More Warning Signs Emerging for AT&T ($T)'s Bet on WarnerMedia

AT&T CEO John Stankey's vision for WarnerMedia conflicts with reality of "Media's just not a great place to be from an investment perspective"

After a recent Wall Street Journal interview with AT&T CEO John Stankey and a busy week for WarnerMedia, it is worth checking back in on AT&T's bet on WarnerMedia. I last wrote about AT&T about 10 weeks ago in July ([memberful_buy_download_link download='7182-membership-mailing-223-july-28-2020']purchase here[/memberful_buy_download_link], Members [memberful_download_link download='7182-membership-mailing-223-july-28-2020']download for free)[/memberful_download_link]. That was about how Q2 results reflected that WarnerMedia Jason Kilar was finding wins for his DTC business with HBO Max, despite evidence of a dysfunctional ecosystem across AT&T.

A barrage of recent headlines suggest that WarnerMedia is now focused on navigating the production and distribution delays resulting from COVID. Any critique or bearish take of its $85B, debt-driven bet on WarnerMedia in October 2020, while in the middle of a once-in-100-year pandemic needs to acknowledge the unusualness of these circumstances.

I agree they exist.

That said, AT&T continues to bet heavily on HBO Max and WarnerMedia with the business logic of:

... "A reduction of 1 basis point of wireless churn across the base is worth about $100 million to us annually” (AT&T CEO John Stankey to investors in January 2020) and “10 basis points of churn is a billion dollars” (former AT&T CFO John Donovan to Fortune Magazine). So, in their words, HBO Max is not an aspirational brand around which to build an ecosystem, but rather a means for leveraging bundling to reduce churn.

I wrote this about AT&T last month, breaking down how "AT&T is Not A Media Ecosystem" when considered through the lens of the IAC MGM hypothesis. I argued how aT&T does not have any easy answers to solving for building a Disney-like ecosystem built around Warner IP. Reading this WSJ interview, I think Stankey understands this, and is relying on the logic above of “10 basis points of churn is a billion dollars”:

AT&T has said it plans to bundle HBO Max’s movies and TV shows with wireless and broadband packages to keep cellphone users happy and to attract new home-internet customers. The company has also told investors it will expand its fiber-optic cable installations to gain more residential customers, an investment worth billions of dollars. It plans to keep spending but would also welcome more government support, Mr. Stankey recently wrote in Politico.

What the IAC MGM Hypothesis framework helped to shed light on is how narrow this bet on WarnerMedia and HBO Max is: Stankey's long-term vision is that a media business has a definable ROI when it helps to solve for churn. A reduction of one basis point of churn marginally contributes to paying down for the WarnerMedia acquisition. AT&T investors should be happy with that.

But, the lurking question that AT&T continues to face is what it means for AT&T to own and operate a media business. There is a quote in the piece from Parnassus analyst Andrew Choi:

“Media’s just not a great place to be from an investment perspective. Hollywood’s always soaked up as much capital as possible.”

We know how John Stankey continues to aggressively sell his operational vision with WarnerMedia as "long-term". But, both the WSJ piece and recent COVID and non-COVID related developments from this week shed light on why this vision continues to invite skepticism.

1. The Witches, Justice League: The Snyder Cut & SVOD economics

"SVOD economics" is the Netflix logic that the value of an investment in streaming content can be recouped across the slate of content at the cost of per picture profitability. Basically, it is a bet on amortization reflecting the "life" of a content library and not an individual film or TV series. Rich Greenfield of Lightshed Partners has been writing and tweeting about this often: that there is a "new math" to producing content for streaming. The market precedent is Netflix's methodology for content amortization:

• The amortization schedule for content is based on historical and estimated viewing patterns and is reviewed quarterly

• Our content library is amortized on an accelerated basis

• Content assets are amortized over the shorter of the title’s window of availability or estimated period of use or 10 years

• On average, over 90% of a licensed or produced streaming content asset is expected to be amortized within four years after its month of first availability.

• First run topical programming like talk shows are expensed upon airing

Last week WarnerMedia announced that Robert Zemeckis' version of Roald Dahl's The Witches is skipping theaters for a debut on HBO Max on October 22, and into theaters internationally on October 28. Of course, that means that theatrical economics - profitability on the movie - has been replaced what is effectively a Halloween marketing bet: that The Witches will create more awareness and drive more sign-ups to HBO Max than attempting to imitated Disney's PVOD experiment with Mulan or Universal's PVOD experiment with Trolls World Tour.

There are two angles to this problem worth discussing one of which I will cover in this section and the other below.

The first angle is an accounting angle: HBO Max is effectively trying to turn the "lemons" of a delayed US release into marketing "lemonade" for HBO Max. Whatever losses it suffers theatrically it plans on recouping via HBO Max. It also seems to believe that Disney+-like PVOD pricing and execution simply are not an option with its consumers.

Which leads to the logical question: if WarnerMedia believes it can recoup for Warner Bros. Pictures on HBO Max with The Witches as a Halloween promotional vehicle. But, one has to wonder what backend talent incentives were drawn up, if any, for this move to take place, as these contracts are not Netflix-like, upfront payment-type contracts: because it is theatrical first, the cast and crew share in the back-end. Which effectively means that, like Netflix, HBO Max's management see some promotional value in The Witches driving valuable target audiences to HBO Max, or engaging more on HBO Max.

Contrast this Zach Snyder's Justice League: The Snyder Cut reshoots, which are exclusive to HBO Max and are currently costing WarnerMedia an additional $70MM. It is not clear how WarnerMedia is accounting for the shoot; but, one way to look at it is, if last quarter's operating income margins are any indication (27%), Justice League: The Snyder Cut will need to be part of a portfolio of movies and shows that drive 4x the sign-ups in the short-term to justify the cost; or, that are long-term hit in terms of consumption to be amortized longer term. Longer-term amortization across multiple "hits" will reflect that $70MM being less of a hit on Operating Income.

The problem here is, it is not obvious how either of these titles helps to solve for reducing wireless churn. Or, put another way, as much as these movies matter to the accounting of the WarnerMedia division of AT&T, it would appear their real measure of success will be measured in terms of basis points of churn. Can The Witches help to drive wireless or broadband fiber sign-ups? Can Justice League: The Snyder Cut reduce wireless or broadband churn?

It does not seem to be that the SVOD math of WarnerMedia's investments in this tentpole content helps AT&T with its business objectives. And with AT&T carrying $150B in debt, it certainly does not want the additional costs and risks of recoupment these films carry if they do not obviously contribute to reduced churn. But, Stankey seems to argue that is the long-term vision, and that vision does not offer the basics of a solid financial rationale.

2. Theatrical and PVOD at WarnerMedia

The second accounting angle to the problem The Witches poses was reflected in the announcement that WarnerMedia's fall slate has been pushed back to 2022, excluding Wonder Woman 1984, which is rumored to go direct to streaming for a Christmas release.

The Entertainment Strategy Guy has a good breakdown of this problem in his three-part series on PVOD and Mulan. He asked if Disney could have afforded to hold back Mulan for a year:

They could, but three things are holding them back. Which I’ve been struggling to explain all summer, and think I just figured out.

First, the financial cost of capital. Which is the idea that if you spend $200 million to make a film, the goal is to eventually make $216 million accounting for inflation since the entertainment industry’s cost of capital is roughly 8%. (No matter what else you know about entertainment, that’s the key math.) If you wait a year, you need to make 8% extra to cover the costs of the delay. That’s the damage “cost of capital” does to a cash flow statement.

(Want an explainer on net present value/the time value of money? Go here.)

For big films, this is clearly worth it; smaller films it isn’t. If the next Fast and Furious film does a billion dollars, taking the 8% cost of capital hit is better than a 60% total revenue hit. Using this logic, Disney should have moved it back.

The second cost, though, may be the real driver. That of what I’m calling “organizational” cost of capital. If everyone moves their films back simultaneously, the problem is many of those films can’t release at the same time. And that means you can’t start making new films, since they won’t have anywhere to go.

In other words, AT&T and WarnerMedia are taking a hit in the hundreds of millions of dollars for 2020 and 2021 to wait to release these movies (presumably $300MM+). Yes, these are COVID-related delays; but, production or release delays are not unusual risks in Hollywood. AT&T needs to eat these enormous costs at the same time it needs to pay down debt and pay out dividends to shareholders (more on this later).

Given that Wonder Woman grossed $821M worldwide in 2017, the lost revenue and cash flow is going to be real, whatever upside it may see in releasing on HBO Max. Not only is PVOD not an option after Mulan, but the best possible option for WarnerMedia with Wonder Woman 1984 within the AT&T ecosystem is HBO Max.

3. The Bigger Problem: AT&T's WarnerMedia Ecosystem (The IAC MGM Hypothesis)

As I wrote last month in WarnerMedia, NBCU, and Theme Parks:

...AT&T has multiple business models of monetizing multiple audiences, but not necessarily multiple business models for monetizing the same audiences. An AT&T wireless customer could also be a viewer of TNT, a visitor to Bleacher Report, and a subscriber to HBO Max. But those are individual entry points which are not associated with the AT&T brand. The AT&T customer is not circulating within an ecosystem between and across multiple services tied to the AT&T brand.

What this means is, if we look past the business logic "one basis point of churn equals $100MM", WarnerMedia's moves towards SVOD economics has one big downside: there is nowhere else within the AT&T ecosystem but HBO Max, wireless, or broadband to monetize these consumers of The Witches, Justice League: The Snyder Cut, and Wonder Woman 1984. Meaning, even if WarnerMedia monetizes these movies with merchandise or video games, so what? HBO Max generates recurring revenues, and reducing churn generates $100MM+ in returns. That is all. Nothing else but HBO Max or perhaps an unbelievable deal for a new 5G iPhone is going to keep these consumers in the AT&T or WarnerMedia ecosystems.

Which brings us back to John Stankey's long-term vision "to bundle HBO Max’s movies and TV shows with wireless and broadband packages to keep cellphone users happy and to attract new home-internet customers". As IAC lays out in its MGM hypothesis, a streaming service alone is not what keeps customers happy or loyal to a service. Rather, what helps to keep customers happy is an ecosystem built around an aspirational brand and which offers multiple avenues to monetize those customers around the same IP. Stankey has expressly stated that AT&T has not built that, and that is not its strategic vision.

Conclusion

Returning to this quote in the WSJ piece from Parnassus analyst Andrew Choi:

“Media’s just not a great place to be from an investment perspective. Hollywood’s always soaked up as much capital as possible.”

AT&T now faces WarnerMedia indeed "soaking up as much capital as possible". Even if the problem is a once-in-a-lifetime pandemic, WarnerMedia creates a number of problems on the cash flow statement and the income statement.

For the income statement, it is not clear to what extent The Witches and Wonder Woman 1984 are part of a larger portfolio of SVOD titles that will help the service to grow revenues, or attract the types of consumers HBO Max can retain for $14.99 per month. Nor is it clear how cast and crew will be compensated for the opportunity cost of the star vehicles bypassing U.S. theatrical box office, an issue that "SVOD economics" avoids with payments upfront.

For the cash flow statement, AT&T is going to be taking a nine-figure hit for the next two years across four titles. To add, that does not include lost cash flow from Wonder Woman 1984 and The Witches skipping domestic theaters. On a related note, there is also the matter of the dividend, as The Wall Street Journal points out. AT&T investors "rely on the dividend", but:

AT&T’s annual dividend yield, which reflects the annual dividend paid per share divided by its price, has surged above 7% after trading around 6% or lower for most of the past decade. That high ratio suggests investors aren’t confident the stock can keep growing with the dividend.

All of this because of the business logic of "one basis point of churn equals $100MM" and “10 basis points of churn is a billion dollars”. There is no arguing with the math of that business logic. What WarnerMedia's struggles during COVID reflect, what the high ration of the annual dividend yield reflects, and what the application of the IAC MGM Hypothesis reflects, is that this is the wrong business logic for managing WarnerMedia.

As I wrote above, any critique or bearish take of AT&T's $85B, debt-driven bet on WarnerMedia in October 2020, while in the middle of a once-in-100-year pandemic, needs to acknowledge the unusualness of these circumstances. I do. That is not my point here.

Rather, my point is, AT&T has not built a brand or ecosystem for consumers that is favorable to the business logic of this $85B debt-driven bet on WarnerMedia in the short-term, nor the long-term.

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