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May 02, 2006

Time Warner: Cable To The Rescue?

Time Warner (TWX) shares have firmed up recently as investors are taking a more optimistic view of its most important division: Cable. Yes, that's right, cable. Despite all the focus that AOL will receive when the company reports earnings on Wednesday morning, it is cable that stands to be largest driver of TWX shares. Regardless of improvement or growth in the company's movie and TV studio, cable networks, or AOL, cable remains the largest division (getting larger when Adelphia closes) and the key to valuation. Each multiple point for cable EBITDA is worth $1 to TWX's share price, so the relentless multiple compression at Comcast (CMCSA) has created a headwind for TWX shares. I think Comcast has finally turned the corner with more upside to come. If so TWX shares should follow. I still don’t think upside at TWX is huge, but a move towards $20 is possible if my thesis on cable stocks plays out.

For 1Q06, several analysts have recently tweaked estimates lower, so I think the consensus figures a re a bit stale. Based on a narrow sample of several analysts I follow, EPS are projected at 19 cents, revenues at $10.8 billion, and EBITDA at $2.6 billion. While these headline figures will get play, investors in TWX should spend most of their time at the segment level. Here is a brief preview of each segment....

AOL has seen the bulk of the estimate reductions in recent analyst reports. Revenues are expected to decline by 7% with EBITDA falling by 9%. EBITDA has been growing at AOL despite declining subscribers due to falling network costs but continuing sub losses are beginning to bit and higher spending on AOL.com and the broadband offering are now hurting margins. US subscriber losses are expected to be around 650,000. Updates on AOL.com traffic and advertising revenue and broadband subscriber growth will be a focus of investors.

Cable should continue to produce strong results. Revenues and EBITDA are projected to increase 13-14% due to continued growth in high speed data, digital TV, and VOIP telephony subscribers. Basic subs are expected to increase by around 20,000, while high speed data subs are projected to grow about 200,000, digital TV about 160,000, and telephony by 250,000. ARPU trends are expected to remain stable.

Filmed Entertainment results are expected to be flat. Estimates have a lot of variability as this segment is hard to forecast. Analysts are expecting a good quarter in DVD sales because the latest Harry Potter film and Wedding Crashers were the top two DVDs during the quarter across all studios. Future health of the DVD market will be the key focus for investors.

Networks is projected to have 7% revenue growth with margin expansion driving 10% EBITDA growth. While these are good growth rates, I continue to fear that this is as good its gets because the cable network business has matured in terms of subscriber growth and ratings gains. Analysts still value this business at a premium so I will be listening for a reason why I should expect growth rates to improve over the balance of 2006 and 2007.

Publishing is TWX's smallest division. Growth in revenue and EBITDA is projected in the low single digits.

One other item of interest on the call will be the pace of the share buyback. As a result of the settlement with Carl Icahn, the size of buyback was increased. As time goes by and the share count comes down, the buyback can provide a significant boost to the underlying value of TWX shares.

This is evident in my sum-of-the-parts valuation model which calculates to a target of $20 based on 2006 estimates and $24 on 2007 estimates. I am only expecting upper single digit EBITDA growth in 2007 so the 20% price bump is benefiting from a reduction in the share count. Other key assumptions for 2007 are that cable sustains low double digit growth and AOL EBITDA is unchanged.

Posted by Steve Birenberg at May 2, 2006 02:09 PM in TWX