« The Dream Is Over | Main | The Credit Market Problem »

August 06, 2008

New Purchase: Time Warner

Following completion of Time Warner's 2Q08 conference call I purchased the stock widely across the Northlake client base and in my personal accounts. The purchase is based on my new, more bullish view of the company's prospects over the next 12 months. TWX finally seems to be emerging from a prolonged period of restructuring and minimal growth. Today, TWX is poised to have the best growth among its peers over at least 2H08. In fact, TWX's financial performance is going to accelerate while Disney, Viacom, and News Corp all decelerate.

TWX shares are the cheapest in this group, particularly after adjusting for the upcoming spin-off of Time Warner Cable. New TWX will be dominated by its Networks and Filmed Entertainment segments. Each of these groups is performing quite well with solid prospects for maintaining double digit growth. TWX does have two ailing businesses, AOL and Publishing. Fortunately, these are smaller contributors.

In addition, I think the odds of complete separation of AOL have risen. Much was made yesterday of the fact that TWX announced that it had completed planning for separation of AOL's access and content businesses. Less noticed was a comment on the call that went something like, "if you look just at our Film, Networks, and Publishing businesses, 2Q revenues rose high single digits and EBITDA advanced 11%." Maybe I am reading too much into this but why isolate these content businesses and exclude AOL's content and advertising businesses unless plans are in the works for a deal or deals involving all of AOL....

....Despite its weak fundamentals, AOL still will generate about $1.6 billion in EBITDA this year and next. I believe any deal would be greeted favorably by investors but generating an incremental $6-9 billion in cash or a stake in another internet company would likely boost the valuation of new TWX. Even at today's depressed prices, old media assets are valued more highly than AOL. Earthlink and Yahoo are currently valued at prices that make a $6-9 billion price on all of AOL very realistic.

Unlike most every other domestic media stock, TWX has catalysts ahead that can drive the stock price. Financial performance is set to accelerate in 2H08 due to strong operating momentum. Cost savings are running ahead of schedule and will bite in 1H09 when easy comps await. A transaction involving at least the access business of AOL is almost certain. A deal involving the content side of AOL is out there given all chatter surrounding Microsoft and Yahoo. Divestiture of Time Warner Cable will be completed by year end providing TWX with a $9 billion dividend and hugely underleveraged balance sheet. Share repurchases will resume once the Cable separation plan is finalized.

I also think that the return of the $9 billion TWC dividend to TWX shareholders has grown more likely. On the call, management noted that it was evaluating "direct return" of cash to shareholders. I read that as either a much larger share buyback or a significant one-time dividend. Acquisition risk exists, particularly if more purchases are made to bulk up AOL's content and advertising businesses. A cable networks acquisition is also a possibility and would not come cheap.

I wrote recently that headwinds from advertising and the lagging nature of advertising fundamentals relative to the economy make the valuation argument in favor of media stocks weak. That is true but TWX is really cheap, has less exposure to advertising than its peers, and has accelerating financial performance prospects.

Backing out the value of Time Warner Cable, TWX shares trade at less than 7 times 2008 EBITDA, about 13 times EPS, and about 12 times free cash flow. Looking ahead to 2009, I think new TWX can grow in the upper single digits, well ahead of Disney, Viacom, and News Corp. Yet TWX trades at the bottom end of the group at just 6 times EBITDA and 11 times EPS. TWX will be the least leveraged company in the group. If TWX moves up to the midpoint of group valuation, as it should since it will be enjoying the best growth over the next twelve months, upside of 15-20% exists. Even greater returns could accrue to shareholders if the company aggressively returns cash to shareholders by dramatically shrinking the share base or paying a large one-time dividend.

Overall, the balance in TWX shares has shifted firmly in favor of the bulls. Risks exist and recent history still does not produce great confidence in management. But the story of improved growth, greater strategic focus, and underleveraged balance sheet, and a very cheap stock has come together. The story should play out over the next six to twelve months setting up TWX as the best investment among large cap media stocks.

Posted by Steve Birenberg at August 6, 2008 04:38 PM in TWX