Warner Bros: fright night for bondholders
Warner Brothers Discovery is breaking up and bondholders have been left carrying the baby. Specifically, a US$37bn bundle of debt joy that will essentially now be supported by only one half of the business. The rating agencies have reacted with horror by placing Warner’s ratings on review for downgrade and signalled that not only is this business not investment grade but that its bonds could fall as far as the single-B range.
How could this happen? How could the marriage of the storied Hollywood stalwart and creative powerhouse Warner Bros and reality TV mainstay Discovery Communications go so wrong?
The answer lies in a combination of massive structural change in the media landscape that has challenged even behemoths like Disney and an aggressive restructure that has stripped bondholders of much of their assets and most of their covenant protections.
The advent of widespread, fast and reliable broadband ushered in the era of video streaming. Netflix led this charge and has grown to dominate the industry with over 300 million subscribers and a global platform. After initially dismissing the threat and even serving it with their own content for a quick and easy return, traditional media began to realise they were “feeding the gremlin after midnight” and scrambled to cut off and catch up with Netflix by repatriating much of their content from the upstart service and build out their own platforms. It was too late. Netflix had too much momentum, scale and brand value, and all the traditional media players did was accelerate the decline of their core cash cow “linear” broadcast channels, whilst growing cash-burning streaming units that were no match for Netflix in scale or free cash flow.
Warner was battered by this storm like the others. The linear broadcast “Networks” unit that generates nearly 80% of group EBITDA has seen its EBITDA fall 25% over the same time period as US cable subscribers “cut the cord” and move to streaming. Streaming has shown strong growth over the same period as it added subscribers, but the cash cost has been enormous and is only just beginning to turn cash generative.
Warner was similarly under water on its balance sheet ambitions. Having amassed an enormous US$50bn+ debt pile (5.4x gross leverage) to create the business (Discovery acquired Time Warner from AT&T), the company set course to aggressively reduce debt aided by the complete suspension of all shareholder payouts until the target of 2.5-3.0x leverage was reached. Alas, this target was never achieved. As a result, Warner closed the last quarter with US$37bn debt and 4.2x gross leverage.
The combination of disappointing performance and the failure to achieve debt reduction targets has severely impacted Warner’s share price, which is down 60% since from its 2021 high. Warner’s policy was to halt all shareholder returns until the 2.5-3.0x leverage metrics were met, and it had previously had a healthy buyback programme. Bigger picture, shareholder confidence in the “transition to streaming” narrative was cracking, with an increasingly prevalent view that Warner was moving from a healthy 40% margin linear business model to a more meagre 20% margin streaming dynamic.
And so we come to this week’s news. With the business clearly struggling and the CEO having just been knocked back on his bumper US$50m+ compensation package by disappointed shareholders, Warner announced the structural break-up of the group into Streaming & Studios and Global Networks. Amazingly, no details were given of the proposed capital structure or financial polices for the two new entities beyond “the majority of debt” staying with Global Networks. Similarly, crucial specifics on the future contractual relationships between these two previously interdependent businesses were scant.
Concurrent with the break up, Warner offered to buy back US$15bn of its bonds (“tender offer”) funded by a new 1st lien secured bridge loan, whilst at the same time proposing changing the terms of those bonds (“consent solicitation”). The aim was two-fold: first, to trim the overall debt load (buying bonds at below par pricing) and clear away short term debt; second, to significantly reduce the protections that lenders benefit from in the current bond documentation.
On this last point, Warner sought to strip out the covenants that protect bondholders in key areas such as asset sales and asset security, and to insert a new “non-boycott” term across the entire bond structure. This “non-boycott” clause prohibits bondholders from forming an effective bondholder group (known as a “co-operative agreement”) by restricting the inclusion of certain key provisions that block engagement with, and refinancing of, the company and would expose bondholders to damages if they were deemed to be in breach of contract. This is a development that Covenant Review described as having “a chilling effect on investors” by eliminating a “useful tool… in future interactions with the company”.
None of this sounds great, so why would investors (turkeys) vote for these amendments (Christmas)? Because of the implicit threat that if you do not tender bonds and consent, then you will end up at the bottom of the capital structure. More specifically, bondholders that do not participate would remain unsecured creditors, while participating investors would sell a proportion of their bonds funded via the new 1st lien secured debt that would subordinate existing unsecured bondholders. Furthermore, any tendered bonds that were not accepted into the tender would be granted 2nd lien security, which would again subordinate the existing non-participating unsecured bondholders.
This is a classic prisoners’ dilemma, which is only exacerbated by this complex tender-and-consent process being conducted on a very tight 5-day timeline. This impairs investors’ ability to both analyse and organise should they want to push back on any of the terms, or create a blocking group vs. the 50% voting thresholds in the documentation. This is, in our view, a significantly negative development for the bond market with the very real risk that these compressed timelines for complex transactions and the aggressively restrictive “non-boycott” covenant become market norms.
Warner is a classic example of a company that has opted to exploit aggressive financial and documentation (re)engineering enabled by its generally weaker investment grade covenants to solve its operational and valuation problems. The day after the Warner announcement, Disney’s CEO Bob Iger said that Disney had considered and rejected the idea of a linear network asset spin out and now considered the combination of linear and streaming as offering “great economies of scale” and a “winning combination” for Disney, its advertisers and its distributors. Iger mused “as others exit (linear) I think it gives us a stronger hand”. Only time will tell if Warner has forgone building a solid long term integrated future for a short term streaming valuation sugar rush and the creation of an isolated melting linear iceberg.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.
