With the current macroeconomic slowdown and heightened risk of recession, the Federal Reserve has embarked on an interest rate hike spree. This is causing borrowing costs to rise rapidly, which is straining companies with weaker balance sheets.
When the economy was in long-term expansion mode (until the pandemic), companies did not hesitate to take on massive amounts of debt to finance their operations and fuel their growth. Along with the technology and health care sectors, the media sector has become notorious for its growing indebtedness. When economic conditions were better and borrowing costs were low, this was less of a problem.
It’s completely normal for most large corporations to go into debt, but debt can be a double-edged sword. When macroeconomic conditions are favorable, companies are encouraged to take on cheap debt to invest in business and increase their profits; however, when the macroeconomic environment deteriorates, debt becomes more expensive to repay and a company could ultimately be exposed to default risk.
There is no doubt that the major changes that have taken place in the media sector in recent years have been costly but necessary for survival. Legacy media giants began to take on debt and pour huge sums of money to fund their streaming efforts.
On top of that, M&A activity has intensified over the past two years, a trend that typically occurs in booming economic conditions. Amid growing competition in the space, consolidation has become rampant in the media industry. But the problem with mergers and acquisitions is that the acquirer assumes the debt of the purchased entity. More recently, when WarnerMedia and Discovery merged, all of WarnerMedia’s debt issues were thrown into the lap of Warner Bros. new CEO. Discovery, David Zaslav.
With the second-quarter earnings season in the rearview mirror, investors took the pulse of the balance sheets of media industry heavyweights. Free cash flow and leverage remained front and center as executives noted heightened uncertainty.
AT&T was often at the top of debt lists; however, after offloading WarnerMedia, Comcast took the top spot. Warner Bros. Discovery ranks third following its merger in April.
However, just because the total amount of debt is high does not mean that the company is in a bad financial situation, and this is where financial leverage comes into play. Although there are several ways to assess financial leverage, investors often look to debt. to EBITDA and debt to equity to analyze the health of companies’ balance sheets, including media.
The debt-to-EBITDA ratio (debt/EBITDA) measures the amount of revenue available to repay debt before covering interest, taxes, depreciation and amortization. Simply put, it assesses a company’s ability to repay its debt, and a higher ratio usually means the debt is too heavy.
A debt-to-equity ratio (D/E) is a method of measuring a company’s financial leverage by dividing long-term debt by equity. It is important when assessing the health of a company because it reveals how much of a company’s operations are financed by debt versus wholly owned funds. When a company has a higher D/E ratio, it is often considered a riskier investment.
At the general level of the communications sector, the average leverage ratio is around 1.9x. Currently in the media industry, Warner Bros.’ 5.0x leverage ratio. Discovery sits at the top end of its peers. Meanwhile, Comcast had a leverage ratio of 2.9x, while Disney’s leverage ratio was around 2.2x, and Netflix’s was around 2.4x, at the end of last quarter. Zaslav must keep his promise to reduce WBD’s debt ratio to between 2.5x and 3.0x within 2 years or risk losing all investor confidence.
Highly leveraged companies are threatened by overall economic conditions as well as changes in the way media and streaming companies are valued. The days of subscriber growth being the only metric celebrated are long gone. As we have seen in recent quarters, investors have now refocused on the fundamentals: profitability and a healthy balance sheet to support future investments.
With an end to the economic downturn not in sight, this new operating environment will naturally weed out weaker players in the media industry. Many industry pundits have expressed concern over the bloated debt that has plagued decades, and now we have finally reached the point of settling the accounts. Changing consumer behavior and changing media landscape are difficult enough. But it is now up to corporate leaders to also find a way to balance the huge debt burden in order to inspire investor confidence in their companies.
