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February 20, 2009

Time Warner Break Up Approved

Back in late November when Time Warner was trading just over $9, I wrote a column for Real Money explaining Why You Should Own the shares. Today the stock stands at $7.56, down about 16%, a bit worse than the S&P 500 which is down almost 13%. During this time, Disney (DIS) and News Corporation (NWSA) are down 23%, while Viacom (VIA.B) is down 4% and CBS is down 20%.

Since I have been buying TWX for Northlake clients since last summer at prices up to $15, I thought you would be interested in latest update.

Last week, Time Warner received the final regulatory, IRS, and government approvals required to proceed with its separation from Time Warner Cable (TWC). The company followed up yesterday with an announcement that the separation would occur via a pro rata distribution of TWC to current TWX shareholders by the end of the first quarter. With the split set to go, I want to revisit the TWX investment thesis which all along has been based on ultimately owning the new TWX consisting solely of the content assets (cable networks, movie and TV studios, AOL, and magazines).

TWC will take about $12 billion of TWX's $38 billion in debt and pay a one-time dividend of $9.3 billion to TWX. New TWX will have Net Debt of $12.6 billion upon completion of the deal, about 2 times EBITDA. The distribution of TWC shares will be about $2 per TWX share.

Upon completion of the spin/split, TWX shareholders have approved a 1-for-2 or 1-for-3 reverse split. As of yesterday's close, TWX's price adjusted for the separation is $5.74. The Board of Directors believes that a higher stock price makes the shares more attractive to a broader array of shareholders.

The investment case for new TWX shares revolves around two issues. First, how will the company use the $9.3 billion dividend payment? Second, what are the prospects for the remaining business units?

The only ting we know for sure about use of cash is that the company plans to retain the current dividend of 25 cents per share. This will no require the use of any incremental cash but the current yield will rise to 4.4%. Management has talked down acquisitions beyond small, bolt on deals and talked up the "consistent return of cash to shareholders." I read "consistent return of cash" to mean a higher annual dividend but that does not seem likely in 2009 given the just mentioned commitment to maintaining the current dividend, an effective increase of over 20%. Most analysts are assuming a large share repurchase program covering the next couple of years once the economic and credit environments stabilize. In the long run, acquisitions to beef up the cable networks or video games might be an alternative. While explicit plans for use of cash would be nice, in the current environment, I think a cash heavy, underleveraged balance sheet is bullish....

Here is a breakdown of revenue and EBITDA contribution and estimated 2009 growth of new TWX:

Download file

AOL: The problems are well known. At 5.4 times EBITDA, new TWX's current EBITDA valuation, AOL is worth $6 billion. Who knows that AOL is worth but Google just wrote down its 4% interest from $1 billion to $274 million suggesting a $5.5 billion valuation for the whole entity.

Filmed Entertainment: This segment is composed primarily of Warner Brothers Entertainment. Warner Brothers is a market leader in movie and TV production. Movies and TV face secular challenges but I see the businesses as stable to slow growth long-term as quality content finds a home on any delivery platform. In the near-term, 2009 is shaping up as flat year despite tough comparisons, a performance that if achieved should resonate with investors. I am hopeful that a tighter and more integrated focus on its film slate, a la Disney, provides an offset to the secular and cyclical challenges in 2009 and 2010.

Networks is home to HBO and the Turner cable TV networks. HBO is on the comeback trail with better ratings for recent new shows following the departure of long-time winners The Sopranos and Sex and the City. It is a stable, subscription based business with an increasing focus on potentially more profitable content production. Turner Networks include TNT, TBS, Cartoon Network, and CNN. Advertising growth has remained positive, far outperforming peers as these types of general interest networks are stealing viewers and advertisers from broadcast TV. In addition, steadily growing subscriber fees paid by cable and satellite operators provides a major cushion against advertising weakness.

Publishing is mostly magazines including People, Sports Illustrated, Time, and Fortune. Magazines are under a lot of pressure but as management focuses on core brands, there is some hope for stabilization as economic pressure ease. Magazines have the benefit of being targeted national ad platforms.

Valuation

Adjusted for the spin-off of TWC, TWX is trading at about $5.74. Against recently provided guidance for "approximately flat EPS of 66 cents," the P-E is 8.5. The EBITDA multiple is 5.3. The guidance seems well grounded in reality. Valuation is similar to Disney and other entertainment conglomerates. I think TWX should get a premium because it has a better asset mix with lower capital intensity and greater resilience to cyclical pressures. In addition, the massive cash balance sets up the company to boost shareholder value once the economy stabilizes. I'm not sure I can make money on TWX in the short-term but I do strongly believe that TWX shares will outperform their peers over the balance of 2009.

Posted by Steve Birenberg at February 20, 2009 10:25 AM in TWX