With the current macroeconomic slowdown and increased recession risk, the Federal Reserve has been on an interest-rate hiking spree. This is driving borrowing costs to rise rapidly, which is causing stress for companies with weaker balance sheets.When the economy was in long-term expansion mode (up until the pandemic), companies were not shy about taking on large amounts of debt to finance operations and fuel growth. Along with the tech and health care sectors, the media sector became notorious for its growing debt load. When economic conditions were better and borrowing costs were low, this was less of an issue.It’s completely normal for most large companies to carry some amount of debt, but debt can be a double-edge sword. When macroeconomic conditions are rosy, companies are encouraged to take on cheap debt to invest in business and grow profits; however, when the macro backdrop deteriorates, debt gets more expensive to pay down, and a company could ultimately be at risk of default.It’s no question that the major shifts in the media business over recent years were costly but necessary for survival. Legacy media giants began taking on debt and poured heaping amounts of cash to fund their streaming endeavors.On top of that, M&A activity heated up over the past couple of years, a trend that typically occurs during booming economic conditions. Amid the rising competition in the space, consolidation became rampant in the media industry. But the issue with M&A is that the acquirer takes on the debt of the entity getting bought. Most recently, when WarnerMedia and Discovery merged, all of WarnerMedia’s debt woes were thrown onto incoming Warner Bros. Discovery CEO David Zaslav’s lap.With second-quarter earnings season in the rearview mirror, investors got a pulse check on the media industry heavyweights’ balance sheets. Free cash flow and debt load remained top of mind, as execs noted increased uncertainty.AT&T often used to top the debt list; however, after offloading WarnerMedia, Comcast took over the top spot. Warner Bros. Discovery ranks third upon completion of its merger in April.However, just because the amount of total debt is high, that doesn’t mean the company is in a bad financial position, and that’s where financial leverage comes in. While there are several ways to assess financial leverage, investors often look to debt-to-EBITDA and debt-to-equity to analyze balance sheet health among companies, media included.The debt-to-EBITDA (Debt/EBITDA) ratio measures the amount of income available to pay down debt before covering interest, taxes, depreciation and amortization expenses. To put it simply, it assesses how well a company will be able to pay off its debt, and a higher ratio generally means that the debt load is too heavy.A debt-to-equity (D/E) ratio is a method of measuring a company’s financial leverage by dividing long-term debt by stockholders’ equity. It’s important when assessing the health of a company because it reveals how much of a company’s operations are being financed by debt versus wholly owned funds. When a company has a higher D/E ratio, it is often viewed as a riskier investment.On a broad communications sector level, the average leverage ratio is about 1.9x. Currently in the media industry, Warner Bros. Discovery’s leverage ratio of 5.0x is on the higher end of its peers. Meanwhile, Comcast had a 2.9x leverage ratio, while Disney’s leverage ratio was about 2.2x, and Netflix’s stood around 2.4x, as of the end of last quarter. Zaslav must keep his promise of bringing down Warner Bros. Discovery’s leverage ratio to between 2.5x to 3.0x within 2 years, or otherwise risk losing all investor confidence.Highly leveraged companies are being threatened by the overall economic circumstances as well as changes in how media and streaming companies are being valued. Long gone are the times in which subscriber growth was the only metric celebrated. As we’ve seen in recent quarters, investors have now shifted their focus back to the fundamentals: profitability and a healthy balance sheet to support future investments.With no end in sight to the economic downturn, this new operating environment will naturally weed out the weaker players in the media industry. Many industry experts have expressed concern over the ballooning debt that had been rampant for decades, and now we’ve finally reached the moment of reckoning. Shifting consumer behavior and the changing media landscape alone are challenging enough. But now it’s up to the companies’ leaders to also figure out how to balance massive debt loads in order to instill investor confidence in their businesses.
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