We Study Billionaires - The Investor’s Podcast Network - TIP359: The Rise and Fall of Archegos and Discovery w/ Andrew Walker

Starting point is 00:00:00 You're listening to TIP. On today's episode, I sit down with one of my favorite portfolio managers, Andrew Walker from Rangely Capital. I took the opportunity to dig deeper on SPACs with Andrew who's currently running a SPAC's focused fund. We then compare your typical SPAC with the Pershing Square Taunteen 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

Starting point is 00:00:27 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 Arkegos along the way. 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.

Starting point is 00:01:04 You are listening to The Investors 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. Welcome everybody to the Investors podcast. I'm your host, Trey Lockerbie, and today I am sitting across from Andrew Walker from Rangley Capital. We're going to talk about a lot of interesting stuff. First and foremost, we're going to cover some SPACs. Andrew covers one of his funds is actually a SPACs-focused funds. We're going to touch on that. And then we're going to merge into the Discovery Warner merger. And see what I did there? And that was really good. I like that. And I'm excited to dig in on this with you, Andrew. So thanks for coming on the show.

Starting point is 00:01:58 Hey, thanks for having me. I'm happy to be here. Spacks and Discovery are, you know, they take up an increasing proportion of my life. So it's good to get on Zoom and talk to someone about them. So 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, Chimoth, Paul Apatia, Ted Seidies, 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've quickly covered things like, obviously, the sponsor gets 20% of the deal and they're kind of incentivized just financially in a disproportionate

Starting point is 00:02:41 way. But I'm just kind of curious to hear what your obsession with specs is and why it's been occupying so much of the fund now. I think there's two separate things there, right? The incentive structures for SPACs are, I don't think it's an exaggeration to state. They're absolutely awful. So if you're the founder of a SPAC, you know, most SPACs come out with about $200 million, the 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.

Starting point is 00:03:11 And what Ben would put up is $5 million for a $200 million spec. 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. That's a great trade for him. He's just made an ADEX 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

Starting point is 00:03:40 $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 5. 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 turns 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. And then for minority investors, it's even worse because a SPAC is a cash shell.

Starting point is 00:04:16 Most mergers destroy value because whoever's buying the company over pays. But mergers, they can create value. And in general, they create value, you know, everybody likes to think they get. a good deal in a merger, but in general, the way you create value for 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

Starting point is 00:04:40 better. So as a minority investor, if you're investing in a SPAC, you are buying into a company and you are 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 shared. I think that's the overview of the incentives and why SPACs can be so bad for minority minority investors. So what am I missing here because I was under the impression that if I'm a retail investor

Starting point is 00:05:02 and I buy into the spec, but pre-merger, and I don't like the company that they picked, or I don't like the deal, I can get my $10 back. You are 100% correct. You can get your $10 back. That's why a lot of hedge funds and event-driven funds love spec so much, right? You go, you buy a spec. So the way most specs were when they IPO, the IPO what's called a unit. And that unit is one share and let's just call it one warrant to make it simple.

Starting point is 00:05:26 and you buy that unit, eventually you can split the share from the warrant. They come, they announce a deal, and you can choose, do I want to hold onto my share or do I want to redeem and get my $10 bat? And even if you redeem, you can keep that warrant. So you get a free warrant. So from a hedge fund perspective and arbitrage perspective, SPACs make a lot of sense because you kind of get a free look at whatever deal they love. What I was talking about for minority investors is it's generally bad if you hold through

Starting point is 00:05:51 the deal. Specs have a huge track record of destroying value after the deals are approved. And what is the warrant, like, what's the strike price typically on that? Is it the $10 per share? It's typically $11.50 to simplify. 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?

Starting point is 00:06:12 I think there's two appeals. The first was, so 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, right? We could buy the units. We'd split them into a stock and a warrant.

Starting point is 00:06:30 We could wait till they announced a 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 a profit. If it was an awful deal, whatever, we'd redeem for $10 per share. We'd sell the warrant. And nothing's ever investing in vice. Nothing's ever risk-free.

Starting point is 00:06:44 But it was about as close to risk-free trade as you could make. That's why we started the SPAC one. More recently, I've become obsessed because, you know, and it's a, typical year, there would be about 200 companies that would IPO in a typical year. And of those, you know, from 2015 to 2019, 200 companies would IPO. Of them, 30 of them or so would be SPACs. In 2020, we saw about 250 SPAC IPOs. And then in the first quarter of 2021, we saw about 300 SPAC IPOs. So that's 550 SPAC IPOs in a year. There aren't 550 new public-ready companies. So these SPACs are pulling in. There's so many SPACs out there. And they're

Starting point is 00:07:21 emerging 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 spacks. I said about 500 spacks 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 blah, but 10% of those deals are going to be really interesting. 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's warrants outstanding, if you can identify a really interesting one and buy it through the warrants, you could make multiples of your money.

Starting point is 00:07:58 So as an investor, it's a really interesting space because there's so many unique companies coming in public through them. 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 a private business. I think that's part of the appeal for them. But you even have, you know, Chamath Palatia, 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? 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

Starting point is 00:08:40 those projections, you could be sued. You broke securities law by providing a forward-looking projections that you miss. If you're doing a SPAC, because a 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 SPACs are providing five-year forward projections, but because of those poor incentives we talked about, a lot of these spacks 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. Then they'd come public. In the first quarter public, If they pull their guidance, the financials would be awful, and the shares would drop like a rock.

Starting point is 00:09:15 And that was kind of a more generous interpretation. You saw things like Nicola, 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. I think that forward 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 specs that come out. So one of the more interesting spacks out there right now is from Bill Ackman's Pershing Square. There's a Pershing Square SPAC that you've written about.

Starting point is 00:09:44 What's the most fascinating thing about this SPAC in particular? Yeah, 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. Pershing Square, originally they were going to hunt for a unicorn target, and in many ways, Pershing Square taunting, which is the SPAC, is a unicorn stack. So it's a unicorn in three ways. First, the incentive system. Most SPACs, we've already talked about how most SPACs, the founders get the 20% of the company

Starting point is 00:10:12 and the promote for very little money. Bill Ackman and Pershing Square Taunting did not take any promote. What they did is all of their promote, quote unquote, was bought, they wrote a $100 million check to buy warrants that buys the Pershing Square stock at $24 per share after they announced a deal. Now, their long-dated warrant, so they can create value as the company. company compounds over time, but he doesn't get any promote. He only bought those warrants. Plus, he agreed to write a one to three billion dollar check to buy Pershing Square common stock

Starting point is 00:10:44 when they announce a deal at the same terms that public shareholders bought in the IPO. 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 the SPAC sponsors would still make four times their money. If Persian 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. 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 Perching Square agreed

Starting point is 00:11:22 that they'll buy one to three billion dollars of stock when they announce a deal. Five to seven billion dollars in cash buying power. That is orders of magnitude larger than every other There's a couple spacks like KKR raised one that touch about a billion dollars, but we're talking five to seven billion. Most spas are two to four hundred million dollars to trust. So it's orders of magnitude larger than every other spec, which means it can go after a lot bigger companies. And it can credibly tell them, hey, you go do a deal with another spec.

Starting point is 00:11:52 That spec might have a lot of redemptions. They might not actually deliver you a lot of money. Even if our spec has a lot of redemptions, because Pershing Square is writing one to three billion dollars of a check, we're going to deliver billions of dollars of cash to you, right? 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 taunting structure. And that is very unique.

Starting point is 00:12:17 As far as I know, there's only one other spec that came with the taunting structure. And a taunting structure, you know, it's kind of famous. Like it's a really popular device plot and murder mysteries and murder movies. So Agatha Christie used a couple in her. There was a Simpsons episode and Archer episode with it. A taunting is basically a group of people put money into a pool and whoever survives gets the money as distributed between them. So you and I could put $10 into a taunting.

Starting point is 00:12:44 Whoever outlives the other would get the taunting, would get $20. They are 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 pontoon works is Persian went public and it's got warrants attached to the shares that are non-redeemed 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 specs. It's got $20 in trust instead of $10.

Starting point is 00:13:17 You'll get your $20 back, but you'll give up those taunting warrants that are attached to it. And if I don't redeem my shares, I have stock in the company. I keep my taunting warrants and I get your taunting 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. That's very interesting. It looks like it originated around the $22 mark per share instead of something like a 10, like a normal spec, and has gone as high as 34, it looks like it touched.

Starting point is 00:13:50 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? Most specs have $10 in trust. This has $20 per share in trust. So you do have to kind of divide by two to compare it to your normal. But I think it's been a couple things. A, there have been lots of rumors about who they're buying. You know, 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, Taunting, discussion board where they speculate on all sorts of targets. Lots of people think they're going to

Starting point is 00:14:26 buy strife or a really buzzy financial unicorn. So some of it has to do with the buzz of Ackman SPAC. The other piece of it has to do with, you know, back in February, every SPAC was trading at a huge premium to trust. And again, Pershing Square is kind of a unicorn SPAC. So it kind of rose with the market. Today at 25, you know, it's got $20 per share in trust. There are warrants attached to it, which aren't attached to most other normal SPAC stocks. So I think it's probably trading for about a 15% implied premium to trust, which is big in today's market. But again, I kind of think it's a unicorn SPAC. So if there was one SPAC that I thought deserved a premium, it would be Persian Squirt taunting. Let's take a quick break and hear from today's sponsors.

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Starting point is 00:19:25 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 things. You're going to see SPACs coming with more and more ludicrous. deals. You could even see this at the height of SPACMania, you know, all these deals valuing the 12th Largic 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. You'll probably see a lot of those. But what's going to happen is the SPACs are going to come with crazy

Starting point is 00:19:55 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 the SPACs that go through, It'll turn out that they didn't do a lot of due diligence, the deals they do what would do awful. And the SPACs, you know, after they report a quarter or two, they'll be dis SPAC, but the stocks will probably go down a lot. So when you're vetting SPACs for your own portfolio, it's mainly the, I mean, the key metric here is the sponsor, right?

Starting point is 00:20:22 Like you're relying on their due diligence and their expertise to create the advantage of why someone will go with that spec over another. How do you go about digging in on those management teams? 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 spats with proprietary deal flow, right? So if you and I raise this back, bankers would come to us left and right and say, hey, this company's going through an auction.

Starting point is 00:20:53 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 winners curse I talked about earlier, where you pay too much for a company. You technically want it, but you pay too much and it destroys value. What I want is someone like Liberty Media, which is run by John Malone and Greg Maffa, absolute legends in the cable and media space. They have proprietary deal flow and a history of creating value, right? So one of the best investments of all time was they bailed out Sirius XM at the bottom in 2009,

Starting point is 00:21:22 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 kind of 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.

Starting point is 00:21:46 And, you know, they extended Com Scores deal with Charter. So they were offering more than just money. And I like that in a SPAC sponsor. You know, 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.

Starting point is 00:22:00 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. Another one, SoftBank. SoftBank actually has three SPACs outstanding. One of them, the largest one, it was like a 525 million SPAC. The ticker is S-F-V-A.

Starting point is 00:22:18 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 SoftBanks Vision Fund. If the market loves it, great. The stock could go up 40, 50% or something, and you'll have big profit. If the market hates it and doesn't trade it above trust, you just redeem. So it's a heads, you could win a lot. And tails, you make a little money situation. So I love those type of trades where you're buying people with proprietary deals and a history of value

Starting point is 00:22:50 creation and you're buying them at or around trust. Let's shift gears a little bit and kind of 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 Arkegos or Archegos, how you say it, and walk us through how the price, I mean, 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. It's really interesting. It's been a crazy year for Discovery.

Starting point is 00:23:26 So I guess I'll back up a little bit. In early December, they launched Discovery Plus, which is their, you know, it's 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, right?

Starting point is 00:23:44 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 Plus. And the early reviews were good. They got really good sign up numbers. And their Q4 call came out and they gave great numbers. They sounded great about Discovery Plus. And the stock just kept going up and up and up.

Starting point is 00:24:06 And every legacy media person was looking at each other and saying, what is the market seen here? Like, yeah, it seems like it's doing good. But the 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 Biacom, another big legacy media stock was squeezing at the same time.

Starting point is 00:24:26 So 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 that had happened was they were buying up 10 to 15 percent of Discovery, Biacom and a couple other companies, and they were doing it with a lot of leverage. So they were just buying, buying, buying, buying, buying, and they were driving the stock price up, up, up, up. In late March,

Starting point is 00:24:56 Viacom did a secondary offering because their stock was really high. They said, we'll raise money. That blew up Archegos, and Archiego's was forced to sell everything and Discovery and Biacom drop like a rock. How leverage were they on that upswing? 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, you know, a lot of us looked at this and we do wonder, like, what were these guys doing? Discovery stock went from 30 to 90 in the course of three months. Like, how were they not trimming it? How did they stay this leveraged?

Starting point is 00:25:27 How could you be invested in a company like that on leverage and manage to lose money when the stock triples? But anyway, that's what's happened with the stock price. Along the same times that Discovery stock price is racing, Discovery reaches out to Time Warner's, the AT&T's CEO and says, hey, you've got Time Warner. Time Warner owns HBO, it owns TBS, TNT, Warner Brothers, a couple other assets. Why don't we merge Time Warner with Discovery and create a media giant? And AT&T ultimately agrees to do this.

Starting point is 00:25:58 And I think it's going to be a really interesting deal. You know, right now in media, there's two truly global scale players. There's Netflix and there's Disney. Time Warner's too small, biocom's too small, NBC's too small. When Warner merges with Discovery, they will be a truly scale. third global player, and you will have, because Discovery is kind of the last viable piece on the board, those three will kind of lock in a dominant scale presence and everyone else will be scrambling to figure out what to do.

Starting point is 00:26:27 This deal, content is a game of global scale, right? If you have 100 million subscribers and you pay $100 million for a movie, the movie cost you $1 per subscriber. If you have $25 million, 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, right? If you think of the breakout hits from the past year to 18 months, all of them are coming

Starting point is 00:26:52 on one of three places. HBO, I think of Mayor of Easttown, which I haven't, unfortunately haven't watched yet, but Mayor of Easttown broke out a couple others. But most of them are coming from Disney Plus. You think the Marvel Cinematic Universe and all that, or Netflix. You know, you can go on and on on all the hits Netflix to launch. That's because those guys have scale and distribution. By merging Warner and Discovery, you get a third global scaled player.

Starting point is 00:27:14 Warner does not have, they've got great content and great assets, but they don't have a lot of their international rights. So 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 hit movies. They don't own the rights to those to put them onto a streaming service, right? 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.

Starting point is 00:27:44 They've got Food Channel, they've got HGTV, they've got Discovery. They've got great background product. What they don't have is they don't have buzzy shows that draw people in. People sign up for a Game of Thrones or for Wonder Woman. Warner Brothers has that. They don't have international scale and they don't have a lot of those kind of background shows that reduce churn. Discovery has that.

Starting point is 00:28:04 You merge the two. You get a third global scale player. And I think the deal is going to be a real home run. Let's take a quick break and hear from today's sponsors. No, it's not your imagination. risk and regulation are ramping up, and customers now expect proof of security just to do business. That's why VANTA is a game changer. VANTA automates your compliance process and brings compliance, risk, and customer trust together on one AI-powered platform.

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Starting point is 00:31:30 All right. Back to the show. 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. So Discovery, you know, they are one of the largest cable companies, cable channels in the world, one of the largest content channels in the world. But their main business is the U.S., 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.

Starting point is 00:31:56 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 Plus, 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 Plus, and get their backlog, their library, everything. And I personally, and I think a lot of people were pretty bullish on this, because Discovery,

Starting point is 00:32:26 they got $2 per user in the Legacy cable bundle, but they did. They were actually responsible for about 20% of cable viewing. So if you kind of did it on a how much they got paid versus how much people watched them, you know, 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 a hours viewing basis, they actually got paid way more than discovery. So I was very bullish about Discovery's direct consumer chances because they had all this great

Starting point is 00:32:56 content. People spent hours and hours per day watching it, but they were kind of under monetized. than the legacy cable bundle. So 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 kind of surprising. I think 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

Starting point is 00:33:23 the super growth that preceded it? So 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. It requires no capax, right? It is super profitable, super high margin business. They get into that.

Starting point is 00:33:46 They're really sticking in the cable bundle when they get that. Every dollar that they get in revenue converts really well to the bottom line into free cash flow. John Malone would call it a free cash flow machine. Over the past five years, it was spitting off free cash flow. flow because, A, once they're in the bundle, you know, you've got this thing where cable channels don't want to black you out because if they black you out, they'll lose subs. But because they don't black you out, they pay increasing prices for you and the cable bundle prices go up. That's why the cable bundle is kind of unwinding. But over the past five years, they've improved

Starting point is 00:34:16 their scale by, they bought scripts, which is another cable channel, became one of the largest cable channel companies out there. And yeah, it's just a great business. 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. 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, maybe like as it should have, given the amount of leverage at play.

Starting point is 00:34:42 But Discovery has a pretty good track record with leverage. So maybe talk to us about that. That's a great point. So 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 kind of make sure they're hitting the scale they need for global streaming. So people are scared about that.

Starting point is 00:35:07 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. 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 that'll de-leverge you. That's part of the reason they got this deal done. When I look at it, I think a couple things. A, Discovery has a great track record of de-leverging, as you said.

Starting point is 00:35:32 They are a free cash flow machine. They levered up to about four or four and a half times when they bought scripts a couple years ago. They said, hey, we'll get down to three times in 18 months or two years. They did in less than a year. This company spits off free cash flow. So when I look at that and when I look at what I think should be a very synergistic merger, given the combined company's assets, I think is going to really improve their standing

Starting point is 00:35:53 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 they'll be much more profitable. It comes out leverage, but that combo, I think they can pay down debt awfully quick. 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?

Starting point is 00:36:16 Because 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? Part of the free cash flow is we're going to be making investments into content. And one of the things I think people are worried about is Discovery, historically, you know, Food Network, HGTV, Discovery Network, you think about all of those. They don't have, they don't have a lot of drama program, right? Discovery has specifically said, we focus on reality and documentary style series because they're much cheaper. And that makes sense for them.

Starting point is 00:36:53 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 a Game of Thrones or a Wonder Woman. 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. Right? Disney's got Marvel, Pixar, Star Wars. Nobody's competing with that.

Starting point is 00:37:16 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 spin-offs 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.

Starting point is 00:37:39 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 fair. people worried 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 $3 million. And one of the things they've said is, no, we know that is not the way.

Starting point is 00:38:01 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. So one of the questions that pops out to me when I look at the financials behind Discovery, it's this cash flow 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. So it's kind of just, it had that big breakthrough with Archegos. It's now traded back down to this all time high that it's hit.

Starting point is 00:38:35 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? Yeah. So 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 U.S. cable bundle.

Starting point is 00:38:54 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 reason that I thought Discovery Plus was so important, right? Discovery Plus, once they launched it and they launched it and they came out and they said, we're beating 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. So Discovery Plus was so important to Discovery because it proved, hey, we have a future

Starting point is 00:39:25 in the streaming world, right? 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 it in the stream world. So that's kind of the long-term overhang on the stock, which I think was going away as Discovery Plus delivered. Post this deal, people are really concerned because is Discovery is a $20, $30 billion enterprise value company. Warner Brothers is $100 billion enterprise value of company. So post this deal, one of the big concerns investors had is Warner Brothers will own AT&T through Warner Bros.

Starting point is 00:39:57 We own 79% of the combined company, and they're going to spin it out to all of their shareholders. And AT&T shareholders are famously dividend shareholders, right? 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.

Starting point is 00:40:18 So people are very concerned that discovery, 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 dividend securities. Interesting. So you think by mid-next year, this deal closes and the shareholders, this stock becomes the AT&T stock.

Starting point is 00:40:45 If you own AT&T stock, one of two things could happen. Either AT&T could do what's known as an exchange offer where they could say, hey, give us AT&T stock trades roughly 30. Discovery stocks, say trades 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 give 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

Starting point is 00:41:09 do, they'll just dividend out all their shares of discovery to their shareholders. And then if you were a shareholder of AT&T, you know, 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. You look in 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 I own discovery, sell. And there's just going to be waves and waves of selling pressure when this deal goes through. All right. So 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.

Starting point is 00:41:41 Yeah, so he's a key shareholder, and he's actually one of the reasons I first got a track to this deal. So John Malone, there's a book on him called The Cable Cowboy. He is an absolute legend in 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. You know, 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 the space.

Starting point is 00:42:07 He's done legendary deals. He bought Sirius XM. His cost faces there is negative. And he's just done great deals. He's the controlling shareholder of Discovery. He owns super voting B shares. And one of the reasons I follow Discovery for a while, but one of the reasons I like this deal is I follow John Malone for years.

Starting point is 00:42:23 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 he, 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.

Starting point is 00:42:51 Okay. 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? You know, everything's opportunity costs. And I acknowledge this stock, the deal could go through, AT&T could give the stock to shareholders and it could trade down 20, 30, 40 percent tomorrow. But I just see so much value in the combined company that I'm willing to risk that

Starting point is 00:43:29 bad mark to market and buy today because the stock market is a funny discounting place. You know, right 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 cash flow yield and this is an actual Netflix Disney competitor. That is way too cheap. We need to buy this and all of a sudden, you know, the stock's $40, $45 before you know it.

Starting point is 00:43:54 I don't know, but I'm willing to buy in based of that because I see so much value in the company. 10% free cash flow year. 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 to the equity because the combined companies coming out five times levered, you know, paying down a little debt, that's a lot of value going to equity. So I honestly think this could be a $100 stock in five to seven years. It's a $30 stock right now. That would be a really good IRA.

Starting point is 00:44:23 The Buffett and me has to ask, what about the management team behind Discovery? Obviously, it looks like they're not issuing dividends. 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? Have you read the snowball? Yes. So if you remember in the snowball, there's a 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 ask him his opinion in the merger. And he says, I think it's a great deal. I think there's a

Starting point is 00:45:02 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. These are two media companies with hugely synergistic assets. The stock, the morning it was announced, both stocks were up 20 percent and then they fell, I think because of the 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.

Starting point is 00:45:28 Discovery is run by David Zaslov. He's been CEO there for a long time. Mix reviews on him. John Malone, who is 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. You know, 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.

Starting point is 00:45:52 They've got great assets. And one thing that I think he doesn't get credit for, you know, 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 per check. And all of the media companies looked at that as free money.

Starting point is 00:46:16 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 up front, 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 Fiatze, all the guy Fiati shows, Chip and Joe, all that, those would have been hugely valuable on 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

Starting point is 00:46:48 we can merge with someone and they can use our content launch with that. 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 scripts, 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.

Starting point is 00:47:08 I think it proved 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, I mean, Zazlov has made tens and tens of millions of dollars as the share price has stalled out for years and years and years. Some of that was beyond his control because it's 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.

Starting point is 00:47:36 All right. So 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. 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 show.

Starting point is 00:47:59 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 Comcasts 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. So again, hustle offer for Disney in 2004, when Disney tried to buy Fox in 2016 or 2017, Comcast came with a awesome. offer at a huge premium to try to break that deal up 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

Starting point is 00:48:38 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, you know, AT&T has fought the DOJ in court twice in the past 10 years. They tried to buy Dean Mobile. The DOJ blocked that. They tried to buy Time Warner. The DOJ tried to block that. They beat the DOJ in court.

Starting point is 00:49:03 They bought Time Warner. I don't think AT&T wanted any part. You know, 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 decided to go with Discovery.

Starting point is 00:49:22 By buying Discovery, Warner Discovery paints Viacom CBS. and NBCU in a corner. There's now, two months ago, there were two scale players, Disney and Netflix, and there were three medium-sized players, NBC, Biacom, 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 a deal for that. That leaves NBC and Viacom scrambling.

Starting point is 00:49:50 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 by 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.

Starting point is 00:50:19 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 in weakness. and we're a buyer in strength. That sounds great to me. You're saying it's just a rumor, though. What exactly has been reported on this interest so far?

Starting point is 00:50:34 So there have been tons of reports that Comcast and NBC, Comcast and NBC wanted to merge with Warner. There have been lots of reports that they tried. There have 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 approaches look like and everything. But I think it's pretty safe to say that AT&T, you know, they evaluate. all their options with Warner, and they settled for the option with discovery with no regulatory risk, where they could de-leverage their balance sheet and where they could create a third

Starting point is 00:51:04 global-scale player. So I think that's why they chose discovery. On the Comcast discovery side, that's just me. Reading the T-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 out on discovery, NBC is subscale At some point, I will have to be a seller of NBC from a position of weakness.

Starting point is 00:51:28 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. Well, since Discovery and Warner already announced this merger, isn't there some sort of exclusivity on that deal, at least for a certain amount of time? No. So this is typical topping 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 discovery.

Starting point is 00:51:55 shareholders. And again, you think back to 2017, Disney and Fox had a deal. Roughly, the deal valued Fox at $30 per share, $35 per share. I'm doing something rough. Six months later, Comcast came with a topping 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. If you turn it down, you better have a damn good reason or else your shareholders are going to sue you for a breach of fiduciary obligation. And what's your take on the stock price if Comcast were to do that in place this topping bid and they pivot and go this direction?

Starting point is 00:52:31 What do you think that does to the price? Is it still a $100 stock? Is it higher? It's tough to say, but I will say, I have never been a part of a company that received a topping bid and been sad as a shareholder, right? Like 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

Starting point is 00:52:56 the Discovery Warner deal. It's a reverse Morris Trust. There's no cash coming to Discovery. It's stock in a new company. So it would be interesting how Comcast chose to discuss it. But again, let's look at the last example. Disney merging with Fox. Disney merged with Fox. It was about a $35 per share deal. Comcast came and tried to break it up with a $45 per share bid, right? That's over 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 are scared to invest it because the headline leverage number scale of people, people are scared about the kind of overhang from AT&T distributing

Starting point is 00:53:35 things. I'm willing to do that. And I don't think a lot of people have thought through the strategic pieces. I think a, most people think a chance of Comcast getting involved is zero. And I think it's significantly higher than zero. 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.

Starting point is 00:54:02 Well, I appreciate that. The easiest way, you know, Twitter, Andrew Rangely, that's ranged like a driving range, L-E-Y, so Andrew Rangely is my Twitter handle. Obviously posts a bunch there. I write a moderately popular finance blog. It's yet another value blog. dot substack.com. And then I do an even more moderately popular finance podcast, which is called Yet Another Value

Starting point is 00:54:25 Podcast, where I would take, 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. 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 this plays out.

Starting point is 00:54:48 Comcast comes with a topping bid for Discovery and you'll just have to have him back on. I'll say, I was the only one who told you so. I look forward to that. Thank you for having me on. We'll talk to you soon. Thanks a lot. 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,

Starting point is 00:55:04 that might be because there was a big updated 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 at Trey Lockerby and all the resources we have for you at the investorspodcast.com. Until next time, cheers. Thank you for listening to TIP. Make sure to subscribe to millennial investing by the Investors Podcast Network and learn how to achieve financial independence.

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