Warner Brothers Discovery: The New Streaming Giant?

Despite the covid-19 crisis, global mergers & acquisition (M&A) activity in 2021 hit a record high for a second consecutive quarter as deals worth $1.5 trillion were announced. This valuation represents a 13% increase from quarter 1, which saw deals total $1.3 trillion. Dealmakers said a boom in the stock market and low borrowing costs – driven by low-interest rates – emboldened companies, private equity funds, and blank cheque acquisition companies to take advantage of favourable market conditions.

Notably, the media and entertainment industry has seen the biggest deal of the year so far as AT&T agreed to spin off and merge its WarnerMedia business with Discovery Inc. The $43 billion deal unites one of Hollywood's biggest studios with Discovery's channels, creating a new streaming giant to rival Netflix and Disney+. The combined company’s expected name is Warner Bros Discovery.

Background - AT&T and WarnerMedia

The emergence of AT&T traces back to the invention of the telephone in 1876 by Alexander Graham Bell. Soon after, the Bell Telephone Company was formed, and it acquired the American Telephone and Telegraph Company (AT&T). After some legal complications, AT&T acquired the Bell Telephone Company and subsequently became the parent company of the entire Bell system.    

AT&T operated as a monopoly throughout the 20th century and accordingly faced many legal disputes with the government. Eventually, US regulators forced AT&T to divest its regional subsidiaries into separate companies. In 2005, one of the divested companies acquired AT&T back in a deal worth $16 billion and the new company kept the honoured AT&T brand; AT&T became a big player again.

Currently, AT&T is the world’s largest telecommunications company and operates through three reportable segments: Communications, which provides wireless services, video, internet, and voice communications; Latin America, which provides Pay TV services in Latin America and other services in Mexico; and WarnerMedia.  

WarnerMedia (formerly known as Time Warner) produces and distributes feature films, television, and other content in physical and digital formats. AT&T announced to merge with Time Warner in 2016 in a deal worth $85 billion. The aim was to market Time Warner's massive pool of content to cable companies and consumers through AT&T’s network. After the merger in 2018, Time Warner became WarnerMedia. The segment generated $30.4 billion in 2020, equating to 20% of AT&T’s total revenue that year. So, the decision to allow WarnerMedia to create a business separate from AT&T three years later came as a shock to many.    

What went wrong with AT&T’s merger with WarnerMedia? WarnerMedia’s streaming service, HBO Max, grew slower than anticipated and was stuck firmly behind Netflix, Disney+, and Amazon Prime. CNBC wrote, “WarnerMedia became an albatross on AT&T shares, which have underperformed Verizon and T-Mobile since the deal's completion date on June 14, 2018." The differences between a wireless phone company and a content asset made it hard for the two companies to synergise, especially under the leadership of a CEO that had little experience in the entertainment industry. Also, AT&T’s ability to expand its fibre network started to wane after the company eliminated roughly 45,000 jobs across its media and telecom divisions post-merger, leading to loss of market share in each industry.    

Background – Discovery, Inc  

Discovery Inc is the world's #1 non-fiction media company, with more than 150 worldwide cable TV networks, including Discovery Channel, Animal Planet, and TLC. Discovery's various networks reach more than 3 billion subscribers in 220 countries. Its segments include U.S. Networks, which accounts for roughly 50% of revenue and consists principally of domestic television networks; Education, consisting principally of curriculum-based product offerings; and International Networks.  

Discovery Inc reported an annual revenue of $10.6bn in 2020, which marks a yearly average increase of 17.8% since 2017. The growth can be attributed to a differentiated low-cost business model that generates stable free cash flows, a leading international distribution platform that simplifies the company’s marketing efforts, and additive growth across Europe caused by increased viewership in this region. Discovery generates the majority of its revenue through advertising and carriage fees paid by cable system operators.

Warner Bros. Discovery - The Deal  

The deal will be structured as a Reverse Morris Trust transaction, a strategy in which a company can spin-off and sell assets to an interested party while avoiding taxes on any gains from such asset disposal. Under the terms of the agreement, if there are no regulatory issues, AT&T will spin off WarnerMedia and allow Discovery to take over the new company. AT&T would receive an aggregate amount of $43 billion in cash, debt securities, and WarnerMedia’s retention of debt.

Warner Bros Discovery, the expected name of the new business, will be separate from AT&T and could be valued at $150 billion, debt included. The new company will combine HBO Max and Discovery+ to compete in the direct-to-consumer business, bringing together names such as HBO, Warner Bros, Discovery, CNN, Food Network, TNT, and more. Upon close in 2022, AT&T shareholders are expected to receive stock representing 71% of the new company, while Discovery shareholders would own 29%.

The market’s initial reaction was negative as shares of AT&T fell as much as 7.9% immediately after the announcement in May 2021, the steepest intraday decline since March 2020. Discovery shares fell less than 1%. Investors were concerned about a dividend reduction as a successful merger means that AT&T would lose WarnerMedia as an asset, resulting in a significant drop in revenue and cash flow. This potential reduction in income was enough to cause investors to sell their shares.  

AT&T hope that the merger will allow them to streamline their business and focus on returning growth to its core businesses. By separating its media businesses, AT&T will be able to freely invest more heavily in 5G technology, while drawing revenue from dwindling cable subscription fees. In the long term, AT&T will likely have an improved financial position with less debt and therefore will better compete with rivals Verizon and T-Mobile.  

For Discovery and Time Warner, they hope Warner Bros Discovery can compete with other streaming services. The new company would take on $55 billion in debt, but it is expected to be a “free cash flow machine” and generate $52 billion in revenue in 2023 alone. With over 200,000 hours of content and plans to invest $20 billion a year toward new content, Warner Bros Discovery will be a serious competitor in the media industry. Netflix, for example, invests $17 billion a year toward new content and only have 30,000 hours of content. In the long term, Warner Bros Discovery hopes to reach 400,000 homes.

Conclusion  

AT&T’s decision to allow WarnerMedia to merge with Discovery initially took many in the industry by surprise. But when you consider AT&T’s lack of media expertise and declining market power in its core businesses, the deal begins to make more sense. Additionally, in the global streaming race, bigger seems to be better, and the potential of Warner Bros Discovery is huge given it would become the second-largest media company in the world. Ultimately, the success of the new company will depend on both its ability to attract new subscribers and the price subscribers are willing to pay for content. With the global media industry and global telecommunications industry expected to grow at an average rate of 9.3% and 5.4% respectively for the next several years, it is safe to predict that there is growth potential for each company if they follow clear and robust strategies.