Warner Bros. Discovery Q3: potential future sequential improvement

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Warner Bros. Discovery (NASDAQ:WBD) management can come across as positive as they want. But this market is all about cash flow and free cash flow and that’s gone in the current quarter. So the market will watch the debt and basically say “yeah, that’s right!” while ignoring some very solid plans put in place by management. There’s a lot of talk about “cleaning up” and repositioning as well as other priorities. But nothing hurts more than showing virtually no cash flow for the size of the deal and then showing negative free cash flow for the quarter.

Free Cash Flow Calculation

This management has a very conservative view of free cash flow, because indicated below:

Warner Bros Discovery Free Cash Flow Calculation

Warner Bros. Free Cash Flow Calculator Discovery (Warner Bros. Discovery Earnings Third Quarter 2022 Press Release)

The payment for a revolving line of credit often appears on the GAAP cash flow statement as a change in other accounts. It is not always included in the calculation of free cash flow because some companies consider that an optional use of the free cash flow generated. I follow a lot of companies and debt payment is in different places (or not at all) when it comes to calculating free cash flow as there is no standard cash flow calculation available.

The other thing mentioned during the conference call was a one-time payment incurred prior to the acquisition (this included heritage conservation bonuses as well as merger and acquisition costs during the conference call) of approximately $400 million. Taken together, the one-time events mean free cash flow will operate at least at the previous rate of about $700-800 million of free cash flow per quarter. This does not include other merger-related payments that will not recur. It is therefore entirely possible that free cash flow will improve even though management presented the statement above showing a decline in free cash flow compared to previous quarters and the previous year.

Evidence of cash flow statement

The cash flow statement provides more evidence that the cash flow is better than what has been presented by the market.

Warner Bros. Third Quarter 2022 Cash Flow Statement

Warner Bros Third Quarter 2022, Cash Flow Statement (Warner Bros Third Quarter 2022, Earnings Press Release)

The cash flow statement again shows the current year cash flow from operating activities down from the previous year despite a much larger business. The obvious row on the cash flow statement is the first one highlighted in yellow. The “Film and television content rights” line is a line that has absorbed a lot of cash. Cash generated from operating activities before the account changes would appear to be closer to $10 billion despite one-time merger charges that occurred elsewhere in the income statement. This is extremely encouraging as these accounts as a group are not expected to have such a large negative change (to absorb money) in the next fiscal year.

Clearly, the company recouped some of that money through the second item highlighted. Obviously, there was a post-merger agreement to settle certain points. This resulted in a verification from AT&T which appears as the second highlighted item.

Management later shows on the cash flow statement that $6 billion of debt has been paid off so far. It’s a damn good start for debt repayment given that management is also reworking the acquisition for better profits, which has resulted in a good amount of one-time cash uses.

Future Cash Flow Potential

The market may think “management is crazy” or overly optimistic. But the evidence presented shows that there is the beginning of a very generous cash flow that should easily service the debt.

Warner Bros Discovery Reconciliation of Net Income to Adjusted EBITDA

Warner Bros. Discovery Reconciliation of net income and adjusted EBITDA (Warner Bros. Discovery Third Quarter 2022 Additional Statements)

Management also mentioned during the conference call that Adjusted EBITDA is not close to where it should be as it is still lower than a year ago. But adjusted EBITDA is also starting to move in the right direction. It should also be noted that on these statements there is approximately $2.5 billion of “restructuring and other charges” that will not appear on next year’s statements.

The current quarterly adjusted EBITDA rate, if sustained, is approximately $9.6 billion. This is starting to make management’s forecast for the next fiscal year very reasonable even as the advertising environment continues to soften. If this proves correct, EBITDA will rise further as the economy recovers before considering further management improvements.

Of course, this depends on the continued improvement in EBITDA. Management actions that have improved EBIDA must obviously continue. Mr. Market clearly believes that these actions will not succeed at this time and EBITDA will not improve. This is what makes it a contrarian opportunity. But management will then provide insight into where at least some of that improvement came from.

Improved Synergy

Management noted the amount of synergies achieved within the organization.

Warner Bros Discovery Synergy Achievement Dollars Description

Warner Bros. Discovery Synergy Achievement Dollars Description (Warner Bros. Third Quarter 2022 Results Presentation Discovery)

As management digs in this sizeable acquisition, there will likely be further upside announcements. The company acquired a division of AT&T with very little to no free cash flow thanks to “the looks of things”. This implies considerable future synergy potential and other reasonable cost-cutting measures that may well release a torrent of cash in the future. It is clear that the management is not there yet. But what is shown above is a damn good start.

This management and several companies that I follow have long emphasized that it takes time for management actions to materialize. The fact that this management has stepped in lends credence to the idea that some results will be apparent next year. Normally, it takes longer with such a large acquisition.

But the spring cleaning and all the headlines suggest that this big acquisition will have faster results than usual.

Take away food

Management’s forecasts seem more reasonable over time. A big acquisition like this is going to take a few years to “get into shape”. But adequate cash flow seems achievable (and it seems achievable quickly). Next year should see EBITDA and cash flow continue to climb as big surprises diminish.

The bears are having a blast with all the write-offs and cash flow disappearing from M&A payouts. This should have been planned before all this started. But it’s easy to lose confidence with a lot of negative information that inevitably comes first whenever something so important needs to be fixed quickly.

Management orientations for 2022 and 2023 with potential headwinds

Management directions for 2022 and 2023 as well as potential headwinds (Warner Bros. Discovery Third Quarter 2022 Earnings Conference Call Slides)

Management already has an annual rate of approximately $9.6 billion in EBITDA, as shown above. To reach the $12 billion shown above next year, an additional $600 million must be found in revenue or cost reductions. This direction will likely attempt both and is expected to succeed in excess of $3 million per quarter by the fourth quarter of fiscal 2023.

Summary

It was a very important acquisition. Acquisitions this large usually have a poor track record of success. But this direction has an overall plan and seems to have the elements in place to be one of the few successful acquisitions of this size.

There are many other things management can do to increase value. They mentioned that there hadn’t been a Superman movies in ages. They also went through all the other franchises that are basically there. If Disney (SAY) can be successful with franchises (and most would agree that they are), so there’s likely to be a lot of value to unlock with acquired franchises this time around.

Because of this and other possibilities, I suspect the 2023 EBITDA projection is conservative. It has a good chance of being increased during the year, unless we end up with a severe recession or an unexpected weakness in a key element of the business.

As the market focuses on cash flow disappearing, I’m going to look at what won’t be spent next year (because it’s a one-time payment and therefore represents a cash flow or even a cash flow cash available next year) combined with operational improvements to ensure EBITDA remains conservative. The next few years after that should show sequential improvement.

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