Thoughts on the AT&T – Discovery Deal

Since the Archegos fallout I’ve written two posts about about Discovery. Part 1 and Part 2. I initiated a position in the Class A shares at ~$41, which is now down 19% in six weeks since DISCA is trading at $33 at the moment. The current price provides a great entry point and I’m considering adding more at these prices.

Despite a good Q1-2021, the downward pressure seems attributed to things outside the business. The market has cooled off a bit due to rates and inflation concerns, Credit Suisse wasn’t done dumping massive bloc of shares to cover a bad loan and yesterday’s announcement of the AT&T-Discovery led to a pre-market price pop of 17%, $2 from break-even, and then the price pop popped. DISKCA dropped. Meanwhile Class B and Class are both higher. This is due to share “triage”, a reshuffling of different share classes. The NewCo will have one class of shares with one vote. Discovery has three classes of shares with different rights and a convertible pref. Let’s just say the NewCo capital structure will be easier and cleaner to understand.

You can see the presentation of the deal here. Below are some of my notes and thoughts on the deal. The new business is unnamed at the moment, so it’s going under NewCo for this post.

AT&T

• AT&T shareholders will own 71% of NewCo. It supposed to be a tax-free spin-off of WarnerMedia assets.
• What is Warner Media: Mainly CNN, TNT, HBO, Warner Bros studio, D.C. Entertainment, but there’s more.
• AT&T will get $43b cash, debt securities and WarnerMedia’s retention of certain debt. This will help reduces its $169b of net debt. That amount of debt does not leave much financial flexibility when you have massive investments to make in 5G and content. Will need billions to match Verizon and T-Mobile.
• AT&T will readjust the dividend after spin-off. The future dividend will be around $8b-$8.6b based on 40% of anticipated FCF of $20b. AT&T currently pays $15b/year and froze it last December after 30 years of increases.
• Future yield should be around 3%-4% range.
• NewCo will spend $20b a year in content. That’s more than Netflix’s $17b and Disney is around there.
• Originally, the DirecTV deal and Time Warner was supposed to challenge Comcast in the pay-TV business, steal digital-advertising dollars from Google, and mount a challenge to Netflix Inc. in streaming. It accomplished none of that. Now it’s going back to its roots: Wireless and broadband.
• Why the deal? #1: The market was never sold on AT&T multiprong strategy of trying to be the king of connectivity/broadband/distribution and king of content. In the direction they are going they are the king of neither. Marrying media content and distribution is a tough game. Verizon tried to be a digital media powerhouse and back-off $10b in and poor results (AOL + Yahoo, come on, how much did you paid a consultant for that genius idea).
• Why? #2: AT&T has a lot of debt, mostly from two massive deals (DirecTV $49b + Time Warner $81b). Net debt is $160b. The largest for a non-financial company.
• Why? #3: AT&T will need a lot of money to invest in 5G and connectivity to be able to stay in the game.
• Why? #4: AT&T realized that WarnerMedia is a different beast that needs a different kind of attention, and will need billions of dollar annually. They are short $2b on committed programming.
• Why? #5: Never a smooth marriage. There was conflicts after the purchase. A clash of culture. A couple rounds of layoffs, and just bad headlines. Hollywood didn’t like it. Moral was low. A lot of key people left. Talent relation is strained due in part to decisions regarding the distribution of theatrical movies.
• Why? #6: A lot of pressure to perform. They took on massive debt on two massive deals and the results aren’t there. DirecTV was a flop. Sold 40% for $1.3b. The verdict is still out on Time Warner but early results are not up to expectations.
• I don’t get AT&T. Isn’t this like the 3rd reorganization, or reshuffle, or reset in the last few years? They bought DirecTV at the peak of pay-TV (2015), then fought the government for two years to approve the Time Warner deal (2018) and now the U-turn?!
• NewCo will be a better home for WarnerMedia. A company purely focus on creating content.
• I never understood HBO’s strategy. It’s confusing. HBO, HBO Go, HBO Now, HBO Max, then they had a 3-tier paying system, then one. Consumers want one HBO.
• Credit to CEO John Stankey for admitting that this wasn’t working instead and looking for solutions. It’s not easy to step back and re-evaluate.

Discovery

• The deal is good for both parties. AT&T can attribute resources to what they now and NewCo will have more content to compete.
• The two most successful players in direct-to-consumer streaming video, Netflix and Disney are almost entirely focused on entertainment, and don’t own cable systems or broadband businesses.
• I like Discovery CEO David Zaslav. He’s a media guy. He knowns what he’s doing. He understands content.
• Zaslav is a deal maker. He’s been acquiring content for the last couple years.
• NewCo will have one share class with one vote.
• NewCo will hold $55b of debt.
• I like the disclosed around Discovery+. They have 15m consumers in five months and provide a good breakdown of the data/key metrics.
• They disclosed that engagement is approximately 3 hours per day per viewing subscriber. 3hr!!!! This is the kind of stuff that you disclosed only if it’s positive. Nobody says they watch the 90 Day Fiancé for 3hrs, they say they watch The Crown, but we know the true.
• In contrasts, AT&T said that HBO has a 44m subscribers without breaking it down. It believed that most of them are HBO-only customers. No numbers on HBO Max, the center piece of the strategy.
• Discovery+ retention is strong and monthly churn is trending towards low single digits.
• According to Zaslav, an hour of non-scripted content cost ~$400k compared with ~$5m for a scripted show.

Despite the stocks being down from my initial purchase, I’m still bullish on Discovery/NewCo. Right stock is getting kicked around for short-term events and market noises. The stock is undervalued. It’s kicking ~$3b in free cash flow. Discovery+ is turning into a success story. Eventually the narrative will change from “declining TV business” to streaming behemoth, just like Disney was able to rebrand itself from an “ESPN” story to Disney+.