“I established a medium position in Discovery, Inc. (NASDAQ: DISCK) stock during the quarter by means of selling the put options as I described in the last quarterly letter. The stock continued to decline in a way that I found hard to explain by fundamental factors, and the gap between price and value became quite attractive. When the put options expired I chose to keep the amount of stock roughly equal to a 10% position. My entry point was approximately 57% of my Base Case value and at approximately 8x normalized EPS for a business that I believe has the ability to grow profits at a moderate rate.
During the quarter, the company announced its plans to acquire the Warner Media business from AT&T. The transaction is structured as an all-equity deal, is expected to close in approximately a year, and Discovery’s CEO is slated to be the CEO of the combined business. The company expects to produce at least $3B in annual cost synergies without impacting content production investments.
The best way to think about the transaction is that Discovery is acquiring a strong and unique asset without paying a premium. The way that acquisitions usually work is that the buyer pays a sizable premium to the seller which frequently transfers most of the value of the synergies to the seller. In this case, the seller, AT&T, was in a difficult position. Essentially they were a forced seller, having taken on too much debt and under pressure from activist investors to simplify the portfolio. As a result, the equity ownership split between Discovery, Inc. (NASDAQ: DISCK)’s shareholders and AT&T approximates the share of pre-synergy profits contributed by the two entities, which implies no meaningful premium paid.
The acquisition has its share of risks. A few come to mind:
• Integration risk of two large and different organizations
• Risk that the Warner Media culture is already strained by the previous integration and changes in management, and that the asset is damaged in a way that is not yet visible to outside observers.
• Risk that between the announcement of the deal and when it closes the best people leave and the organization generally suffers, hurting future results.
• The new company will now be participating in the much more competitive scripted content area, which Discovery’s CEO previously frequently described as unattractive.
• Large amount of debt used to finance the deal
Mitigating those risks is the very strong brands and library that Warner Media has. The crown jewel is HBO and its library. With no expected layoffs among creative staff expected, this should be just as attractive a place to work under Discovery’s ownership, if not more so. CNN also has a very strong brand and hard-to-replicate global presence. These assets are very likely to be growing their profit streams for many years to come in most imaginable scenarios. Warner Studios, which is the #1 TV studio by revenue and volume, is also a strong business that supplies a lot of the industry with great content. I am far less impressed with the quality of the TNT and TBS networks and don’t think they are that valuable, but they are not important to the value of the deal nor the competitive position of the new company.
At this point it’s too early to be overly precise about the impact on intrinsic value from the deal. First, the deal still has to get approved and close. Second, both companies are in early stages of their own streaming rollouts, the success of which will influence the strategy and value of the combined company. However, I think it’s fair to characterize the range of potential impacts on Discovery, Inc. (NASDAQ: DISCK)’s pre-deal intrinsic value as neutral to strongly positive. I see a reasonable worst case for the deal as being that unexpected business problems and integration snafus offset the value of the synergies. Could it be worse than that? I think the probability is low because of the strength of the brands and the library of content, which form a large portion of the competitive advantage of the business.
Following the announcement of the deal the stock sold off further, from the low $30s to the high $20s. This is understandable in the short-term. Market participants were excited to be fed a steady diet of positive short-term news flow about the pace of the rollout of Discovery’s streaming product. In a market hungry for catalysts and short on patience, this has now been replaced by the purgatory of a 12+ month wait for the deal to close, followed by a further wait for the integration to take effect. So I am guessing that to the garden-variety market participant, the stock looks like “dead money” for the next year or two. Nothing exciting to see here, time to look for companies with better short-term momentum.
That is a very different perspective from the one that I have. I am not trying to answer the question of “what happens next” or will there be positive surprises over the next few quarters. I am trying to be a rational and impartial judge of the range of business values based on the long-term prospects of the companies that I invest in. On that basis, I believe that Discovery’s value is likely much higher than the current market price, and that the downside to my Worst Case scenario is relatively low if things don’t go our way. That’s the kind of investment situation that I find to be quite attractive, which is why I made it a medium-sized position.”