Warner/Discovery Challenge: Streaming, Cash Flow – Morgan Stanley (NASDAQ: DISCA)

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Warner Media (T +3.4%) and Discovery (DISCA +3%) are about to complete their transformative media merger in a weeks – and Morgan Stanley says investors are focused on the coming tension between investing in the streaming business and generating free cash flow.

The merger is a value-creating operation for Discovery (DISCA +3%), analyst Ben Swinburne and team write, but the company retains an equal weight rating on the company for three reasons: visibility into pro forma financials is “poor” and EBITDA revisions tend to fall since the announcement of the agreement; “the cost of getting earnings forecasts wrong is high” since the net debt leverage of the new company will be 4.5x to 5x; and “while we appreciate Discovery’s confidence” in its ability to scale streaming while generating $8-9 billion in free cash flow in 2023, competitor experience suggests otherwise.

“Specifically, Disney (DIS -0.1%), NBCUniversal (CMCSA +2.6%) and Paramount Global (PARA +1.6%) streaming plans have all followed a somewhat similar cadence,” the company states. drive greater revenue growth.”

This is just the beginning and the new Warner Bros. Discovery should be able to adjust its strategy flexibly over time, but free cash flow volatility feels more like a risk than a benefit, according to the company.

Discovery has already hedged the interest rate risk against half the debt required to complete the transaction; thereafter, says Morgan Stanley, the focus is on the new company’s ability to meet synergy targets and repay debt to achieve a 2.5x to 3x leverage target within 24 months.

Following Discovery’s earnings report on Thursday, Morgan Stanley said the print was broadly in line with expectations and the spike in direct-to-consumer investment is in the rearview mirror. Aside from some pockets of weakness in the US broadcast ad market (due to the supply chain), advertising revenue continues to show growth with particular strength internationally.

It is increasing its forecast for stand-alone discovery OIBDA by about 2% for 2022 and 2023, mainly due to lower international spending; it has a price target of $27 on DISCK versus the current $28.48.

Discovery has set its shareholders’ meeting for March 11 and expectations are high for the deal to close in mid to late April.

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