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Discovery, Inc. (NASDAQ: DISCA) is on the verge of a very large takeover. Such acquisitions can be very risky. In fact, historically large acquisitions often don’t deliver on the promises made by more than a few ambitious management teams. Therefore, any help, no matter how small, is more than appreciated by the shareholders. The economy is providing unexpected help here by presenting itself in the best shape it has been in around two years. That makes potential customers a little more willing to spend money on new company products than they otherwise would have been. For investors, that should mean the upcoming merger will get off to a good start in a benign economic environment.
There will still be some work to do on management as management forecasts significant synergies.
Discovery Inc. Fiscal Year 2021 Cash Flow From Operating Activities (Discovery Inc. Q4 2021 Results Press Release)
Discovery Inc. Fourth Quarter and Fiscal Year 2021 Summary Operating Results (Discovery Inc. Q4 2021 Results Press Release)
One of the things to note is that the company had a huge increase in cash flow in the fourth quarter, which was enough to bring the full year on a small increase. Another look at the details for the fiscal year shows that cash flow actually grew quite a bit more to cover the increase in “content rights and liabilities,” while that small increase remained.
One of the benefits of the merger has to be the potential for the merged company to have to buy slightly fewer rights to content. Thus, if this cash flow trend continues for the combined company, cash flow from the existing business (before any post-combination benefits) could be increased somewhat.
This is important because time is extremely important when it comes to paying off debts.
Some of us noted the acquisition of Anadarko (`C) by Occidental (OXY), which was followed by the OPEC price war and then the coronavirus demand destruction. Now, Occidental had to execute its deleveraging strategy of selling assets in a far less supportive environment. Selling prices of assets sold during this period are likely to have suffered. It’s the kind of future that quickly eats away at potential gains.
With that in mind, management’s guidance on debt repayment is summarized below.
Discovery and AT&T presentation of merger financial details (Discovery and Warner Media combine announcement presentation in May 2021)
Obviously, Discovery, Inc. is making some financial efforts to close this deal. Any positive factors like a strong economy that allows for more discretionary spending are likely to result in faster debt repayments that reduce the debt burden. The time it takes for management to “reconcile” the debt is likely to decrease. This reduces the excessive financial risk.
The business itself, if run properly, usually generates a fairly large amount of free cash flow that can be used to pay down debt. Therefore, the ability to grow revenue is required for this transaction to look like a good deal to shareholders. Management will have several avenues to successfully pursue this endeavor with the combined company.
To some extent, costs are fixed for a range of revenues. The risk is that these costs may become “unfixed” and out of management’s control due to market conditions. So, controlling content costs will be another key to the success of this deal.
Preliminary gains from a strong economy may also prompt the market to re-evaluate common stock. A little extra revenue makes streamlining the merger process more palatable to the market. The launch of new profitable ventures by the merged entity should also be easier.
It goes back to the time value of money since a dollar paid back now will cost much less in interest than a dollar paid back (from debt) in the future. Since the increased debt is many billions of dollars, there are definitely potentially hundreds of millions in interest expenses (in the future) that can potentially be saved. Management may also have more leeway should certain parts of the merger benefits prove more difficult than initially anticipated.
It will also become easier to sell non-core assets at a better price. In addition, the acquisition of required departments or equipment can prove to be more expensive. But overall, this merger seems to come at great time economically for the company.
Comparison of Discovery Inc. stock prices over five years (Discovery Inc. 2021 Annual Report)
So far, share prices are obviously “stuck”. It may be that long-term management saw the merger as an opportunity to resume the growth of the company’s “early days” (or a recapture of the company’s heyday). The question of the market after the merger will focus on the accuracy of the management vision.
Should management be successful, the share price will not match the price record shown above in the future. The company will be much larger after the merger and will have gained several distinct lines of business.
There will be several opportunities for apparent growth such as: B. Streaming and the benefits of streaming in the future. This new area of business seems a little crowded these days. However, the potential benefits to other parts of the company as the streaming wars get underway will likely offset at least some of the cost effects of those streaming wars.
The way of discovering too much cash flow and profit (Discovery and Warner Media combine presentation in May 2021.)
Most media companies (including this one) have a vision of how the future businesses will generate tons of cash and profits. It always boils down to revenue having to exceed costs in order to have enough bottom line cash to keep shareholders happy.
It always sounds so easy. But those of us who’ve followed Netflix (NFLX) know that management’s original talk of a “virtuous circle” hasn’t materialized yet because costs have spiraled out of control. In fact, the company again reported large negative cash flow and negative free cash flow last quarter.
This happens because there is a lot of competition for the viewer’s time. Any potential customer has virtually unlimited ways to entertain themselves. There really aren’t any meaningful competitive moats when it comes to competing for anyone’s free time. As a result, it’s far more common for costs to spiral out of control than you might think. That’s probably the biggest risk in this industry.
Having reviewed the risks and logistical challenges of a large merger like this, it still appears that management has a very good chance of making this combination a success. The management is already familiar with large parts of the business and has been running a successful business for some time. Management has to learn something (and it has to learn fast). But the combined deal is likely a less risky proposition than for AT&T(T), which really had no experience in this part of the business.
Personally, I like management’s prospects for success. As such, I will keep any Discovery shares I receive from my AT&T shares. I’ll decide whether or not to increase my holdings after a few months, once I see a quarter or two of reporting.
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