8 July 2021

In today’s episode, Trey Lockerbie sits down with one of his favorite portfolio managers, Andrew Walker from Rangeley Capital. Trey took the opportunity to dig deeper on SPACs with Andrew, who is currently running a SPACs focused fund. This episode has been recorded in early June and a few weeks later, Pershing Square announced a 10% SPACquisition of Universal Music Group, which was not listed in the rumored roster of prospects, but makes the conversation even more interesting.

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  • Billionaire Bill Ackman’s comparison of the typical SPAC with the Pershing Square Tontine SPAC and why Andrew calls it a “unicorn” SPAC
  • Discovery Channel and Warner’s recent merger
  • The collapse of Archegos


Disclaimer: The transcript that follows has been generated using artificial intelligence. We strive to be as accurate as possible, but minor errors and slightly off timestamps may be present due to platform differences.

Trey Lockerbie (00:02):
On today’s episode, I sit down with one of my favorite portfolio managers, Andrew Walker, from Rangeley Capital. I took the opportunity to dig deeper on SPACs with Andrew, who’s currently running a SPACs-focused fund. We then compare your typical SPAC with the Pershing Square tontine SPAC from billionaire Bill Ackman, and why Andrew calls it a unicorn SPAC. Andrew and I recorded this in early June, and a few weeks later, Pershing Square announced a 10% SPACquisition of Universal Music Group, which was not listed in the rumored roster of prospects, but makes the conversation even more interesting. Then we take a right turn and navigate through the recent merger between Discovery and Warner, and the collapse of Archegos along the way.

Trey Lockerbie (00:44):
Andrew has a contrarian take on the merger and believes that with the free cash flowing from Discovery, the new entity can easily endure the short-term chop and produce a lot of value to the upside. Andrew’s one of the sharpest minds in the value investing community. So grab a kombucha and enjoy this deep dive into two very interesting topics with Andrew Walker.

Intro (01:07):
You are listening to The Investor’s Podcast, where we study the financial markets and read the books that influence self-made billionaires the most. We keep you informed and prepared for the unexpected.

Trey Lockerbie (01:27):
Welcome, everybody to The Investor’s Podcast. I’m your host, Trey Lockerbie. And today, I am sitting across from Andrew Walker from Rangeley Capital. We’re going to talk about a lot of interesting stuff. First and foremost, we’re going to cover some SPACs. One of his funds is actually a SPACs-focused fund, so we’re going touch on that, and then we’re going to merge into the Discovery-Warner merger. See what I did there?

Andrew Walker (01:51):
That was really good. I like that.

Trey Lockerbie (01:54):
I’m excited to dig in on this with Andrew. So thanks for coming on the show.

Andrew Walker (01:58):
Hey, thanks for having me. I’m happy to be here. SPACs and Discovery, they take up an increasing proportion of my life, so it’s good to get on Zoom and talk to someone about them.

Trey Lockerbie (02:07):
We’ve touched on SPACs a few times on the show here and there, and we’ve had some guests that are really big on the idea, Jason Karp, Chamath Palihapitiya. Ted Seides even running a SPAC fund of sorts now. And you’re doing so as well. And what keeps coming up for me, I guess, as a retail investor is just constantly seeing headlines about this idea that the incentives that the sponsors have don’t quite align with retail investors. We’ll quickly cover things like, obviously the sponsor gets 20% of the deal and they’re incentivized just financially in a disproportionate way, but I’m just curious to hear what your obsession with SPACs is and why it’s been occupying so much of the fund now.

Andrew Walker (02:50):
I think there’s two separate things there. The incentive structures for SPACs are, I don’t think this is an exaggeration to state, they’re absolutely awful. If you’re the founder of a SPAC, most SPACs come out with about 200 million, they raise $200 million in trust. So you and I, we’d get 200 million, we’d give it to a third party, let’s call him Ben. And Ben would go, take that 200 million, try to find a deal. And what Ben would put up is $5 million for a $200 million SPAC. And if he manages to find a deal that is approved and goes through, in exchange, he will get 20% of the company’s equity. So we gave him $200 million, he finds a deal and it goes through, he gets 20%. That’s effectively $40 million assuming the shares trade around trust.

Andrew Walker (03:31):
That’s a great trade for him. He’s just made an eight X without actually really creating any value. But for us, it’s actually a disastrous trade because if Ben doesn’t find a deal, he loses that $5 million. So Ben is actually incentivized to find any deal at any cost that can get done. Let’s say he finds a deal, it gets approved, and the stock goes from 10 to five. You and I have lost half our money, absolute disaster, but the company’s value has gone from 200 to 100 million, he gets 20% of it, he changes his $5 million into $20 million. Pretty good for him, right? So the incentives for a SPAC sponsor, in general, are to get a deal, any deal done because if they do that, they will make multiples of their money.

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Andrew Walker (04:12):
And then for minority investors, it’s even worse because a SPAC is a cash shell. Most mergers destroy value because whoever’s buying the company, overpays, but mergers, they can create value, and in general, they create value. Everybody likes to think they get a good deal in a merger, but in general, the way you create value for a merger is from operating synergies, financial synergies, all that type of stuff. A SPAC is a cash shell, it has no synergies. The only way it can win a deal, for the most part, is to go to an auction and be the high bidder. So as a minority investor, if you’re investing on a SPAC, you are buying into a company and you’re paying the top dollar for it, and even worse than that, you’re paying 20% more than top dollar because you’re getting diluted by the founder’s share.

Andrew Walker (04:52):
I think that’s the overview of the incentives and why SPACs can be so bad for minority investors.

Trey Lockerbie (04:58):
So what am I missing here? Because I was under the impression that if I’m a retail investor and I buy into the SPAC but pre-merger, and I don’t like the company that they picked or I don’t like to deal, I can get my $10 back.

Andrew Walker (05:11):
You are 100% correct. You can get your $10 back. That’s why a lot of hedge funds and event-driven funds, they love SPACs so much. You go, he buys SPAC… So the way most SPACs work, when they IPO, they IPO what’s called a unit, and that unit is one share, let’s just call it one warrant to make it simple. And you buy that unit. Eventually, you can split the share from the warrant. They come, they announced the deal, and you can choose, “Do I want to hold on to my share, or do I want to redeem and get my $10 back?” And even if you redeem, you can keep that warrant. So you get a free warrant. So from a hedge fund perspective, an arbitrage perspective, SPACs make a lot of sense because you get a free look at whatever deal they want.

Andrew Walker (05:47):
What I was talking about for minority investors is, it’s generally bad. If you hold through the deal. SPACs have a huge track record of destroying value after the deals are approved.

Trey Lockerbie (05:58):
And what is the warrant? What’s the strike price typically on that, is it at $10 per share?

Andrew Walker (06:03):
It’s typically $11.50 to simplify.

Trey Lockerbie (06:06):
All right. So let’s talk a little bit about how you’ve gotten so involved with SPACs. What’s the appeal for you running your own fund?

Andrew Walker (06:11):
I think there’s two appeals, the first was… We run a SPAC fund, full disclosure, and we started it in late 2018, early 2019. So, actually before the SPAC boom, and we started because, for years, we had looked at SPACs as asymmetric trades based on exactly what I told you before. We could buy the units, we’d split them into a stock and a warrant. We could wait till they announced the deal. If it was a great deal, that the market loved, great, we’d sell the stock on the open market for a profit. We’d sell the warrant for profit.

Andrew Walker (06:37):
If it was an awful deal, whatever, we’d redeem for $10 per share, we’d sell the warrant. Nothing’s ever investing advice, nothing’s ever risk-free, but it was about as close to risk-free trade as you can make. That’s why we started the SPAC fund. More recently, I’ve become obsessed because in a typical year, there would be about 200 companies that would IPO in a typical year. From 2015 to 2019, 200 companies would IPO, of them, 30 of them or so would be SPACked. In 2020, we saw about 250 SPAC IPOs. And then in the first quarter of 2021, we saw about 300 SPAC IPOs, that’s 550 SPAC IPOs in a year.

Andrew Walker (07:15):
There aren’t 550 new public-ready companies, so these SPACs are pulling in… There’s so many SPACs out there and they’re merging with every company, and there’s companies that have never been public before, new types of companies that have never been public before that are coming public. And that’s awesome for an investor who’s willing to look through all these SPACs. I said about 500 SPACs have come public, I think about 250 or 300 have done deals. Probably 50% of those deals are going to be awful, 40% of those deals are going to be below, but 10% of those deals are going to be really interesting.

Andrew Walker (07:45):
And because they’re bringing new types of companies public, if you can identify one of those 10% of deals, there’s a lot of upside potential. And because there are warrants outstanding, if you can identify a really interesting one and buy it through the warrants, you could make multiples of your money. So as an investor, it’s a really interesting space because there’s so many unique companies coming public through that.

Trey Lockerbie (08:05):
And with so many coming onto the scene, as you mentioned, one would think, is this just going to be the new way of doing things? And this is such a faster path to market or path to IPO for private business. I think that’s part of the appeal for them, but you even have Chamath Palihapitiya, I think recently coming out publicly saying there needs to be more regulation around SPACs, I think because they’re proliferating so much. Do you think that there’s more regulation to come?

Andrew Walker (08:33):
Look, one of the reasons SPACs got so big is because if you’re doing a normal IPO, you can’t provide projections, because if you miss those projections, you could be sued. You broke securities law by providing a forward-looking projection that you missed. If you’re doing a SPAC, because the SPAC is actually already a public company and technically what they’re doing is just a merger with another company, in a merger, you can provide projections. So these SPAC are providing five-year forward projections, but because of those poor incentives we talked about, a lot of these fast came public with these beautiful, rosy projections. “Yeah, we didn’t earn any revenue last year, but in five years, we’re going to be bigger than Amazon.”

Andrew Walker (09:08):
Then they become public. In the first quarter public, they pull their guidance, the financials would be awful, and the shares would drop like a rock. And that was a more generous interpretation. You saw things like Nikola, where they went public and they literally rolled a vehicle down a hill and called it a working prototype. So I do think there needs to be regulation. And I think that poor projection loophole should really be investigated, and I think they need to look at all these things. But it’s just a bad incentive system for 90% of the SPACs that come out.

Trey Lockerbie (09:36):
One of the more interesting SPACs out there right now is from Bill Ackman’s Pershing Square. There’s a Pershing Square SPAC that you’ve written about. What’s the most fascinating thing about this SPAC in particular?

Andrew Walker (09:48):
Yes. So take everything I said about bad incentives and bad structure for SPACs, and you can basically throw it out the window for Pershing Square’s. Pershing Square, originally they were going to hunt for a unicorn target. And in many ways, Pershing Square Tontine, which is the SPAC, is a unicorn SPAC. So it’s a unicorn in three ways. First, the incentive system. We’ve already talked about how most SPACs, the founders get the 20% of the company in the promote for very little money, Bill Ackman and Pershing Square Tontine did not take any promote.

Andrew Walker (10:18):
What they did is, all of their promote “was bought.” They wrote a $100 million check to buy warrants that buy the Pershing Square stock at $24 per share after they announced the deal. Now, they’re long-dated warrants, so they can create value as the company compounds over time. But he doesn’t get any promotes, he only bought those warrants, plus he agreed to a right of $1- to $3 billion check to buy Pershing Square common stock when they announced the deal at the same terms that public shareholders bought into the IPO.

Andrew Walker (10:49):
The incentive system for Bill Ackman, the only way he will make money is by Pershing Square going up over time. I gave an example earlier where a SPAC’s price could go down by 50% and these SPAC sponsors would still make four times their money. If Pershing Square stock went down by 50% after they announced the deal, Bill Ackman, because his deep out of the money warrants would be basically worthless, Bill Ackman would lose more than any minority shareholders. So his incentives are aligned. That’s one.

Andrew Walker (11:14):
Number two, it’s by far the largest SPAC that’s ever been raised. They raised $4 billion in trust. And in addition, Bill Ackman and Pershing Square agreed that they’ll buy one to $3 billion of stock when they announce the deal, five to $7 billion in cash buying power, that is orders of magnitude larger than every other SPAC. There’s a couple SPACs, like KKR raised one that touched about a billion dollars, but we’re talking five to seven billion. Most SPACs are two to $400 million in trust. So it’s orders of magnitude larger than every other SPAC, which means it can go after a lot bigger companies, and it can credibly tell them, “Hey, you go do a deal with another SPAC, that SPAC might a lot of redemptions, they might not actually deliver you a lot of money. Even if our SPAC has a lot of redemptions because Pershing Square’s writing one to $3 billion of a check, we’re going to deliver billions of dollars of cash to you.”

Andrew Walker (12:04):
So they can credibly say, “You get certainty of a huge check and our incentives are significantly aligned,” and they can go after bigger targets. And then the third thing is, Pershing Square is a tontine structure, and that is very unique. As far as I know, there’s only one other SPAC that came with a tontine structure. And a tontine structure, it’s kind of famous, it’s a really popular device plot in murder mysteries and murder movies. So Agatha Christie used a couple in her books, there was a Simpsons episode and Archer episode with it. A tontine is basically a group of people put money into a pool and whoever survives gets the money and is distributed between them.

Andrew Walker (12:41):
So you and I could put $10 into a tontine, whoever outlives the other would get the tontine, would get $20. They’re generally banned because governments don’t like pools of money that people will collect when some of the people die because it encourages murders and that’s why they’re such good murder mystery stories. But in this case, how the tontine works is, Persian went public and it’s got warrants attached to the shares that are nonredeemable, that don’t break off from the shares. And what happens is, if they announce a deal and you and I both own shares and you redeem your stock, you’ll get your $20 per share back. It’s different than SPACs, it’s got $20 in trust instead of 10. You’ll get your $20 back, but you’ll give up those tontine warrants that are attached to it.

Andrew Walker (13:23):
And if I don’t redeem my shares, I have stock in the company, I keep my tontine warrants, and I get your tontine warrants. So it’s incentivized for people who believe in whatever deal they do. If they don’t redeem, they’ll get extra warrants in the company from the people who do redeem.

Trey Lockerbie (13:40):
That’s very interesting. It looks like it originated around the $22 mark per share instead of something like a 10, like a normal SPAC, and has gone as high as 34, it looks like it touched. Now, it’s back to around, as of this time we’re recording, around 25 bucks. What’s been the driver for that activity to date? Has there been rumors of a merger and that’s what pumped it a little bit, or what’s your take on that?

Andrew Walker (14:02):
Most SPACs have $10 in trust, this has $20 per share in trust, so you do have to divide by two to compare it to the normal. But I think it’s been a couple of things. A, there’ve been lots of rumors about who they’re buying. There was reporting that they made an offer for Airbnb, there was a reporting that they made an offer for Bloomberg. You can go on, there’s a daily Reddit, Pershing Square Tontine Discussion Board, where they speculate on all sorts of targets. Lots of people think they’re going to buy Stripe or a really buzzy financial unicorn.

Andrew Walker (14:30):
So some of it has to do with the buzz of Ackman SPAC. The other piece of it has to do with… Back in February, every SPAC was trading at a huge premium to trust. And again, Pershing Square is a unicorn SPAC, so it rose with the market. Today at 25, it’s got $20 per share in trust. There are warrants attached to it, which aren’t attached to most other normal SPAC stocks. I think it’s probably trading for about a 15% implied premium to trust, which is big in today’s market. But again, I think it’s a unicorn SPAC. If there was one SPAC that I thought deserved a premium, it would be Pershing Square Tontine.

Trey Lockerbie (15:06):
You alluded to a little earlier, a lot of SPAC deals going bad. What happens exactly when SPAC deals start falling apart?

Andrew Walker (15:15):
There are about 500 SPACs looking for deals right now, and again, there aren’t 500 public-ready companies. So I think what we’re going to start seeing is a couple of things. You’re going to see SPACs coming with more and more ludicrous deals. You could even see this at the height of SPAC mania, all these deals valuing the 12th largest electric vehicle company that had never produced anything that thought they could get a car on market in five years coming with a multi-billion dollar valuation.

Andrew Walker (15:40):
You’ll probably see a lot of those, but what’s going to happen is, the SPACs are going to come with crazy deals and investors are going to start voting a lot of these deals down left and right and the SPACs will redeem and the investors will get their money back, but the founders will lose their sponsor promote. And some of those SPACs that go through will turn out that they didn’t do a lot of due diligence, the deals they do will do awful. And the SPACs after they report a quarter or two, there’ll be just SPACs, but the stocks will probably go down a lot.

Trey Lockerbie (16:06):
So when you’re vetting SPACs for your own portfolio, the key metric here is the sponsor. Like you’re relying on their due diligence and their expertise to create the advantage of why someone would go with that SPAC over another. How do you go about digging in on those management teams?

Andrew Walker (16:23):
The great thing about 500 SPACs is there’s 500 SPAC sponsors. And you can bet on the sponsors that you really like and that you think will deliver a good deal. So the things I personally like to look for is I want SPACs with proprietary deal flow. If you and I raised a SPAC, bankers would come to us left and right, and say, “Hey, this company is going through an auction, do you want to come in?” And we put in a high bid for one and we get a deal done. And that’s how you get the winner’s curse that I talked about earlier, where you pay too much for a company, you technically wanted, but you paid too much and it destroys value.

Andrew Walker (16:53):
What I want is someone like Liberty Media, which is run by John Malone and Greg Maffei, absolute legends in the cable and media space. They have proprietary deal flow and a history of creating value. So one of the best investments of all time was they bailed out Sirius XM at the bottom in 2009, in the financial crisis. Or more recently, this was a smaller deal, but because they’ve got relationships across the media space, they injected $100 million at really preferential terms into Comscore, which is a Nielsen competitor, but they injected in it and they got access to that deal because they have relationships up and down the media space and when they put money in, they weren’t just offering money, they were also offering relationships.

Andrew Walker (17:35):
And they extended Comscore’s deal with Charter. So they were offering more than just money. And I liked that in a SPAC sponsor. If you merge with Liberty Media, they could say, “Hey, you want to do something on the sports side? We own Formula One, we own the Atlanta Braves, we own Charter. We can get you distribution, we can get you relationships. We can get you all that.” So I want that type of proprietary deal flow when I’m looking for one. Another one, SoftBank. SoftBank actually has three SPACs outstanding. The largest one is like a 525 million SPAC. The ticker is SFVA.

Andrew Walker (18:08):
That one trades a little below trust right now, it trades for about $9.92. And I love that bet because I buy it right now, within the next year, they’ll announce a deal. It’ll probably be with a unicorn company that’s in Softbank Vision Fund. If the market loves it, great, the stock could go 40, 50% or something and you’ll have a big profit. If the market hates it and doesn’t treat it above trust, you just redeem. So it’s a head, you could win a lot, and tails, you make a little money situation. I love those types of trades where you’re buying people with proprietary deals and a history of value creation, and you’re buying them at or around trust.

Trey Lockerbie (18:43):
Let’s shift gears a little bit and move into this discussion around the Discovery-Warner merger. Walk us through the recent activity around Discovery, especially around the timeline of this merger announcement, then with the activity with Archegos, however you say it. Walk us through how the price… If a retail investor pulls up this chart, it looks like Mount Everest and it comes right back down. So walk us through a little about the stock, where it is today, especially as it relates to the merger.

Andrew Walker (19:13):
It’s really interesting. It’s been a crazy year for Discovery. I guess I’ll back up a little bit. In early December, they launched Discovery+, which is their Discovery direct-to-consumer product that they launched. The stock was around 25 or 30. They launched it, it got good reviews. I think people really liked the vision, the price point, the economics they laid out and everything. And then earlier this year, the stock started taking off. It went from 30 to 35, to 40, to 45. And I think a lot of people looked at it and said, “Oh, the market must be really giving them a lot of credit for Discovery+.”

Andrew Walker (19:45):
And the early reviews were good, they got really good signup numbers. And their Q4 call came out and they gave great numbers, they sounded great about Discovery+, and the stock just kept going up and up and up. And every legacy media person was looking at each other and saying, “What is the market seeing here? Yeah, it seems like it’s doing good, but this stock is just on a squeeze.” And this was a month after GameStop and AMC ran for the first time, so a lot of people said, “Is this a short squeeze? I don’t think so. The short interest in this isn’t crazy.” And Viacom, another big legacy media stock was squeezing at the same time.

Andrew Walker (20:17):
You can go back and read the transcripts, the management teams at Discovery and Viacom, they thought the market was giving them a Netflix multiple. They thought the market was finally seeing the vision that they had been laying out for years. Well, it turns out Archegos, which was a family office, but it turns out what had happened was, they were buying up 10 to 15% of Discovery, Viacom, and a couple of other companies, and they were doing it with a lot of leverage. So they were just buying, buying, buying, buying, and they were driving the stock price up, up, up, up. In late March, Viacom did a secondary offering because their stock was really high. They said, “We’ll raise money.”

Andrew Walker (20:50):
That blew up Archegos and Archegos was forced to sell everything and Discovery and Viacom dropped like a rock.

Trey Lockerbie (20:55):
Well, how leveraged were they on that upswing?

Andrew Walker (20:59):
Yeah. So they said the leverage was about five to one. So for every $1 of equity, they were putting about $5 of debt. And a lot of us looked at this and we do wonder, what were these guys doing? Discovery stock went from 30 to 90 in the course of three months. How were they not trimming it? How did they stay this leveraged? How could you be invested in a company like that on leverage and managed to lose money when the stock triples? Anyway, that’s what’s happened with the stock price. A lot of the same times that the Discovery stock price is racing, Discovery reaches out to AT&T’s CEO and says, “Hey, you’ve got Time Warner. Time Warner owns HBO, it owns TBS, TNT, Warner Brothers, a couple of other assets. Why don’t we merge Time Warner with Discovery and create a media giant?”

Andrew Walker (21:46):
And AT&T ultimately agrees to do this. And I think it’s going to be a really interesting deal. Right now in media, there’s two truly global scale players. There’s Netflix and there’s Disney. Time Warner is too small, Viacom’s too small, NBC is too small. When Warner merges with Discovery, they will be a truly scaled third global player and you will have… Because Discovery is the last buyable piece on the board, those three will lock in a dominant scale presence and everyone else will be scrambling to figure out what to do. Content is a game of a global scale. If you have 100 million subscribers and you pay $100 million for a movie, the movie costs you a dollar per subscriber.

Andrew Walker (22:25):
If you have $25 million dollars, it costs you $4 per subscriber, so that’s a big advantage. The bigger you get, the more scale you have, the more you can invest into content. Right now, Netflix and Disney have that scale. If you think of the breakout hits from the past year to 18 months, all of them are coming on one of three places, HBO, I think of Mare of Easttown, which I, unfortunately, haven’t watched yet, but Mare of Easttown broke out a couple of others. But most of them are coming from Disney+, you think the Marvel Cinematic Universe and all that, or Netflix. You can go on and on all the hits Netflix’s launched. That’s because those guys have scale and distribution.

Andrew Walker (22:59):
By merging Warner and Discovery, you get a third global scale player. Warner, they’ve got great content and great assets, but they don’t have a lot of their international rights. HBO, Warner doesn’t own the rights to HBO internationally, Sky actually owns the rights to HBO in Europe. Warner sold a lot of their movies, they don’t own the rights to those to put them onto a streaming service. The key thing with Discovery is, Discovery owns all of their international rights. When you merge the two, Discovery has great content that you kind of just sit down, go brain dead, and consume. So they’ve got Food channel, they’ve got HGTV, they’ve got Discovery.

Andrew Walker (23:37):
They’ve gotten great background product. What they don’t have is they don’t have ballsy shows that draw people in. People sign up for a Game of Thrones for Wonder Woman. Warner Brothers has that, they don’t have international scale and they don’t have a lot of those kinds of background shows that reduce churn, Discovery has that. You merge the two, you get a third global scale player. And I think the deal is going to be a real home run.

Trey Lockerbie (23:59):
Well, let’s talk a little bit about the underlying business of Discovery, pre-merger. Talk to us a little bit about what this merger does to the financials.

Andrew Walker (24:08):
Discovery, they are one of the largest cable companies, cable channels in the world, one of the largest concept channels in the world, but their main business is the US, the legacy cable bundle. They’ve got Discovery, they’ve got Food Network, they’ve got HGTV, they’ve got a lot of other channels. So when the 60 or 70 million people who still subscribe to legacy cable bundle, Discovery gets about $2 per sub for every person who subscribes. That has historically been a great business, but as the cable bundle unravels, it’s going away. They were transitioning to Discovery+, which was going to be a direct-to-consumer offering, where instead of getting on the cable bundle, you could go and subscribe, get Discovery+, and get their backlog, their library, everything.

Andrew Walker (24:48):
And I, personally, and I think a lot of people were pretty bullish on this because Discovery, they got $2 per user in the legacy cable bundle, but they were actually responsible for about 20% of the cable viewing. So if you did it on how much they got paid, versus how much people watch them, they got paid very low amounts of money compared to something like ESPN, which would get $8, $10 per sub, because it has Monday Night Football, which a lot of people really want, but on an hour’s viewing basis, they actually got paid way more than Discovery.

Andrew Walker (25:18):
So I was very bullish about Discovery’s direct consumer chances because they had all this great content, people spent hours and hours per day watching it, but they were under-monetized in the legacy cable bundle.

Trey Lockerbie (25:29):
Let’s talk about the free cash flows because I’m seeing Discovery over the last five years, it’s averaging around 18% year over year, free cash flow growth, a big dip, I think in 2020 for COVID, which is actually surprising if I think about it, a lot of media companies did pretty well through COVID. So do you know why there was such a decline last year? And then maybe talk a little bit about the super growth that proceeded it.

Andrew Walker (25:52):
Discovery, I mentioned John Malone who runs Liberty Media before, John Malone is the controlling shareholder of Discovery. And he loves Discovery for the same reason most people love businesses. If you think about their business, they’re cable channels on a cable network, that means, it requires no cutbacks. It is super profitable, super high margin business. They get into that, they’re really sticky in the cable bundle. When they get that, every dollar that they get in revenue converts really well to the bottom line and it’s free cash flow. John Malone would call it a free cash flow machine.

Andrew Walker (26:23):
Over the past five years, it was spitting off free cash flow because A, once they’re in the bundle, you’ve got this thing where cable channels don’t want to block you out because if they block you out, they’ll lose subs. But because they don’t block you out, they pay increasing prices for you and the cable bundle prices go up. That’s why the cable bundle is unwinding. But over the past five years, they’ve improved their scale by they bought Scripps, which is another cable channel, became one of the largest cable channel companies out there. And it’s just a great business.

Andrew Walker (26:51):
They took pricing because as they got larger, they commanded better prices from the cable companies, and they managed to increase their free cash flow.

Trey Lockerbie (26:59):
Let’s talk a little bit about the leverage around the deal, because a lot of people, I think are a little concerned maybe that’s why the price hasn’t been moving as it should have given the amount of leverage at play, but Discovery has a pretty good track record with levers. So maybe talk to us about that.

Andrew Walker (27:13):
That’s a great point. This company, when Discovery and Warner Brothers merge, they’re going to emerge with five times leverage, and people are very concerned. That is an awful lot of leverage for a company that’s going to still get a lot of money from the legacy cable bundle, that has to invest a lot of money into content to make sure they’re hitting the scale they need for global streaming. So people are scared about that. The reason they’re emerging with so much leverage by the way is because AT&T, they’ve got a lot of debt, and AT&T as part of this deal, they wanted to unlever their balance sheet.

Andrew Walker (27:43):
So Discovery said, “All right, we’ll lever the combined company up, you take a big dividend from Warner when you sell it to us, we’ll pay down the leverage over time and deleverage you.” That’s part of the reason they got this deal done. When I look at it, I think a couple of things, A, Discovery has a great track record of deleveraging as you said, theory-free cashflow machine, they levered up to about four, four and a half times when they bought Scripps a couple of years ago. They said, “Hey, we’ll get down to three times in 18 months or two years.” They didn’t in less than a year. This company spits off free cashflow.

Andrew Walker (28:11):
So when I look at that, and when I look at what I think should be a very synergistic merger given the combined companies’ assets, I think is going to really improve their standing in the DTC world. I think they’re going to be able to get a lot more subs. I think churn comes down a lot over time. I think there’ll be much more profitable. It comes out leveraged, but that combo, I think they can pay down debt awfully quick.

Trey Lockerbie (28:32):
So you’re saying the advantage is primarily coming from the library that both entities have both nationally and internationally? What about the content creation piece, and obviously that’s a huge competitive advantage for someone like Netflix, and just the innovation rate of Netflix pumping out new shows so consistently. What’s your take on how they use this free cash flow and reinvest it?

Andrew Walker (28:58):
Part of the free cash flow is, they’re going to be making investments into content. And one of the things I think people are worried about is Discovery historically, Food Network, HGTV, Discovery Network, if you think about all of those, they don’t have a lot of drama program. Discovery has specifically said, “We focus on reality and documentary size series because they’re much cheaper.” And that makes sense for them because they didn’t want to go compete with the big Netflix, Disney budgets and all that. The problem with that is, that’s great background and library viewing, but again, that doesn’t draw people in like Game of Thrones or Wonder Woman.

Andrew Walker (29:31):
When they merge with Warner Brothers, they’re going to have incredible properties. I think the only company that will have better IP than them is actually Disney. Disney has got Marvel, Pixar, Star Wars, nobody’s competing with that. But when this company is merged, they’re going to have Warner Brothers, so they have the DC studios. They’ve got the rights to other fantastic assets that can really bring people in, think of all the HBO shows, Game of Thrones. They’ve got like four Game of Thrones spinoffs in the works. They’re going to have great assets that draw people in. They use the Discovery Library to reduce churn, keep people watching, I think that combination is going to be really powerful.

Andrew Walker (30:06):
You mentioned what happens to the content creation, I’ll go back a little bit. People worried because Discovery is buying Warner Brothers and Discovery historically has focused on cheaper reality fare. People worry that they were going to say, “Hey, we’re going to cut the budget on the DC cinematic universe. Game of Thrones, $10 million per episode, that’s pretty expensive, let’s make it three million.” And one of the things they’ve said is, “No, we know that is not the way. We need to invest in big buzzy shows that will draw people in, and then we can use the strength of our reality library to keep them in once they’re in there.”

Trey Lockerbie (30:35):
One of the questions that pops out to me when I look at the financials behind Discovery, it’s this cashflow machine, as you said, and right now it’s trading at almost half of its enterprise value in market cap to enterprise value, but it’s yet at the all-time high that it’s hit in 2019 and 2020. They had that big breakthrough with Archegos, it’s now traded back down to this all-time high that it’s hit. Maybe this is the new floor, but what’s your take on it? Why have we seen this level so consistently? And why has it not been even consistently higher than this?

Andrew Walker (31:09):
I think there’s two things. If I just zoom out for Discovery over the past six years, the big worry has been these guys, all of their money for the most part comes from the US cable bundle. As the cable bundle unravels, what’s going to happen to Discovery? And that’s been a huge overhang on the stock for years and years, and years. And that’s one of the reasons that I thought Discovery+ was so important. Discover+ once they launched it and they launched it and they came out and said, “We’re bidding all of our subscriber targets. Our subscribers are watching an hour and a half to two hours per day, which is great, great engagement. Our subscribers who sign up for the free to play they’re converting to pays at record rates.”

Andrew Walker (31:46):
So Discovery+ was so important to Discovery because it proved, “Hey, we have a future in the streaming world. You guys don’t need to value us like a terminal asset that will die once the cable bundle goes away anymore, you guys can value us like a company that will be able to make in an extreme world.” So that’s the long-term overhang on the stock, which I think was going away as Discovery+ lover. Post this deal, people are really concerned because Discovery is a 20, $30 billion enterprise value company, Warner Brothers is a $100 billion enterprise value company. So post this deal, one of the big concerns investors had is, AT&T through Warner Bros owns 79% of the combined company. And they’re going to spin it out to all of their shareholders.

Andrew Walker (32:28):
And AT&T shareholders are famously dividend shareholders, they will own AT&T for the dividend. Discovery does not pay a dividend. Once this merger goes through, they’re going to focus on debt paydown, they’re going to focus on investing in content, and eventually, they’ll probably focus on share buybacks, but they’re not going to focus on dividends. So people are very concerned that this merger is going to happen, it’s going to complete in the middle of 2022. AT&T is going to give their Warner Brother Discovery shares to their shareholders. And every shareholder is going to sell irregardless of price because they’ve just received a security that does not pay a dividend and they want dividends securities.

Trey Lockerbie (33:03):
Interesting. So you think by mid-next year, this deal closes and the shareholders, this stock becomes the AT&T stock?

Andrew Walker (33:11):
If you own AT&T stock, one of two things could happen, either AT&T could do that’s known as an exchange offer where they could say, “Hey, give us AT&T stock trades, roughly 30.” Discovery stock say trade’s roughly 30. So AT&T could say, “Hey, we own a bunch of Discovery stock now, if you give us one share of AT&T, we’ll get you one share of Discovery.” That’s one way they could do it. The way they’ll most likely do it and the one that people are concerned is they’ll just dividend out all their shares of Discovery to their shareholders. And then if you are a shareholder of AT&T, you owned 100 shares of AT&T, you wake up the next day you own 100 shares of AT&T and 20 shares of Discovery.

Andrew Walker (33:48):
You look at your account and you say, “I don’t want to own 20 shares of Discovery, I bought AT&T for the wireless network, I bought it for the dividend now own Discovery, sell.” And there’s just going to be waves and waves of selling crusher wins if this deal goes through.

Trey Lockerbie (34:02):
Talk to us a little bit more about John Malone and how he fits into this picture and why we should focus so much on him.

Andrew Walker (34:08):
Yeah. So he’s a key shareholder and he’s actually one of the reasons I first got attracted to this deal. John Malone, there’s a book on him called the Cable Cowboy. He is an absolute legend in the media telecom investing space, Al Gore in the early ’90s called him the Darth Vader because he ran TCI, which was the biggest cable company at the time. Nobody ever likes their cable company. He ran it, he built it, he made it into a mega-giant. So he’s a legend in this space. He’s done legendary deals. He bought SiriusXM. His cost spaces there is negative. And he’s just on great deals. He’s the controlling shareholder of Discovery. He owns super-voting B shares.

Andrew Walker (34:44):
And one of the reasons I follow Discovery for a while, but one of the reasons I like this deal is, I followed John Malone for years. John Malone does not give up voting controls of the companies he owns. In the Discovery AT&T deal, he is giving up voting control of Discovery. And not only is he giving up voting control, he’s giving it up without getting any extra money, any extra premium, which I can’t remember a time he’s given up voting control without getting something in return. So one of the reasons I like this deal is John Malone, an absolute legend in the space, he is so bullish on the deal that to get it done, he gave up voting control without getting a premium.

Trey Lockerbie (35:19):
So you’re saying that the market is discounting the stock, mainly because they have this anticipatory anxiety of sorts that once it gets dividend out to AT&T, the retail investors who have now inherited this stock will simply sell it because they have no interest in it. But that begs the question, well, why do you disagree with that? What’s your take on the stock?

Andrew Walker (35:42):
Everything’s opportunity costs and I acknowledge this stock, the deal could through, AT&T could give the stock to shareholders, and it could trade down 20, 30, 40% tomorrow. But I just see so much value in the combined company that I’m willing to risk that bad mark to market and buy today because the stock market’s a funny discounting place. Right now it’s discounting, “Hey, there’s going to be this overcame.” But six months from now, people could get really excited about Discovery, the stock could move a little bit and people could say, “Oh, I’m buying the combined company at a 10% free cashflow yield. And this is an actual Netflix, Disney competitor, that is way too cheap. We need to buy this.”

Andrew Walker (36:16):
And all of a sudden, the stock’s 40, $45 before it, I don’t know, but I’m willing to buy in base of that because I see so much value in the company. 10% free cash flow yield, they’re going to be able to pay down billions and billions of dollars of debt every year. People are worried about the leverage. Once they pay down billions and billions of dollars a debt over a year or two, that value should accrue with equity because the combined company is coming out five times levered, paying down a little debt, that’s a lot of value going to the equity. So I honestly think this could be $100 stock in five to seven years. It’s a $30 stock right now. That would be a really good IRR.

Trey Lockerbie (36:50):
The Buffett in me has to ask, what about the management team behind Discovery? Obviously, it looks like they’re not issuing dividends there, they’re not doing much share buyback, which is, I don’t know, that’s interesting given the price, but what’s your take on the management of Discovery, and how does that play into your thesis here?

Andrew Walker (37:09):
Have you read The Snowball, Warren Buffett’s biography?

Trey Lockerbie (37:11):

Andrew Walker (37:12):
So if you remember The Snowball, there’s this scene, Warren Buffett is on the board of Cap Cities, is what it’s called. Cap Cities is a big television station. And Cap Cities and ABC announce a merger. And they get Buffett on the phone, he’s a director and they asked him his opinion on the merger. And he says, “I think it’s a great deal. I think this is going to be the rare merger where a stock goes up, because you merge two media companies together, and there are generally a lot of synergies when you merge two media companies together.” And I feel the same way about Discovery and Warner.

Andrew Walker (37:40):
These are two media companies with hugely synergistic assets, the stock, the morning, it was announced, both stocks were up 20% and then they fell, I think because of some of the concerns we talked about, but I think this is a hugely synergistic deal that’s going to create a lot of value over time. Let’s turn to the Discovery management team. Discovery is run by David Zaslav. He’s been CEO there for a long time, mixed reviews on him. John Malone, who was the chairman, controlling shareholder of Discovery raves about him. I think he’s done a really nice job operationally. He was dealt a tough hand.

Andrew Walker (38:09):
If you reround 20 years, Discovery was a one-channel cable company, and he’s grown this thing into an absolute cable giant that takes up 20% of viewing time in the cable bundle. They’ve got great assets. And one thing that I think he doesn’t get credit for, the reason a lot of these media companies are struggling is because five years ago, Netflix went to all the media companies with a big checkbook and they said, “Hey, you’ve got a lot of movies, you don’t make any money on those movies that are in your library, give us the streaming rights to them, and we’ll write you a couple million dollars for a check.”

Andrew Walker (38:39):
And all the media companies looked at that as free money. And three years later, all the media companies looked at and said, “Oh, no, that was a bad idea. We can’t launch our own streaming services because we took this free money upfront, but it turns out we way undervalued our content.” Discovery has never done any of that. Even though they could have made tens and hundreds of millions of dollars in profit by selling the rights to all their shows, 90 Day Fiancé, all the Guy Fieri’s shows, Chip and Jo, all that. Those would have hugely valuable in the market. They never did any of that because they kept their eye on the prize and they said, “At some point, we’re going to want the rights to those, so we can launch a global consumer franchise or we can merge with someone and they can use our concept launch with that.”

Andrew Walker (39:17):
So I think he’s had a good vision. I think he’s done a nice job building this company through acquisitions. It’s tough to look at any of the acquisitions he’s done and say they were bad. When Discovery bought Scripps, a lot of people thought that was going to be a really bad merger. They outperformed on dividends, they outperformed on synergies, they’ve done really well. I think it proves to be a hugely synergistic merger. Those are all the positives. The negatives is, this man is paid a lot of money. John Malone famously pays his lieutenants a lot of money, but David Zaslav has made tens and tens of millions of dollars as the share price has stalled out for years and years and years.

Andrew Walker (39:51):
Some of that was beyond his control because it sold out because people said, “Hey, you’re a legacy cable bundle player and your future is really questionable,” but he has gotten paid a lot of money, and the stock hasn’t really performed.

Trey Lockerbie (40:03):
Lastly, I just want to cover your take on Comcast and how they play into this as maybe even a hedge to the entire deal.

Andrew Walker (40:12):
Comcast is two companies. They own Comcast Cable, the largest cable player in America, and they own NBC Universal. And they’re headed by Brian Roberts, who I have great respect for. His dad started Comcast, but I think he’s done a fantastic job running Comcast. I’ve heard nothing but good things about him. He’s very strategic and very visionary. The one thing to know about Comcast is they have wanted to get into the media space for years. In 2004, they actually launched a hostile offer for Disney. They bought NBC in 2008, through 2010 from GE. They love the content space, and when they want to get bigger into the content space, they are not shy about being aggressive.

Andrew Walker (40:47):
So again, hostile offer for Disney in 2004. When Disney tried to buy Fox in 2016 or 2017, Comcast came with an offer at a huge premium to try to break that deal off and merge Fox and NBC together. When they couldn’t buy Fox, they ended up paying a huge premium to buy Sky, which was a lot of European assets. So Comcast is very willing to pay top dollar to buy strategic media assets. For months, there’s been rumors that Comcast and NBC wanted to merge with Warner, and AT&T ultimately decided… AT&T has fought the DOJ in court twice in the past 10 years. They try to buy T-Mobile, the DOJ block that. They tried to buy Time Warner, the DOJ tries to block that, they beat the DOJ in court, they bought Time Warner.

Andrew Walker (41:31):
I don’t think AT&T wanted any part, merging NBC with Warner, that is a $200 billion merger. There would have been congressional hearings, the DOJ would have done a year’s long investigation. It was up in the air if that would have been approved or not. AT&T didn’t want any part of that. So AT&T decides to go with Discovery. By buying Discovery, Warner-Discovery paints, ViacomCBS, and NBCU in a corner. Now two months ago, there were two scale players, Disney and Netflix, and there were three medium-sized players, NBC, Viacom, and Warner. Discovery was the last remaining asset that you could buy with no regulatory concerns that would get you to that third player. Warner’s announced the deal for that, that leaves NBC and Viacom scrambling.

Andrew Walker (42:16):
I think it’s possible that Brian Roberts looks at the board and says, “Hey, you know what the best solution here is? Let’s have NBC buy Discovery. And if we do that, we become the third-scale global player. We paint Warner into the same corner that they’re painting us into. And by the way, down the line, if we get a new administration that’s more open to mergers, we can do an NBC-Discovery-Warner merger, but we’ll do it from a position of huge strength where we say, ‘Hey, Warner, you’re subscale…'” NBC again, they own HBO’s rights in Europe, “We’re a global player. We’ve got great scale. We’ll buy you, but you’re a seller and weakness and we’re a buyer and strength.”

Trey Lockerbie (42:54):
That sounds great to me. You’re saying it’s just a rumor though, what exactly has been reported on this interest so far?

Andrew Walker (43:01):
There have been tons of reports that Comcast and NBC… Comcast and NBC wanted to merger with Warner. There’ve been lots of reports that they tried. There’ve been lots of reports that AT&T wanted no part of that regulatory headache. We haven’t seen the deal proxy yet, so we don’t know exactly what their approach has looked like and everything, but I think it’s pretty safe to say that AT&T, they evaluated all their options with Warner and they’d settle for the option with Discovery, with no regulatory risks, where they could B, leverage their balance sheet, and where they could create a third global scale player.

Andrew Walker (43:31):
So I think that’s why they chose Discovery. On the Comcast-Discovery side, that’s just me reading the tea leaves. It is a non-consensus opinion, for sure. But again, if I look at Robert’s history, he has been aggressive when he wanted to buy synergistic media assets. And I do think he’s going to look at the board and say, “If I miss on Discovery, NBC is subscale. At some point, I will have to be a seller of NBC from a position of weakness. Let me go out and grab an asset that would let me hit scale and I can be a buyer from a position of strength.”

Trey Lockerbie (44:02):
Well, since Discovery and Warner already announced this merger, isn’t there some exclusivity on that deal at least for a certain amount of time?

Andrew Walker (44:10):
No. This is typical talking bid stuff. If Comcast comes with a topping offer for Discovery, Discovery’s board has a fiduciary obligation to consider any topping bid that will create more value for shareholders. And again, if you think back to 2017, Disney and Fox had a deal, roughly the deal valued Fox at $35 per share, I’m doing something rough. Six months later, Comcast came with the talking bid that valued Fox at $45 per share. And yeah, Fox had a contract, but their board has a fiduciary obligation. This happens in public company mergers all the time. If you get a topping bid, you have to consider it.

Andrew Walker (44:45):
If you turn down, you better have a damn good reason or else your shareholders are going to sue you for breach of fiduciary obligation.

Trey Lockerbie (44:51):
And what’s your take on the stock price if Comcast were to do that and place this topping bid, and they pivot and go this direction, what do you think that does to the price? Is it still $100 stock? Is it higher?

Andrew Walker (45:02):
It’s tough to say, but I will say, I’ve never been a part of a company that receives a topping bid and been sad as a shareholder. Comcast-NBC, in order to break this merger up, they’d have to go to Discovery and they would have to present a bid that is better than the current bid that Warner has on the table. Right now, how it’s structured is an interesting question because this deal is structured as reverse… The Discovery-Warner deal, it’s a reverse Morris trust, there’s no cash coming through Discovery, it’s stock in a new company. So it would be interesting how Comcast choose to discuss it. But again, let’s look at the last example, Disney merging with Fox.

Andrew Walker (45:37):
Disney merger with Fox, it was about a $35 per share deal, Comcast came and tried to break it up with a $45 per share a bid. That’s over a 30% premium. If I got over 30% premium for Discovery, I would probably be pretty happy. I think it’s a hugely synergistic merger that creates a lot of value. I think people are overlooking it or scared to invest it because the headline leverage number skills, people are scared about the overhang from AT&T distributing things. I’m into that, and I don’t think a lot of people have thought through the strategic pieces. I think most people think the chance of Comcast getting involved is zero, and I think it’s significantly higher than zero.

Trey Lockerbie (46:12):
Yeah. I think this is fascinating, the financials are great on its own. Really interesting stuff here, Andrew. Before we let you go, you’ve got a lot going on, where can they learn about your blog, your podcast, Twitter handle? How can people find you, follow along with what you’re producing because this is amazing content?

Andrew Walker (46:29):
Well, I appreciate that. The easiest way, Twitter, AndrewRangeley, that’s Range like a driving Range, L-E-Y. So AndrewRangeley is my Twitter handle. Obviously, I post a bunch there. I write a moderately popular finance blog, it’s yetanothervalueblog.substack.com. And then I do an even more moderately popular finance podcast, which is called Yet Another Value Podcast. It’d be like this, I’d have an investor on who’d say, “I have a position of Discovery.” And for an hour we talk exclusively about Discovery, much the way you and I talked about it for the last 30 minutes.

Trey Lockerbie (47:04):
Fantastic. Well, this is awesome. I really appreciate you coming on the show, Andrew, and look forward to following along on this, and let’s circle back maybe sometime after we see how the hell this plays out.

Andrew Walker (47:15):
Comcast comes with a topping bid for Discovery, and you’ll just have to have me back on, I’ll say, “I was the only one who told you so.” Yeah, this was fun.

Trey Lockerbie (47:21):
I look forward to that.

Andrew Walker (47:22):
Yeah. This was fun. Thank you for having me on.

Trey Lockerbie (47:23):
We’ll talk to you soon. Thanks a lot.

Trey Lockerbie (47:25):
All right, everybody, that’s all we had for you this week. If you’re noticing that you’re not getting these episodes automatically in your app anymore, that might be because there was a big update at Apple recently, so be sure to go into the app and press the Follow button so that you get these episodes automatically. We Study Billionaires now has the Sunday episode, the Wednesday Bitcoin episode, and now a Thursday episode. So you don’t want to miss the extra content. And please don’t forget to check me out on Twitter @treylockerbie, and all the resources we have for you at theinvestorspodcast.com. Until next time, cheers.

Outro (47:57):
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