, taxes, depreciation, and amortization (EBITDA).
To improve its financial situation, the company is undergoing a broader restructuring. Management thinks it can find $5 billion of cost synergies within the next few years, seeking out efficiencies after the merger. Cutting marketing and content spending is also a priority.
These cost-cutting measures could help in the near term by helping to optimize the income statement and minimize losses, but they risk leading to slower growth over time. A streaming competitor like Netflix, for example, will still spend more on marketing and content to fuel its growth, as its balance sheet is in a much better position than Warner Bros. Discovery's.
Furthermore, management is banking on free cash flow production primarily from the television networks, which generate the bulk of adjusted EBITDA, to help pay down debt. The issue is that the networks segment is a dying business due to the cord-cutting secular trend. This means Warner Bros. Discovery has a sizable challenge ahead of it to milk its longtime moneymaking division in order to fix the overall company's financials.
As a result, there's a ton of execution risk here. It seems like paying down that huge burden is going to take some time.
Should you buy Warner Bros. Discovery's stock?
Although shares are up 59% in 2023, they are still down 40% since the combined entity started trading in April 2022. Therefore, it doesn't appear as though investors have completely bought into the story here. Warner Bros. Discovery's stock reflects this continued pessimism, as it currently sells at a price-to-sales (P/S) multiple below 1.
Investors might be intrigued by this seemingly attractive valuation, as the upside appears to be big. But there is a lot of risk, as I touched on earlier. In my opinion, it's probably a good idea to leave Warner Bros. Discovery on your watch list for now.
