Bernstein Research media analyst Todd Juenger returned to coverage of the industry Monday after a three-month sabbatical, upgrading Discovery Inc. to “Market Perform” from “Underperform,” but cautioning that the programmer, which agreed to merge with WarnerMedia in May, has some heavy lifting ahead.

Juenger took a three month sabbatical beginning on July 30, and Bernstein suspended coverage of media companies in his absence.  The analyst, who joined Bernstein in 2012 after heading up TiVo’s Audience Research business, has proven himself to be one of the more insightful analysts covering the programming space. 

In upgrading Discovery, Juenger also announced that he was dropping coverage of AMC Networks “to focus on stocks with broader investor interest.”

Juenger didn’t pull any punches upon his return. Although he increased his rating on Discovery, he lowered his 12-month price target on the stock to $26 from $28, reflecting his concerns about its ability to integrate the WarnerMedia business.

“[W]e continue to have high conviction that these businesses face a long list of very serious concerns, including: the legacy business is facing insurmountable structural pressure, the streaming future is riddled with risk for this set of brands, including the daunting complications of the WarnerMedia integration and rationalization,” Juenger wrote of Discovery. “However, the market seems to also share those concerns, and has driven the stock price down to a level where we can no longer argue the risk/reward for investors skews significantly negative from here.”

Juenger continued that he believed Discovery’s stock price already reflects the market’s belief that it will miss its streaming revenue guidance, cash flow guidance or both. 

“As the closing date approaches, the key question for investors from a catalyst perspective is: if the company takes down their guide, will that be bad for the stock (confirming tougher business conditions and lower financial results) or good for the stock (clearing the overhang, regaining investor confidence in a believable outlook on which to price the stock)?”

In his report, Juenger points out that Discovery WarnerMedia is not yet the “streaming powerhouse” depicted in headlines, but instead relies almost entirely on traditional linear cable network revenue to fund its streaming endeavors. How it manages to keep that linear business generating cash while its streaming business grows will be critical. 

“Ironically, the more successful the streaming service becomes in the market – the more pressure is put on the linear networks, which is the tyranny of the innovator's dilemma,” Juenger wrote, adding that the new entity will have a leverage ratio of about 5 times cash flow, and has promised to use excess free cash flow to lower debt. 

“We think this puts the company in a very difficult box to start from: promises to both invest in streaming and invest in delevering,” Juenger continued. “It also greatly amplifies risk to equity value. Any downturn in either EBITDA/FCF, or the valuation multiple of the stock, will fall sharply on the equity holders.”

Discovery shares were up more than 5% in early trading Monday to $24.70 each. The stock was priced at $24.52, up 4.6% ($1.08 each) at 12:09 p.m. on Nov. 1.  

Juenger also didn’t want to downplay the massive integration issues the combined company will face once the deal closes.

Integration Issues Loom 

“Which departments survive, which get merged or deleted, who stays/who goes, who's in charge, how to design incentives for leaders of the legacy business and the streaming business, and how to align that market by market, region by region and globally,” Juenger wrote. “All while trying to deliver/exceed on financial synergies promised to the investment community. This complex task will not only require significant expense, but also significant management bandwidth and distraction. And employee trepidation, and time. Important decisions cannot be made before the new leadership is installed (otherwise it undermines the authority of the new leadership).”

Juenger also saw some potential bright spots, including overdelivering on streaming growth and potential synergies. The analyst wrote that the market usually forgives other sins if a company manages to add more streaming customers than expected, and so far most streaming services have. 

In addition, Juenger added that if consumers pare down to three or slightly more than three streaming subscriptions, Warner Bros. Discovery will likely be among them. 

“This view would be supported by a belief that HBO would continue its history of putting forth a handful of truly distinctive premium entertainment series every year, and the addition of Discovery's portfolio would add complementary engagement value,” Juenger wrote.

As far as synergies, Juenger pointed to Discovery’s 2017 purchase of Scripps Networks. Less than three months after closing that deal, Discovery raised its cost synergy target from $350 million to $600 million. 

“One could easily expect Discovery will once again exceed the original target,” Juenger wrote. “Which, theoretically, could be additive to the $14 billion EBITDA guidance (or, give the company that much extra room to invest in streaming, or de-lever).”

Like other virtual MVPDs, YouTube TV is a money-loser.

That’s the bad news. “Even worse, there doesn’t seem to be an obvious path to not losing money,” Bernstein analyst Todd Juenger explained in a Weekend Media Blast analysis on YouTube TV issued Friday. “The financial model doesn’t scale.”

YouTube TV doesn’t break down its financials publicly, but Juenger estimates that YouTube TV is losing about $5 per month per sub, but readily admits that the toughest assumption in making that calculation is the CPM on the product. Given the current, relatively small size of YouTube TV’s sub base, that’s not a material number for a deep-pocketed company like Google and its parent, Alphabet.

Even at 1 million subs, YouTube TV, which is also exposed to annual price inflators from programmers, would lose $60 million per year. “Not even a rounding error for Alphabet,” Juenger noted. “No analyst would even bother modelling it.”

But what if the losses grow to $10 per sub and YouTube TV pulls in 5 million subs. “Now we have a loss of -- $600mm OI. Material yet? How about 10mm subs, now we exceed -$1bn in OI losses. Surely, that would catch investors’ attention.”

With that as the backdrop, it’s clear that YouTube TV’s financial overhang is greater the more successful it becomes from a subscriber basis.

“Google knows this. So what is their plan?” Juenger asks, holding that he doesn’t believe it’s their intention to lose money on every YouTube TV sub indefinitely.

Google hasn’t provided those details, but Juenger speculates on a handful of items – some more disruptive than others -- that could be part its plot to improve the business as it moved further down the road:

1. Google believes consumers will “fall in love with the product,” giving it the green light to eventually raise the price enough to generate a profit. Notably, it already has raised the baseline price of YouTube TV following the recent addition of networks from Turner. But raising prices will be difficult, Juenger said, because of video competition and “reference points” from SVODs such as Netflix and Amazon.

2. Google believes its ad model will prove so superior, they will generate CPMs will in excess of what Bernstein has modeled, and spread across Google’s video inventory in a way that helps put YouTube TV in the black.

3. Google believes their advertising model will prove so superior, TV networks will turn over national inventory for Google to sell. But Juenger says it’s unlikely that networks will cede the rights to any of their premium inventory (or semi-premium or dubiously-premium inventory) to a third party.

RELATED: YouTube Seeks TV Ad-Vantage

4. Google believes they will gain enough subs and importance in the marketplace to push back on TV network price demand, and possibly drop overpriced or unwanted networks. Juenger points that that this one is probably folly, as no MVPD, virtual or otherwise, has been able to pull this off.

5. Google has ambitions to get into the live TV business themselves and try to own the economics. If that’s to happen, Juenger sees it most likely in sports, by Google forming its own "network(s),” and acquiring sports rights. Rights for the NFL, MLB and NHL will be coming up in 2021/2022 timeframe, he points out. 

It's unclear what Google has in mind, but Juenger sees YouTube TV taking some of these paths to help the financials of the OTT TV model pay off, or at least pay better.  

In a note to investors, BernsteinResearch says it still expects the Comcast/Time Warner Cable merger to be approved by the FCC--with conditions--and close by the end of first quarter 2015 or the beginning of the second quarter.

While it notes that sentiment has become more negative on the deal following the FCC's stopping of the shot clock on the transaction, it suggests that and other concerns of investors are overstated.

The BernsteinResearch team, led by senior analyst Paul de Sa, points out that procedural disputes like those that stopped the clock--access to contracts, incomplete filings--are typical in large and controversial mergers. They point out that the clock was stopped once for the Comcast/NBCU merger and twice for the Verizon/SpectrumCo deal (both of which were approved).

They also downplay the concerns that the FCC may establish a speed threshold for the Internet access marketplace, arguing that the competitive marketplace is local, not national, and offered speeds are not relevant. They also proving market power in interconnection would be tough.

As for the network neutrality proceeding having an adverse impact on the deal's outcome or timing, they say they see little interaction between the two, with the exception that rules with some for a Title II hybrid approach could make the merger approval less controversial, which "backlash" against weaker rules could make it "incrementally" harder.

The researchers suggest that, as with the Comcast/NBCU merger, the FCC will likely make adherence to whatever new rules it comes up with a condition of the deal, just in case those rules don't pass court muster, as the last ones did not. Comcast is still subject to the 2010 Open Internet rules thrown out by the court per that deal condition.

As to inside-the-Beltway analysts expressing doubts about the deal, "we suggest they should be treated with skepticism by investors."