I am reading more and more about many who believe that, now that Warner Bros. Discovery, Inc. (NASDAQ:WBD) has fallen all the way down to under $10 per share, it simply must be a good deal now, and they’re considering buying in to try to time the rebound.
I am not buying in, even at these reduced levels. However, many aspects of Warner’s operations have already been ably covered by other writers, for bullish and bearish takes.
Instead of doing an overview of the whole company, therefore, I want to do a thorough analysis of one thing about Warner that hasn’t been covered yet at all here on Seeking Alpha, and let investors decide for themselves how if at all it changes their thinking.
Tricky Thing About Sports: Bidirectional Band
This article concerns sports broadcasting deals, and specifically the way the nature of their financials can be deceptive to investors trying to assess the profitability of the deals. We will use the NBA as our test case since that is hands down Warner’s biggest sports deal.
NBA’s TV deals were announced back in 2014 and run from 2016-17 through 2024-25. They were reported as costing $2.6 billion per year, but of course, that is an average number. Almost no ten-year deal will see the exact same fee charged for the entire ten years, especially when the price tag in question starts with a B, rather than an M. So it is with sports broadcasting deals. There are annual escalators built into the deal and it pencils out to $2.6 billion at the midrange.
However, the range isn’t quite as wide as you might expect. Or, let me rephrase, it probably isn’t quite as wide as you expect. This is exactly the sort of thing we have to calculate and deduce on our own because neither the leagues nor the broadcasters hardly ever disclose this kind of thing.
But the general industry trend has been for deals of around a decade’s length, give or take a year, to have a bidirectional band of roughly 15% or so. That is, you start the first year 15% below the average and you’re at 15% above by the time you finish. And this comes with more or less linear increases along the way, which is about as apropos as you’ll find on this Earth.
I can’t offer definitive proof that this is the industry average because there is no comprehensive survey of these highly secret contractual terms. But every once in a while something leaks out. Marquee Sports Network in Chicago, the new home of the Chicago Cubs, reported spending $115 million in 2021 – 13% below the reported average annual value of the contract, which since it was the second year of the contract is probably about right. Marquee is supposedly paying the Cubs $132 million a year for exclusive rights to all their non-national game broadcasts.
Cable-Sports Dichotomy
Some of you might be surprised to hear the range is as tight as that, or perhaps not. More important than how this range compares to our expectations, however, is how this range compares to the revenue range of the businesses that NBA content is being sold to over the same period.
A bidirectional delta of 15% is roughly equivalent to a straight-line increase of 35% over the decade life of the contract, i.e., its last-season price will be 35% higher than its first season price. You can confirm this calculation yourself simply by dividing 115% over 85%, the prices in the last and first years, respectively.
This number is, in relative terms, very low compared to the same indicator for linear TV bundles, which see increases of close to 10% per year in price per subscriber and more than double over the nine-year span NBA contracts run for.
No Letup In Sports Revenue Growth
One could argue that linear-TV is seeing shrinking subscriber counts, to go along with these rapidly rising prices. And therefore its revenue, which is the key number that we really care about, is not growing as rapidly as its headline price is. This would be true if we were discussing scripted content, which is rapidly defecting from linear to on-demand. However, it is far less relevant for sports content.
Sports is universally acknowledged to be just about the only remaining glue holding the linear bundle together. When the quarterly ritual of reporting how many video subscribers they’ve lost is performed, cable and satellite companies like DirecTV (T) and DISH Network Corporation (DISH) know, as do their listeners, that almost all of those leaving are scripted content fans who have grown sick of subsidizing fans of sports which they don’t watch.
As a result, as cord-cutting has progressed over the past decade, sports rights have continued to climb meteorically in price while more and more scripted content has been finding its way outside the linear bundle. Charter Communications, Inc.’s (CHTR) recent dispute with Disney was the culmination of this trend; Charter demanded that Disney’s streaming services be bundled in with its linear networks and Disney rebutted by arguing, with more than a little validity, that its streaming services were separate from its linear networks because so much of the originals scripted content that they produced went straight to streaming without ever broadcasting on linear at all.
So, even if total revenues are not increasing at 10% a year, sports-related revenues, for all intents and purposes, are. It is scripted revenues that are collapsing, and scripted costs are falling right along with them as more and more production takes place on direct-to-streaming sets.
The Power Of Compounding
So sports revenues go up 10% a year steadily, while costs are increasing at much lower 3-4% per year numbers and then making massive jumps once every decade or so in the first year of every contract renewal to even things out again.
The significance of this industry trend, which has now been in place for well over two decades, is this: profit numbers are almost never averaged across the deal’s life to reflect it. As investors, we have the benefit of most of a company’s capital expenditures being properly amortized over the expected lifetime of the asset when we look at a company’s GAAP results. If a company builds a factory for 3x annual revenues, it won’t report a massive loss the year of construction because that cost will be amortized over the factory’s thirty-year lifespan, and annual costs will only increase 10%.
Media companies, however, tend to report their rights fee and production costs in a snapshot manner; whenever a fee or cost is paid, it is reported as a cost that year, with no amortization or cost-averaging. This makes sense for scripted television programs which tend to be reauthorized (or not) from one year to the next and to see stars getting raises that are more or less in line with the viewership increase or decrease of that show.
However, it makes far less sense in the context of sports rights which are locked in for a decade at a time upfront and feature the massive one-time hikes paired with the comparatively tame, inflation-level escalators. This maldistribution of costs and revenues means that sports broadcasting deals are slanted heavily in the sports leagues favor in the opening years of a deal, moving through roughly average to be heavily slanted in the broadcaster’s favor at the tail end of the deal, when the 10% has had years to compound over the far more modest escalators.
Waxing And Waning Profit Cycle
Whenever you analyze a media company with a major sports broadcasting component, therefore, even a Fox Corporation (FOX) or an NBCUniversal (CMCSA) but especially a sports-centric company such as The Walt Disney Company (DIS) or Warner, you absolutely must take into account what life-stage its sports contracts are at. If they are at the beginning of the cycle, those companies are probably considerably more profitable than their headline yearly numbers make them appear. If they’re in the middle, the reported profit is probably about right.
If, however, they are in the back end of the cycle, then they are substantially less profitable than they appear to be. So it is, unfortunately, with Warner. The heart of its sports strategy is the NBA, whose broadcast agreement is now in the final two years of a nine-year deal. Warner’s profit numbers are therefore more than a little deceptive, since they reflect an operating paradigm with a defined shelf-life that will terminate when the NBA comes back in two years to reset the clock and slant the deck back in their favor again.
Disney’s profit numbers are similarly distorted, but they at least have the benefit of a more broadly distributed sports spending program which means that of their many, many different sports deals, expirations and renewals are usually cycling out at more or less even intervals, at least reducing – albeit not eliminating – the distortionary effect of their largest sports contracts.
Not so for Warner, whose NBA deal is twice the size of its MLB and NHL deals combined. Even when you throw March Madness, hands down its best sports deal, in the mix, the NBA is 50% larger than all three put together.
Turner doesn’t even have an NFL or college football deal.
Gaming Out The Endgame
This, then, is the situation: Warner will continue to reap outsized profits from its NBA deal for the next two years, the two most profitable years of the deal for the broadcaster. After that, the NBA will seek, according to reports, no less than a tripling of its rights fee as the price of a new deal; and many industry experts believe – hard as it is for me to imagine in light of cord-cutting’s accelerating speed – that it will get it or something close to it. Either from Warner, or from someone else.
If Warner refuses and walks away, which it unquestionably should at that price, the resulting loss in ad revenue and subscription fees will drastically shrink its revenues at Turner Networks.
Conversely, if Warner Discovery does give the NBA the increase it is seeking, its annual rights payment will go from 115% of the old average level to 85% of the new, 3x higher level, or roughly 255% of the old average level. In other words, Warner Discovery will almost certainly see its rights payment more than double seemingly overnight if it re-ups with the NBA.
The key point is that Warner Discovery’s current profit/free cash flow numbers are somewhat deceptive. There is no scenario in two years where its profits continue at current levels. It will either pay a massive rights fee increase or suffer a massive revenue decline when the NBA leaves and takes its ads and, most likely, subscription revenue with it.
Of course, if the linear bundle survived all the way to the 2030s, Warner Discovery would once again be on the back end of the deal and would reap massively higher free cash flow than it is now; on that hypothesis this would all even out. But consider the risk factor that was revealed for Warner Discovery; remember, last month before Charter and Disney re-upped it wasn’t clear that the linear bundle would survive to the end of 2023. And certainly, those who expect that Warner will be reporting tremendous improvements in profitability and free cash flow over the next few years have somewhat of a cliff edge approaching.
Implications Across The Board
This analysis has focused on Warner because the NBA is the next major sports deal up in the renewal cycle, and Warner is the most dependent on the NBA. However, much the same approach should be taken to evaluating any broadcaster with a major sports portfolio. Some of them, however, do not suffer for the new perspective as much as Warner does.
Paramount Global (PARA) and NBCUniversal are in the first year of their new deals with the Big Ten, meaning that their profit is actually being somewhat underreported on those deals. The same goes for their NFL deals which just kicked in this year, the first year of an 11-year cycle. Somewhat counteracting this, however, is that Paramount Global is now well into its March Madness deal and if anything is probably moving into the broadcast-slanted years of that deal. The same goes for NBC’s Olympics deal.
As for Disney, the King of Sports, well, it has so many sports deals that they tend to counterbalance one another somewhat, making the impact somewhat less than Warner. Still, I wouldn’t rule out the impact completely. Disney, like Warner, is profiting massively from the current cycle of NBA deals and is almost certainly looking at a major hit when they renew, since Disney’s ESPN seems every bit as determined as Warner’s Turner to keep the NBA onside.
Investment Summary
This isn’t to say management has lied or been deceptive; it’s just part and parcel of operating in the sports broadcasting space. But not all the investors who are bullish on WBD seem to fully understand this, I’m sorry to say.
When the market prices Warner’s P/E down in the tail end of its largest sports deal, it’s not being cynical or unreasonable; any long-term valuation system like the stock market is going to price on the long-run average profit margin of the company, not the exaggerated profits it reports when the deal is in its most profitable years (Warner isn’t actually profitable right now, but you know what I’m trying to say.) The market price of Warner’s stock right now is a reflection of the fact that a hit of somewhere between $1.2 and $2.2 billion is approaching, regardless of which choice Warner ultimately makes.
Warner may, or may not, look undervalued when its current Enterprise Value is laid alongside projected synergy savings in the coming years. However, its market price becomes a good deal easier to understand after an investor takes their projected HBO/Discovery nets/DC movies/etc. numbers and subtracts $2 billion a year from whatever number they are currently expecting.
Investment Recommendation
Despite the potential for substantial improvement in some of Warner’s other operations, I would avoid the stock until the extent of the NBA damage becomes clearer. Regardless, however, investors who do choose to buy in should know what awaits Warner at the other end of the NBA renewal cycle and should filter any reported profit number from a sports broadcaster in light of what stage of the renewal cycle it is in.
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