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November 01, 2006

Time Warner Earnings: Limited Growth But Stock Looks Decent

Time Warner (TWX) reported 3Q06 results that were largely inline with consensus estimates. The shares initially traded down about 2% on a sell the news reaction with investors likely focusing on slightly lower than expected segment results at the company's Cable business. Cable is the largest division by far and the only one with a clear path for double digit growth over the next few years. Offsetting the slightly shortfall at Cable is better than expected results at AOL. If TWX shares had not performed so strongly of late, they probably would not be trading off nearly as much as 2% on these results.

TWX reported revenue of $10.9 billion and adjusted EPS of 19 cents against consensus estimates of $11.1 billion and 20 cents, respectively. Given all M&A activity in the quarter, I don’t find the miss relative to consensus to be very meaningful. This was a very difficult quarter to model.

Where results really matter this quarter is at the segment level. On this basis, the quarter was inline with expectations. On a revenue basis, AOL was better than expected, Cable and Networks were slightly worse than expected, and Filmed Entertainment and Publishing were inline. On an EBITDA basis, AOL and Filmed Entertainment were better than expected, Cable was worse than expected, and Networks and Publishing were inline....

AOL had a 3% revenue decline but saw EBITDA increase 21%. Sub losses were higher than expected at 2.5 million, driving subscription revenue 13% lower. This was more than offset by much better than expected advertising growth of 46%. Costs fell 10% primarily driven by lower marketing expenses as AOL is no longer trying to attract paying subscribers. Pageviews fell 3%, a slower rate of decline than recent quarters. Management forecast pageviews to grow in 2007.

So far, the transition to free AOL is going better than expected. New registered users are up by 3 million. Of those 2 million are formerly AOL paid subscribers and 1 million are new to AOL. Keeping formerly paying subs within the AOL universe of sites is critical to reigniting pageview growth and driving advertising. Formerly, almost everyone who left AOL stopped uses AOL services. I remain skeptical that AOL will prove to be an industry leading web property over the next several years. I think they are capturing low hanging fruit and as the transition toward the free model matures AOL will be at best the #3 player. At that point, sustaining advertising growth above industry growth rates will be difficult and the recent significant bump in implied valuation for AOL within TWX will falter.

Cable comparisons vs. a year ago are impossible due to the acquisition of Adelphia and associated deals with Comcast. However, analysts seemed a little concerned about the trends at the historical, non-Adelphia systems where slower than expected gains in VOIP Telephony subscribers led to a series of questions. Additionally, marketing and customer service costs at the Adelphia systems were higher than expected. I think any controversy related to these figures are much ado nothing at this point. Should the next quarter or two show similar results, it may turn out that this quarter was a tipoff. I don’t expect that to occur.

Filmed Entertainment EBITDA was better than expected with the gains appearing to come form a one-time benefit and better than expected results in TV syndication. The movie business has picked up recently and the film slate looks good starting with the upcoming release of Happy Feet. Investors won’t be concerned with current trends in this division as they look forward to easy comparisons in 2007. One item to watch is the continued negative comparisons for DVD sales. Better product should help but it is probable that this highly profitable revenue stream is facing secular pressures that will not abate.

I remain concerned about growth prospects for Networks where the maturity of the traditional cable networks is pushing divisional growth to the mid to upper single digits form prior double digit growth. Revenues grew just 4% this quarter, although part of the reason was the closing of the WB Network. Management commented positively about the current scatter market for cable TV advertising. I still think the risk remains to the downside over the next few years as subscriber growth has slowed and ratings are stagnant.

Publishing, the company's smallest division, which is about to shrink further with the sale of 18 magazine titles, reported very much inline results. The hope is to drive internet revenue for the largest properties like People and Sports Illustrated while keeping print trends fairly stable. The strategy may work but it won’t be enough to move the needle at TWX.

I think TWX shares will stabilize quickly following the initial sell-off. Momentum is strong and many analysts can justify upside into the mid $20s. I don’t agree but for now the trend remains firmly upward.

Posted by Steve Birenberg at November 1, 2006 09:28 AM in TWX