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February 27, 2006

Icahn and Time Warner Settle: Upside If TWX Can Sustain Growth

The market has reacted coolly to the settlement between Time Warner (TWX) and Carl Icahn as TWX shares given up all their gains since the company reported earnings and the Icahn-Lazard report was released. I think the additional debt funding a larger share buyback is incrementally positive for TWX shares, especially if visibility for upper-single digit EBITDA growth in 2007 and 2008 comes into focus.

I have adjusted my spreadsheet incorporating some basic assumptions about the settlement but the result is stand by my recent decision to lower my target price based on 2006 estimates to $20. Incorporating my new assumptions did raise my year end target price slightly to $20.42. I assumed that the company would buyback an additional $2.5 billion in shares over and above my previous assumption of $12.5 billion (all at $18 per share). In total, I have the company shrinking the share base by 833 million shares in 2006 from the year end total of 4.7 billion. The $15 billion buyback in 2006 doesn’t really add much value to shareholders as it is merely replacing debt with equity in the enterprise value calculation. My impression is that analysts and management already assumed $500 million in 2006 cost savings in estimates and guidance so that part of the settlement doesn’t add value either.

In 2007 and beyond the deal could begin to add value as the share shrink begins to bite....

Financial leverage now is working in favor of shareholders as free cash flow driven debt paydown effectively transfers value from bondholders to stockholders. Assuming another $5 billion in shares is bought in 2007, the share base will shrink by a further 278 million (again assuming $18 per share) but there will be no expansion in leverage as the share repurchase is funded almost entirely from free cash flow. Free cash flow in 2007 should about match the 2006 level of $4.5 billion as EBITDA growth matches the higher interest expense. Ultimately, assuming the additional $500 million in cost savings in 2007 is incremental, I calculate a year end 2007 target price of $24.35, a generous 38% above yesterday's closing price.

None of this analysis includes the Adelphia deal. Based on the current multiple being given to Comcast shares, adding cable cash flow actually hurts TWX valuation the way I look at it. Nevertheless, a two year target return of 38% is pretty attractive especially considering that the leveraging up of the company is working for the benefit of shareholders as long as EBITDA growth holds in the upper single digits.

I've been back and forth on TWX for the past six months. For now, I'll remain on the sidelines due to concerns about growth that make me hesitate to buy now based on a year end 2007 target price. However, if growth in 2007 looks promising and some time passes, I can see again adopting a positive posture on TWX shares.

Posted by Steve Birenberg at February 27, 2006 08:33 AM in TWX