Good Quarter at Time Warner Goes Unrewarded

Time Warner reported a good 3Q09, beating expectations on most key metrics. EPS of 45 cents exceeded the consensus estimate of 37 cents. Revenues of $6.81 billion fell slightly short of consensus for $6.97. EBITDA was down just 2%, far ahead of expectations for a drop of 11-14%.

The upside came in Networks and Filmed Entertainment which are the core businesses of the slimmed down Time Warner. Networks upside came in margins as EBITDA grew 14% against an as expected 5% gain in revenues. Tight expense management including only a modest increase in programming costs drove the EBITDA gain. Total advertising in Networks fell 3%, a little better than expected. TNT and TBS appear to have had positive advertising growth offset by negative growth at CNN which is lacking Presidential election related advertising this year.

Filmed Entertainment reported 34% EBITDA growth against expectations ranging to 20% declines once again revealing the hopeless nature of modeling film studio profitability. The upside came form the phenomenal success of The Hangover, lower than expected print and advertising expenses, a $40 million favorable reversal related to home video catalogue sales, and ongoing cost reduction initiatives. Warner Brothers seems to have taken major strides toward more consistent film profitability a la Disney and News Corporation.

Publishing and AOL were both down over 20% in revenues with EBITDA declines of 46% and 23%, respectively. About the only good thing that can be said regarding these segments is that year over year declines are stabilizing. AOL also had a better than expected margin performance.

Similar to Viacom yesterday, TWX shares initially bounced higher on the good results but then gave back the gains. The combination of these two reports suggests a stabilized but not yet improving ad environment. On 1Q calls, stating that the worst was over for advertising was good enough to power the stocks. Now that the stocks have rallied sharply, investors need improvement not stability. As a result, we are getting sellers even as numbers and commentary are good and constructive. Basically, as noted in the preview, the bar was set very high leaving near-term trading skewed toward sell the news.

Next up is Disney after the close on Thursday. I expect more of the same although investors tend to follow Disney's lead more so than the other major entertainment companies.

Time Warner Officially Jettisons AOL

I have been strongly in favor of a separation of AOL from Time Warner (TWX) for several years. I am not convinced there is much hidden value in AOL but getting rid of a management distraction and significant negative talking point for investors should be helpful to TWX's stock valuation. In addition, AOL is has been and probably remains a drag on long-term growth of TWX, which is now being driven by the company's cable networks.

Despite my enthusiasm for a split and the formal announcement on Thursday, I do not think this is a catalyst for a higher TWX stock price in the near-term. The move was widely anticipated and telegraphed, right down to the timing. In fact, when speculation about the split reached its peak in early May, coinciding with improved sentiment toward advertising trends, I sold all Northlake positions in TWX 10% above the current price. Even if you accept the possibility that AOL's valuation will be a few billion higher than most analysts assume, the incremental value would only get TWX shares back to their recent high.

Analyst estimates assume AOL will produce about $1 billion in EBITDA in 2009, down 30% plus vs. 2008 and well under half the level of just a few years ago. According on UBS analyst Michael Morris, if you put Yahoo's (YHOO) multiple on the display business, United Online's (UNTD) multiple of the access business, and ValueClick's (VCLK) multiple on the ad network business, AOL would be worth about $6 billion. This is as much as $1-2 billion, or $1-2, more than investors could be imputing into the current TWX share price.

The official announcement lacked a few key details that should be determinative for AOL's valuation and any TWX benefit. First, TWX will be buying back Google's 5% stake in AOL. Google just wrote this down to $274 million, implying a $5.5 billion value for AOL. The price of the buyout will go a long way toward establishing AOL's initial trading value. Second, TWX did not announce AOL's capital structure. AOL produces significant free cash flow as capital spending is minimal so only taxes come off the EBITDA line. On $700 million in free cash flow AOL could support $3-4 billion in debt but given the uncertainty surrounding AOL's future cash generating capabilities, TWX may not be able to pass off anywhere near that much debt.

This discussion also raises the issue that TWX will be giving up 20-30% of its free cash flow when it jettisons AOL. The remaining businesses are not capital intensive but they do require more working capital to operate. This gives TWX incentive to create more potential value for its post-AOL shareholders by transferring significant debt to AOL.

The bottom line is that the AOL spin-off is a long-term positive for TWX. However, it is not actionable in the short-term unless you want to make a bet on AOL's valuation and capital structure. Furthermore, even if you make the bet, TWX shares are not undervalued by more $1-2, just 4-9%.

Sold Time Warner

I sold all client and personal positions in Time Warner (TWX) on Thursday morning. The shares had rallied 39% since re-opening for trading following the completion of the spin-off from Time Warner Cable (TWC) on March 27th.

Most of the TWX owned by Northlake was purchased in August 2008. Adjusted for the split from TWC, those shares incurred a loss of 26%. Another round of TWX was purchased in November 2008. This buy proved timely and the shares were sold for a 27% gain. Clients who purchased in both instances lost about 11%. Given the market rout since mid-September 2008, TWX ended up being a satisfactory investment. The stock did better than the other major media companies during these time frames.

Media stocks have been unusually strong since the market began its rally in early March. TWX moved first thanks to the value realized and improved balance sheet resulting from the restructuring. In the past two weeks, the media stock rally accelerated as most major companies reported first quarter earnings. Earnings generally beat lowered expectations and management commentary indicated that key media fundamentals in advertising and DVD sales were stabilizing.

The media stock rally may have peaked this morning following News Corporation's quarterly earnings report after the close on Wednesday. The stocks shot up as trading opened Wednesday in response to comments from Rupert Murdoch that "the worst is over" and that "in some businesses revenues were healthier." Rupert has been unusually bearish for the past year so his comments were well received by recently more bullish investors. Coming on the heels of more optimistic comments form Disney (DIS) CEO Bob Iger when his company reported on Tuesday afternoon, media stocks were once again in vogue.

The rebound in TWX shares allowed me to sell the stock at 13 times estimated 2009 earnings and 6.9 times operating cash flow. I think this is a full and fair valuation given the still weak economic environment and uncertain timing of a return to growth for advertising. To see TWX or other major media stocks move significantly higher requires an upturn in fundamentals by the fourth quarter of 2009. I think that is quite possible but getting from here to there smoothly is unlikely. As a result, selling TWX and looking for a better entry point on it or other media communications over the next few names is the correct strategy.

The sale also fits my view of the market. I have been regularly commenting in emails, blog posts, and the Twitter feed that I thought a sharp pop above 900 on the S&P 500 could be the top of the current rally. The fact that the move occurred this week when earnings season winds down, the stress tests results are released, and the monthly employment is due created a fundamental backdrop to the prices in my market outlook.

Over the past few weeks as the market has rallied I trimmed positions in Discovery Communications and Apple, sold the holdings of NII Holdings and Time Warner, and swapped some of the aggressive index ETFs purchased in March for the less volatile S&P 500. Portfolios are now cautiously positioned allowing for buying on pullbacks or selected new investments if economic fundamentals are truly turning up.

Disclosure: AAPL and DISCA are widely held by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.

Time Warner: Good Results and AOL Exit Drive Upside

Time Warner (TWX) reported better than expected 1Q09 results. Headline financial numbers of 35 cents, $6.95 billion in revenue, and $1.56 billion in EBITDA each exceeded estimates. On its own, the financial performance would have been enough to push the stock higher. However, news that an AOL spin has moved to the front burner added fell and led the stock up 4%.

I still like TWX but near-term catalysts are mostly played out. An AOL spin is likely incorporated in the stock now and while the 2009 outlook is slightly improved, the current quarter is going to be the most difficult of the year. A clean beat to 2Q estimates in July is next prominent catalyst followed by a resumption of share buyback activity. The message on timing o the AOL spin was muddled but I think it will be a few months based on the repurchase of the Google stake, the requirement for an independent valuation, and the need for Board approval. I suspect the share repurchase announcement will coincide with the AOL spin. This news seems likely to come around the time of the 2Q report.

The bottom line is that the restructured TWX looks like a stronger entity than previously expected due to tighter management of costs and a somewhat improved revenue outlook for the cable networks and filmed entertainment segments. Upside to the upper-$20s later this year is plausible but following a 21% pop since the split from Time Warner Cable (TWC), further near-term gains may be difficult.

Getting back to the quarter, the upside came from better than expected revenue and margins at Filmed Entertainment and higher than expected margins at Networks. Costs saving and TV production drove Filmed Entertainment. Networks outperformed the industry with a 2% advertising decline though I had hoped for a bit better. 2Q advertising is trending to a mid single decline. This is a good performance in a tough environment but also a little worse than I hoped for.

Publishing and AOL struggled mightily as expected. AOL revues fell by 23% with a 37% decline in EBITDA. Publishing revenues dropped 23% with profitability collapsing by 92%. AOL ad revenue fell over 20% and Publishing dropped 30%. AOL should produce similar performance in the next few quarters while Publishing is likely to improve margin due to seasonality.

Disclosure: TWX is widely by clients of Northlake Capital Management, LLC including in Steve Birenberg's personal accounts.

Time Warner Earnings Preview: It's All About Advertising Growth

Time Warner (TWX) reports its first quarter since completion of its restructuring on Wednesday morning. The company no longer owns cable systems and is not a content focused company with greater than 2/3rds of operating income coming from film and TV production and cable networks.

Consensus estimates call for EPS of 38 cents, revenue of $6.8 billion, and EBITDA of $1.51 billion. I am not trustful of the EPS number and I find the revenue number to be above more recent estimate revisions.. The estimate range is quite wide and may not be fully transitioned to the new TWX. Revenue is forecast to decline 9.5% with EBITDA down 17.6%.

The first quarter is going to be the weakest of the year due to tough comps at the Filmed Entertainment segment. 1Q08 had the I Am Legend DVD which sold very well. There is no comparable title this year. AOL and Publishing will be very weak thanks to advertising declines that could be north of 20%.

The one bright spot should be Cable Networks where revenues should rise close to 5% with EBITDA up about 7%. Cable nets benefit from upper single digit growth in affiliate fees and advertising trends are holding in relatively well. The single most important takeaway form the quarter will be 1Q advertising growth for cable nets and commentary about the outlook 2Q and the rest of the year. If TWX can hold cable net advertising growth in positive territory, the stock should continue to be a leader. Any deceleration to negative growth, especially beyond low single digits, will put a quick end to the recent rally in the shares.

The other focus for investors will be trends and potential separation at AOL.

Disclosure: TWX is widely held in by clients of Northlake Capital Management, LLC including Steve Birenberg's personal accounts.

TWX Takes Another Step Toward Ridding Itself of AOL

The WSJ is reporting that TWX has asked bondholders for consent to amend covenants. The amendments essentially switch collateral on the bonds from AOL to HBO. The idea is to set up AOL for a spin-off as a debt-free company. I've written often on TWX noting that any divestiture of AOL will be positive for TWX shares as it will remove a no growth asset, free up management time, and increase the importance of well positioned cable networks and film and TV studio. TWX popped nicely last week post the spin of TWC. I think more upside lies ahead as long as cable networks ad growth gets no worse than flat to down low single digits. Here is everything I have written on TWX over the years.

Housekeeping: Sold Time Warner Cable

I sold all the shares clients received last week in Time Warner Cable (TWC) as a dividend from Time Warner (TWX). For each share of TWX owned prior to the 1 for 3 reverse split, clients received .03867 shares of TWC.

For the long-term, I think the market is undervaluing cable stocks but I fear that 2009 estimates will still be falling especially as the companies report 1Q09 results late this month. Current estimates call for low to mid single digit growth rates for operating cash flow in 2009. I fear a negative reaction in cable stocks if those estimates fall further. In addition, I am worried about a further deceleration in subscriber growth. The hit to financial performance will be minor but investor sentiment may sour as fears about the competition between cable, telco, and satellite TV companies grow.

In the long-term, I think investors are already too pessimistic toward cable companies. As the economy stabilizes and resumes growth, operating cash flow should accelerate to mid single digits. In this scenario, free cash flow will grow double digit. Current valuations for cable stocks on EBITDA or free cash flow suggest that growth may remain flat or go negative. With plenty of penetration left for broadband, digital TV, advanced TV services, and telephone, I think a mid-single digit growth rate is likely. The risk to this bullish outlook are that basic cable subscription loses accelerate and/or pricing on all services falls in a discounting battle with telcos.

TWC has a bit more short-term risk than Comcast because its balance sheet is stretched due to the $10 billion dividend it paid, moslty to TWX, as part of the restructuring. In addition, the CEO has been unusually bearish in his public comments, which makes me worry about 1H09 trends. Thus, sell TWC now and keep an eye on cable stocks for an opportunity later this year when expectations are fully reset lower.

TWX is held in Northlake client accounts including my personal accounts.

Why Would a Senior Google Exec Leave for AOL?

Time Warner (TWX) has hired one of Google's most senior executives to run AOL. Tim Armstrong was a member of Google's Operating Committee and President of Americas Operations. Armstrong also has a background in traditional media including developing internet properties at traditional media companies.

Armstrong is undoubtedly totally loaded due to his 8 plus years at Google (GOOG), so this seems like an odd move given AOL's declining relevance and very poor financial returns. From that perspective alone, this has to be considered a positive for TWX. Obviously, Armstrong sees something at AOL from which he can create value.

Maybe more important, it seems unlikely that he would move to AOL unless he was given a very clear plan for the future of the division including the possibility that he will either become Chairman of a public company when AOL is spun out or that he will get a big golden parachute when AOL is divested. Either would be bullish for TWX shares.

I've commented extensively that any separation of AOL from TWX is bullish even if value realized for shareholders is not much above $0. That is unrealistic of course. Even after writing down its AOL investment last month, Google's valuation implies a $5 billion valuation, or over $1 per TWX share. Earthlink (ELNK) still has a market cap of $700 million, a reasonable looking stock price chart, and free cash flow machine in its dial-up business (half of AOL).

TWX has said repeatedly that it would directly address AOL's structure after it completed the split from Time Warner Cable (TWC). That will occur at the end of March so I view the new management at AOL as a positive that some resolution is coming in 2009. Once again, almost any resolution is a bullish for TWX

TWX is held in Northlake client accounts including my personal accounts.

Time Warner is Watching Watchmen

The Weekend box office continued its year long win streak but for the second consecutive weekend there was a disappointment from a highly anticipated film.

Led by Watchmen, the box office rose 12.7% according to BoxOfficeMojo.com. Every weekend since late December is positive and year-to-date total receipts for the North American box office are up 14.4%.

Next weekend will probably break the box office winning streak due to a tough comparison but the news is still good for theater companies Regal Entertainment (RGC), Cinemark Holdings (CNK), and National Cinemedia (NCMI).

At the studio level, so far 2009 looks good for Time Warner (TWX) and News Corporation (NWSA), while Disney (DIS) has struggled. Disney gets another chance this coming weekend with Race from Witch Mountain. Lionsgate (LGF), which has a rough run of bad news, has a winner in Tyler Perry's Madea Goes to Jail, which came in second last weekend and is now the highest grossing film in the Tyler Perry franchise.

Watchmen Profit Analysis

Watchmen grossed $55.6 million for the second biggest March opening of all-time but it fell short of expectations for a $60-70 million opening. It is too early call the total box office potential for the film but based on Saturday's drop and comparisons to similar films the North American take seems likely to be around $150 million. The film opened in most foreign markets and pulled in at another $27 million, again a disappointing figure. Being long Time Warner, I had hoped for a better opening weekend to provide some cushion to 2009 estimates for the Filmed Entertainment segment.

With a rumored production cost of $150 million and Warner Brothers admitting to a marketing budget of $50 million in the U.S., the film is going to have a tough time breaking even. This is a disappointment for TWX but unlikely to change 2009 estimates. In addition, Watchmen is a one-off project as opposed to an attempt to launch a new franchise so if the film disappoints it is not a problem for the long-term....

....Based on a November 16, 2008 article in the LA Times, Watchmen's economics involve four major entities. Warner Brothers (owned by TWX), Legendary Pictures, and Paramount (owned by Viacom) split production costs (25%/37.5%/37.5%). Warner Brothers has North American distribution and marketing and Paramount has overseas distribution and marketing. 20th Century Fox (owned by NWSA) gets a percent of the domestic box office due to its initial ownership of the project.

Let's take a look at potential profitability to Time Warner assuming that North American and International box office totals $300 million, split evenly. These figures could be optimistic based on opening weekend trends, especially the international figure. I developed my own model for this analysis but double-checked it with David Poland of Movie City News after which I adopted several of David's thoughts. David maintains his own blog at The Hot Blog.

If the film does $300 million globally, box office receipts to the studios will be $165 million (45% of box office goes to the theaters). Distribution fees are calculated as a percent of gross box office. Fox's cut will be 8% of the gross or $24 million. TWX gets a distribution fee of 10% on North America or $15 million. VIA gets the same payout on International. Subtracting this $54 million from the studio shares leaves $111 million.

BoxOfficeMojo says production cost is $150 million and the studios are admitting to a $100 million marketing budget split equally between North America and International. We can use those numbers but if history is a guide they are low.

If we subtract the production and marketing costs of $250 million, the film is at a loss of $139 million based solely on theatrical revenue. I think the studios that underwrote the production cost expected to be at least breakeven on theatrical revenue.

All is not lost, however, as most profits in the movie business in recent years have come from DVD sales, TV rights, and merchandising. Revenues from these sources are directly related to box office performance. DVDs, in particular, should be very important given the large and devoted following of the Watchmen graphic novel. Three DVDs are in the works including two premium issues. Watchmen also benefits from reissue of the book, two new "Making of Watchmen" books, and an animated DVD of the book.

I think profits from DVD sales and rentals could run as high as $120 million assuming sales of 6 million units at a wholesale average price of $20 and a 60% margin, and typical popularity at Blockbuster and Netflix. TV rights in the US and abroad and books and other merchandising could bring in another $40 million in profits.

Add non-theatrical profits of $160 million to the theatrical loss of $139 million and Watchmen ends up being modestly profitable to the tune of $21 million. As mentioned, admitted production and marketing costs are too low so it is more likely the film produces a small loss.

TWX Watchmen Exposure

The major player in Watchmen from a stock perspective is TWX. I began this commentary by noting I did not think estimates would come down. The numbers support this, especially in the murky world of movie accounting. TWX is unlikely to ever take a write-off on Watchmen even if worldwide box office ends up closer to $200 million. However, investors and analysts expected more from the film so the margin for error on estimates has shrunk considerably and will fall further if Watchmen has poor legs.

I think TWX's poor performance on Monday (-5%) reflects the Watchmen disappointment but keep an eye this coming weekend's box office, especially outside the US to see if the pressure on the rest of TWX's 2009 film slate gets ratcheted up a notch or two.

TWX is widely held in Northlake client accounts including my personal accounts.

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.

Time Warner: Relatively Good Earnings But Murky Outlook

Given the circumstances, Time Warner (TWX) reported decent 4Q08 results and provided better than expected guidance. However, to be perfectly honest, there are so many charges and related future cost savings that it is very difficult to tell whether guidance for "about flat" results in 2009 fairly reflects underlying operating trends. I fear that guidance may slightly overstate fundamentals. That said, relative to peers TWX is performing quite well. Even if 2009 operating trends are actually slightly down, which is I think is the reality, the other big cap media conglomerates are looking at operating income declines of at least 10-20%.

TWX benefits from the fact that it has no exposure to local advertising and broadcast television. It has troubled business in AOL and magazine publishing but these are smaller business relative to the cable networks and film studio. Both the larger divisions look like they will enjoy small up years in 2009.

The best piece of news out of the quarter is that the dividend will remain unchanged when the Time Warne Cable split occurs. When TWX goes ex-dividend for the split, the share price should drop by about $2. This means the dividend is effectively increased by over 20%. The new current yield will be will be about 3.5%. Management indicated that the dividend would rise with free cash flow. With tight controls on capital investments I think a dividend increase for 2010 is likely assuming business conditions do not get considerably from today. Management also indicated that it was lowering its long-term target for balance sheet leverage and would be below the target for the foreseeable future. They also talked down acquisitions. This means that share repurchases are likely to resume once economic conditions stabilize.

4Q results at the operating level were in line with recently lowered estimates....

....AOL was poor as expected with an 18% advertising decline. However, sub losses slowed and cost saving kept margins ahead of expectations. Filmed Entertainment also closely matched estimates with strength at HBO and the incredible success of The Dark Knight overcoming weakening DVD sales. Cable Networks enjoyed 7% advertising growth which is remarkable in this environment (Disney reported -6% for ESPN). Adjusting for a litigation charge related to a 2004 event, margins expanded slightly. Publishing was poor with advertising revenues dropping 20%.

Add it all up and adjusted EPS of 23 cents trailed consensus of 26 cents. However, none of the analysts I follow closely were above 24 cents so I think that consensus may be lagging due to the company's guidance reduction in mid-January. Revenues were a little below expectations at $12.3 billion. I was expecting $12.5 billion. Most of the shortfall was at the movie studio where revenue predictability is notoriously low.

4Q08 was only important to TWX shares to the extent it gave clues on the 2009 outlook. Unfortunately, not that much can be gleaned form 4Q08 because anecdotal and actual evidence suggest that key drivers of media companies including advertising and DVD sales decelerated further in January. TWX did indicate that advertising at its cable networks was holding up and remains positive but with limited visibility. Cancellations are low but scatter market activity is also low with pricing up slightly. Publishing and AOL appear to be getting worse. The film studio has a good lineup this year, especially a new Harry Potter film and several promising new tentpoles. Assuming reasonable success for the releases at the box office the film studio should have an up year.

As mentioned restructuring activity is very high as TWX tries to reposition its operating segment against both secular and cyclical challenges. Management was optimistic that permanent cost savings would show up in 2009 offsetting much of the restructuring. This is a big reason why guidance for "about flat" is plausible even as business conditions continue to decelerate.

Time Warner 4Q08 Earnings Preview

Time Warner effectively preannounced 4Q08 results when it updated its guidance for 2008 last month. The guidance brought 2008 EBITDA to a gain of just 1% but several items were legitimately one-time so the headlines off the guidance update were more negative than management intended. Underlying growth in 2008 is probably closer to 3% which is a pretty good compared to peers and the very troubled markets for advertising and DVD sales.

I think trends at the segment level for 4Q08 are widely understood. Cable Systems will be positive but slowing as subscriber growth is under pressure even in growth areas like broadband, digital TV, and telephone. Filmed Entertainment had a good quarter thanks to The Dark Knight but faces tough comps. Cable Networks have held up well with ad growth still in positive territory. AOL is really struggling as display advertising especially at portals is under pressure. Publishing is also weak with national advertising at magazines finally succumbing to broader advertising pressures.

There will be two areas of major focus on the conference call: an update on the split with Time Warner Cable (TWC) and 2009 guidance....

....The TWC split is expected to close in 1Q09. TWX will give up all ownership of TWC in return for $9.3 billion in cash and offloading of corporate debt. Timely closing of this transaction is important to any bull case for TWX shares.

The split also has major implications for guidance. While TWC is capital intensive it produces a lot of free cash flow and is very recession resilient. I think 2009 expectations for TWC growth are too high but revenue, EBITDA, and free cash flow should all be in positive territory.

Excluding TWC, new TWX becomes a pure play content company. Advertising exposure rises considerably. Investors already expect a bad year for AOL and Publishing so the focus will be on Filmed Entertainment and Cable Networks. Positive year-over-year growth in revenue and EBITDA in these segments would support the idea that TWX is best positioned among the major entertainment to weather the recession. Cable Networks are especially important as this is the only true growth business within TWX's asset base.

As a TWX bull with a long position, I would like to hear that trends at the cable networks have advertising holding in positive territory. If I hear that and the TWC split is on time I think the shares are higher. If not, my thesis on TWX is in trouble.

The Dark Knight Can Sell DVDs

The Dark Knight debuted strongly on DVD selling 3 million units on its first day. This should be good news for Time Warner although that is mostly because it was not a disappointment. The very top DVD titles continue to sell reasonably well. It is the group just beyond the top ten and the catalog that are suffering with non-top 10 new releases seeing as much as a 20% decline and the overall market down in the mid to upper single digits. Not good but individual companies with the very top sellers will probably not disappoint in 4Q.
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Also encouraging for TWX and Holly wood is that 25-30% of The Dark Knight sales may have been in blu-ray. Blu-ray gets a price premium that has huge marginal profitability. Maybe those $128-$199 blu-ray players sold on Black Friday are finally making the difference for the thus far disappointing uptake of the technology.

Or maybe not, at its analyst day on Thursday, Dreamworks Animation indicated that blu-ray was an immaterial number for Kung Fu Panda which will be a top 5 DVD title in 2008 and was just released at retail in early November.

Speaking of DWA, I'll have a longer summary on Monday but the analyst meeting went pretty well. The stock sold off a bit early in the meeting possibly related to a statement about 10 million Panda DVDs worldwide in for 4Q08. I think that is slightly light. As the meeting went on the company did a nice job of explaining its higher and more consistent earnings power and also offered an outlook that could lead to up EPS in 2009 vs. the current consensus for an 8% drop. The stock is out of short-term catalysts but the long-term story looks better than I expected. I am pondering the position I put on in early November which is at a modest loss.

Why You Should Own Time Warner

Time Warner (TWX) is one of the world's leading entertainment companies. The company owns AOL, 84% of Time Warner Cable (TWC) , Warner Brothers, HBO and a leading stable of cable networks including TNT, TBS and CNN. Time Warner also still owns its iconic magazine titles including Time, People and Sports Illustrated.

In early 2009, Time Warner will split off TWC, leaving TWX as a pure-play content company. Presently, TWC produces approximately half of EBITDA. After the split, the new TWX will get more than half its EBITDA from Cable Networks, with AOL and Filmed Entertainment (movie and TV production) generating another 20% each. The balance will be from magazine publishing. New TWX will have about $29 billion in sales and $6.4 billion in EBITDA. Debt will be $9 billion to $10 billion, less than 2 times EBITDA, leaving TWX with the best balance sheet in major media. Free cash flow will likely be $2 billion to $3 billion.

Adjusted for the TWC split, TWX is trading at less than 5 times 2009 EBITDA and about 7 times EPS. I am assuming that EBITDA will fall by 12% in 2009. This is below consensus, which is falling.

Short-Term Catalysts

Valuation-based ideas have not worked as the market crashed, but TWX is really cheap. In this case, cheap will matter because the split from TWC provides a catalyst to recognizing the value. TWC shares have outperformed TWX shares, making TWX shares cheaper post-split. Once the split is finalized, investors will look at New Time Warner and see a mix of assets that have low capital intensity and produce high free cash flow. The company will have a remarkably good balance sheet, making a material dividend or share buyback or an accretive acquisition a positive outcome.

Time Warner is also attractive at the operating level. AOL and Publishing are going to struggle in 2009, with double-digit declines in advertising. The film and TV businesses should be flattish in 2009; cable networks remain the best-performing media assets, and Time Warner's nets have been leading the industry for more than a year. About 70% of Time Warner's operating income should be down no worse than 5% in 2009, a good performance relative to media and many other consumer discretionary sectors.

Long-Term Drivers

Time Warner will have one of the most attractive asset mixes among diversified media companies after the TWC split. Both the growth and free cash flow profile will be attractive. Eventually, AOL will be resolved, either by turning it around or (more likely) by selling it. Any outcome for AOL wherein Time Warner reduces its exposure is bullish.

Time Warner will also benefit long term from the relatively poor management over the past decade. Time Warner's margins are below peers such as Disney (DIS) and News Corp. (NWS.A) , as is the consistency of its financial results at its film studios and cable networks. It seems backward, but the historically poor performance gives Time Warner more room to pull its financial results up to its peers, thus driving superior growth.

After the split, look for a big share buyback, material dividend, accretive acquisition or possibly a combination of all three. Depressed valuations across media dramatically reduce the risk that Time Warner uses its stellar balance sheet to make a dilutive acquisition.

What Could Go Wrong

The overwhelming risk for TWX shares is that advertising deteriorates further, driving 2009 financial results significantly below even the lowest estimates. Given negative sentiment toward AOL and Publishing, any accelerated decline in cable network advertising would be especially painful for TWX shares.

There is also a risk that the TWC spilt falls apart due to the current turmoil in the credit markets and the need for regulatory approval, which continues to drag out. Spending all of its cash on acquisitions as opposed to share buybacks or dividends would also be a disappointment.

My Position

I am long TWX for my clients and in my personal accounts. I started buying my position in early August at $14.87. My most recent trades came this week when I averaged down for some clients between $8 and $8.60.

The Bottom Line

The pending split of TWC and creation of new Time Warner is a positive catalyst. Time Warner will be left with two business generating 70% of profits that should hold together fairly well in 2009. The balance sheet will be very strong, providing plenty of options for enhancing shareholder value. Margins are below par and management is just beginning to implement strategies that have worked well for peers. For the short term or over the long haul, TWX looks like a winner.

Good Quarter Supports Time Warner Shares

Time Warner reported solid 3Q08 results given the economic environment. The stock is reacting positively against a weak market to start the day. The good news is that (1) Turner Networks continue to provide upper single digit growth, (2) Time Warner Cable is showing expected resiliency given the utility like nature of its business, and (3) the Time Warner Cable split appears to be set for early 2009 despite credit market conditions.

Once the split is complete, TWX will be a content focused company with the largest portion of revenue and operating income coming form Turner Networks and Filmed Entertainment. Both of these businesses are performing well at the moment which should give investors confidence that the new TWX will be positioned to hang tough in 2009 against a weak economy and poor advertising trends.

The lagging business units at the new TWX are AOL and Publishing. AOL had another steep revenue decline and continues to experience weak advertising trends. However, cost controls were excellent in 3Q indicating that the business is being managed effectively thus reducing the risk that it implodes and drags down the much larger Turner Networks and Warner Brothers studio.

Publishing is really struggling and faces serious secular and cyclical headwinds. Fortunately, Publishing is a smaller division and even if it underperforms in 2009 it should not materially impact overall results....

....Time Warner Cable had another solid quarter of upper single digit growth. Growth will slow in 2009 but should remain in the mid-single digits. IT sounds like the split from TWX is on which is a positive for TWX as a $9 billion cash dividend will come TWX's way dramatically improving the balance sheet. Even if the split falls apart, the steadiness of TWC is helpful given the uncertain economic outlook in 2009.

TWX shares can continue to claw back recent losses. I'll be surprised if the stock can get back to $14-15 but I still think it can outperform the market and move higher as long as the market is stable. My confidence in the 2009 outlook is improved which would lead me to average down if the shares pull back in a market correction.

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.

Time Warner Finally Discarding AOL?

Time Warner shares have enjoyed an above average 9% rebound over the past two days since reports surfaced that the company appears to be more aggressively seeking a new ownership arrangement for AOL. While the NY Times threw water on the idea that a sale to Microsoft was likely, the mere fact that TWX management appears to be getting more aggressive about AOL is a positive for the stock. I believe that lack of confidence in management's strategic thinking and willingness to act are major factors in the bad performance for TWX shares even by media stock standards....

....I am working on larger column about a post-AOL and post Time Warner Cable TWX. However, basically what you would have is Viacom with a much larger publishing division. Looking at a chart of Viacom over the past few months might make investors ask why Time Warner wants to go this route. However, Time Warner's film and TV studios are clearly better than Viacom's. The cable networks are comparable although their strategies target different demographic segments. TWX's large magazine publishing operation is a drag on overall growth, with added near-term risk if the national ad market continues to catch up to local market weakness.

The bottom line is that Time Warner is cheap even if AOL is sold for almost nothing. The benefits of a more focused company with a superb balance sheet more than outweigh getting the perfect deal done for AOL. I guess I am saying that the mere fact that AOL discussions are now public means that investors should treat any deal as a good one. The worst case scenario is that AOL stays under the TWX umbrella.

Time Warner: So Bad It Might Be Getting Good

Time Warner (TWX) reported another mediocre quarter even after adjusting for some items that cause the reported numbers to understate the results. Revenue grew just 2% and adjusted EBITDA grew just 3%. The revenue figure matched estimates while the adjusted EBITDA is a bit ahead. EBITDA strength came from cost controls at AOL that kept the EBITDA decline to just 25%. The company also announced that it will fully separate Time Warner Cable (TWC) although no details were provided. Investors were expecting a final decision on TWC and I believe the weak action in the shares has more to do with this than the financial results.

I thought management was defensive and analysts skeptical, frustrated, and even hostile on the call. For the stock, I think the current position of the analysts and investor community is bullish. We are in give up phase and the stock sits at a multiyear low. Some good news lies ahead in terms of restructuring and a pickup in growth. Segment results in this quarter reveal some underlying strength for the two largest contributors to EBITDA, Cable and Cable Networks. The pending split of Cable leaves open the question of whether value will be conferred to TWX shareholders and in what manner so right now investors won’t pay for the better results at Cable. Similarly at Cable Networks, heavy [program investments are restricting margins so the strength in ratings and advertising is no flowing through and thus going unrewarded.

With Cable having its own currency already and now showing some improvement in subscriber metrics, I think that AOL remains the biggest obstacle to a higher stock price. Any transaction involving AOL that creates clear value in the $12 to $15 billion range would significantly help TWX's stock price if it meant AOL was separated from TWX. The Yahoo situation cries out for TWX management to get involved....

....1Q08 EBITDA growth of 3% adjusted is below the gull year guidance of 7-9%. Management reiterated guidance which means that growth has to pick up sharply over the balance of the year. On the call, management pointed out that excluding AOL, EBITDA grew 8% in the quarter. This occurrence would be the best catalyst for TWX shares and there is reason t believe thanks to this quarters' segment results.

TWC had a good quarter with revenues up 85and EBITDA up 7%. Subscriber growth metrics beat estimates across the board including growth in basic subscribers. These results suggest that cable industry expectations have been effectively reset to levels that won’t disappoint and may even surprise to the upside.

Cable Networks had excellent advertising growth of 13%, the second consecutive quarter of double digit growth. Programming expense growth will slow later this year so flow through to EBITDA should commence.

These two segments represented 75% of adjusted EBITDA this quarter. If AOL can turn traffic growth into positive advertising growth, the shares will rally. I am not confident in AOL as I still think it is a horribly weak brand but the core AOL business is a shrinking part of the mix so some hope remains. Easier comps in 2009 will also help.

I am getting intrigued by TWX as a contrarian call. The stock action is terrible. The press is horrible. Analysts and investors are frustrated. But the underlying assets offer better growth than they have recently shown and signs of improvement exist. As Doug Kass likes to say, it makes me go hmmmm.

AOL Still Dragging Down Time Warner

Time Warner (TWX) shares are down 10.8% so far this year, lagging most other large cap media stocks. News Corp (NWS) is down 6.1%, Disney (DIS) is down just 3.7%, and Viacom (VIA) is down 5.2%.

The largest single component of TWX's valuation is Time Warner Cable (TWC), whose shares are down less than 1%. This suggests that investors are placing less value today on TWX's content assets than they were to start to t the year. In fact, you could say that the content assets have been devalued by much more than 10% since TWC makes up at least one-third of the total value of TWX. This makes the comparison to NWS and DIS even more appalling for TWX shareholders.

TWX's key content assets are Cable Networks, Filmed Entertainment, and AOL. Led by good ratings and strong scatter advertising the TV nets are performing well this year. Filmed Entertainment is also having a good year on flattish box office a gain of around 20% in DVD units.

The business mixes of NWS and VIA are fairly similar to TWX's content businesses. VIA lacks a big internet business while NWS has MySpace and TWX has AOL. Speaking of AOL, if you follow the preceding analysis of TWX's other segments it seems that the incremental valuation destruction at TWX this year must be coming from investor's views of AOL. It is well known that AOL has suffered a sharp slowdown in advertising growth. This may be investors to question the long-term strategy of redeveloping AOL as an ad-based business. I've long been skeptical of this transition because I believe AOL has a very weak brand. AOL represents Web 1.0 not Web 2.0....

....Further exacerbating concerns over AOL is the stunning silence from TWX management while the Microsoft-Yahoo dance continues. Chris Atayan has forcefully argued that TWX is missing a chance to rid itself of its AOL problem. The problem has only grown larger this year as outlined above.

Carl Icahn is still messing around trying to rescue his massive loss in Motorola. Maybe he should end his truce with TWX.

News But Nothing Exciting at Time Warner

I find little to get excited about regarding Time Warner's quarterly results, guidance, or commentary. The results were quite close to expectations pretty much across the board. The guidance contained no surprises. Commentary about business conditions and strategic actions offered little new insight. The shares are trading up 5% in a strong tape for media stocks. Disney and News Corp reminded investors that media companies can perform against economic headwinds. This is allowing depressed valuations to lift slightly and in the case of TWX and NWS estimates are rising slightly. I can construct an upside scenario for TWX shares based on either operating results or sum of the parts but the upside is not huge and the risks are higher than at DIS or NWS because TWX's businesses do not have the same operating momentum. If I were long TWX, I could justify holding on. If I weren't long and wanted media exposure, I'd look elsewhere.

In 4Q07, TWX reported EPS of 28 cents on revenues of $12.64 billion. Both figures almost exactly matched estimates. EBITDA rose 16% aided by acquisitions. For the year, EPS were 96 cents, up 20%. Guidance for 2008 includes EBITDA growth of 7-9%, free cash flow of at least $3.6 billion, and EPS of $1.07 to $1.11. I think the guidance is slightly below current estimates but nothing that will cause a problem or be a surprise. On the call, management indicated that AOL and Cable Networks would not fare well in 1Q08 so the year looks a bit back end loaded.

With the reported numbers and guidance providing little excitement, the focus was even more on new CEO Jeff Bewkes commentary on strategic actions. He announced significant actions with a tight timeline for resolution by the end of April but the news was nothing that had not been widely speculated by investors.

In terms of a broad approach to the business, Bewkes discussed the need to invigorate the content engine with an eye on news distribution channels such as VOD, digital downloads, and streaming. He also said that TWX could do this with another round of cost savings. Given the recent content run at Disney and News Corp, these comments were not surprising. They do point out that TWX has lost its focus as a content company. Getting back to basics is helpful.

As far as corporate restructuring goes, there were two key announcements. First, the access business of AOL is being separated from the advertising driven businesses. This is designed to increase the strategic options of the total AOL business but it was not clear what they had in mind. Second, formal discussions have begun with the independent directors of Time Warner Cable with the most probably outcome being a complete split. The impetus behind the discussions is the differing capital needs of the cable system and content businesses. Third, another round of cost cutting will be completed with corporate costs coming first and major changes coming for the New Line studio.

These actions seem unlikely to be warmly greeted by investors. AOL has issues and it is not clear that any premium to the current implied is warranted. 4Q ad growth again severely lagged broader internet trends and 1Q08 ad growth may be negative. Is this just a cyclical adjustment or is AOL a weak brand? Separating cable makes sense long-term as the financing strategies are incompatible. However, cable is TWX's faster growing business and the valuation is very depressed. The only way this creates near-term value is if TWC shares enjoy multiple expansion.

To reiterate, an upside scenario to $18-20 can be easily constructed based on EBITDA, free cash flow, or sum of the parts. But getting from here to there is tricky given the lack of positive momentum in most of TWX's businesses.

That's all I got. Plenty of numbers to analyze at the segment level but I don’t think they currently matter and I can’t provide value added.

AOL and Cable Dragging Down Time Warner

Time Warner reported a solid quarter, ahead of analyst estimates. However, 2007 guidance was maintained suggesting that the 4Q will be weaker than expected. At the same time, segment results showed bad news at AOL and Cable which are the two key drivers of TWX shares. The cable news really wasn't bad relative to collapsing expectations off of Comcast's earlier results and cautious management commentary over the past few months. It did get put in a worse light though when DirecTV's results, particularly on subscriber metrics, beat estimates.

The larger issue was at AOL. Advertising growth decelerated again and came in at a worse than expected 13%. AOL lost a lot of market share to Google and Yahoo last quarter. Earlier this year, AOL's advertising growth was outpacing the industry and optimism about the new portal based strategy was running high. I have always been skeptical because I feel that AOL is a weak brand with weak demographics. Further, AOL is particularly challenged by MySpace and Facebook given its historic reliance on families. This view appears to be accurate now that the boost from initiating a new strategy is wearing off....

....In fact, according to Jessica Reif of Merrill Lynch, Time Warner's latest 10-Q suggests that the outlook for AOL advertising is even worse than 2Q and 3Q results imply. Loss of a large customer and display growth is the mid-single digits means that advertising growth is going to decelerate further. The 10-Q states this fact and notes that growth will remain under pressure in 1Q08 as well.

Without a turn a upward in AOL's advertising growth and renewed investor enthusiasm for cable, TWX shares are going to have a hard time gaining any upside traction. This is the case even in a break-up of the company as public market values of comparables to TWX's segments don’t justify a sum of the parts valuation much above $20.

Forget The Time Warner Breakup Stories

I want to echo the comments about Time Warner made yesterday by Chris Atayan, my RealMoney.com colleague. Despite renewed speculation, a breakup of the company is unlikely to add value in the near-term. Time Warner is overanalyzed and sum of the parts has been modeled exhaustively. If the sum of the parts were significantly higher than the low $20s, the stock would be higher. Put Comcast's multiple on the Cable segment, Viacom's multiple on Filmed Entertainment and Cable Networks, Yahoo's multiple on AOL, and give the publishing a modest premium to the current newspaper multiples. What you get is low $20s. Sure, if private market values or public auction were used the sum of the parts could be 20-30% higher but no one is suggesting that Time Warner's segments are going private with the exception maybe of AOL and publishing.

The problem with Time Warner shares is that the two biggest drivers of value, Cable and AOL, are both out of favor. I think that cable will re-emerge as a profitable investment theme when 3Q and 4Q results are announced. If you want to play that, Comcast is a pure play. I think AOL has issues because it is a weak brand with poor demographics. That doesn’t mean that the weak 2Q and lowered guidance won’t be reversed in coming quarters. It does mean that AOL will at best mathc the growth rate of online advertising. It is not worth a premium valuation to Yahoo. Film, Publishing, and Cable Networks are mature. At times they will accelerate (as film is doing now due to a successful year against easy comps for Warner Brothers), but these businesses won’t move the stock valuation needle meaningfully.

Chris is right. Time Warner should keep buying back stock, dramatically raise its annual dividend, and focus on managing and investing in the different businesses. That might not be enough for impatient investors but over a 12 month or longer time horizon it is the best recipe to get the stock price up independent of a big rally in Comcast, Yahoo, and Google.

Time Warner 1Q07: Stock Looking As Good As It Has In Some Time

Time Warner (TWC) reported slightly better than expected 1Q07 results highlighted by strong operating profits at AOL and Cable and better than expected performance against a tough comparison in Filmed Entertainment. The shares are reacting appropriately, up 2-3% so far. I think more upside remains with $23-24 being a legitimate target over the next few months.

Revenues of $11.2 billion matched consensus estimates while EBITDA of $3.1 billion was above consensus and equaled the highest estimates on the street. EPS of 22 cents were ahead o the 20 cent consensus. Guidance for revenue and EBTIDA was maintained but EPS guidance was bumped up by 5 cents attributable to lower interest expense, faster share buybacks and the better than expected operating profits.

The conference call Q&A was mostly focused on AOL. Many analysts, myself included, remain skeptical that the year-over-year gains in EBITDA and big increases in advertising revenue are sustainable. The outcome of this debate will be the greatest driver to TWX shares over the next year. In 1Q, AOL revenues fell by $500 million but EBITDA increased by $100 million or about 25%. Lower marketing and networks costs related to the dial-up business and 35% growth in the high margin advertising revenue is driving the EBITDA gains....

Management is pleased that pageviews are stabilizing and expects growth to occur within the next several quarters. Increased monetization of ad inventory is driving the growth along with a big new customer who began buying advertising a year ago. Management admits that advertising growth will begin to slow but still expects to at least match industry growth rates. I worry that without a sharp acceleration in pageviews, monetization efforts will no longer be enough to drive advertising especially as inventory sellout ratios reach normal levels. SO far, my view is not the popular one. As comparisons toughen starting next quarter, we'll soon find out if my opinion has any validity.

Filmed Entertainment was the other source of upside EBITDA surprise in the quarter as revenues held in better than expected due to TV sales and the box office hit 300. Margin performance provided substantial upside to EBITDA vs. consensus. IT is worth noting, however, that forecasts of revenues and EBITDA in the film business are often way off. TWX has a strong lineup of films later this summer that should drive very good financial results in the fourth quarter via DVD sales.

Cable Networks showed decent revenue growth of 6% adjusted for divestitures. Margins were solid allowing flow through to EBITDA. I still think analysts value this division too highly given that it has moderated to mid to upper single digit growth but the as long as growth stays in this range, this segment should not be a factor in the share price.

Publishing was poor although management attributed the problem to non-magazine businesses held within the segment. Publishing produces less than 3% of EBITDA.

For comments on Cable, please see my earnings summary for Time Warner Cable (TWC).

Time Warner 4Q06 Good Enough

Time Warner (TWX) reported 4Q06 results that were very close to analyst estimates across the board. There don't appear to be any surprises in the overall results or at the segment level. On first glance, it appears that AOL and Cable performed at least well as expected, possibly with a little upside.

TWX also provided guidance for 2007. If I am interpreting the language correctly it looks like operating EPS are expected at 90 cents. This figure is below analyst estimates that average $1.01. TWX provided EBITDA guidance of mid to high teens growth off a 2007 base of $11.1 billion. This equates to $12.8-$13.1 billion which is also a little below what I found in a review of three or four analyst models. Please note that the mid to high teens growth is not pro forma for the acquisition of Adelphia. Pro forma EBITDA growth will be closer to 10%. TWX trades off EBITDA not EPS so the EPS guidance shortfall is not meaningful. On EBITDA, I suspect that the guidance could be conservative but TWX management does not have a history of announcing guidance that everyone knows they will beat. That could be changing as the company is coming out its long period of restructuring. Then again, maybe not. Management did indicate that 1Q07 had a tough comparison which is the sort of comment that can be read as indicating they are being conservative with guidance.

As outlined in my preview, a sell the news reaction is possible given the great performance of TWX shares over the past six months. If my initial reaction that 2007 guidance is slightly less than analyst estimates proves correct, a moderate decline in the shares could be in the cards for today. However, there is nothing here that should change anyone's mind so if the shares did sell off I would expect any decline to be modest and would not read anything into it.

Here is a close look at the segments which is where the action is for TWX....

AOL: Advertising growth remained healthy at +49%. AOL is easily outperforming Yahoo. I still wonder whether this growth is sustainable as page views at AOL are still declining. I also worry that the quality of current page views is poor as new free AOL subscribers may or may or not stick with the service. Subscriber losses were 2 million which is less than expected but management indicated they still expect the same number o paying subscribers to quit.

Cable: Results at TWX's most important division were good. The only blemish was loss of 52,000 basic subscribers at acquired Adelphia systems, primarily in Dallas and LA. TWX should be able to fix this relatively quickly with better customer service and more aggressive triple play marketing. Revenue and EBITDA growth continues to be firmly in the low to mid teens range. Subscriber additions for high speed data, digital TV, and VOIP Telephony were as expected.

Filmed Entertainment: Results were slightly worse than very poor expectations but this is a notoriously volatile and difficult to model segment. Investors are looking ahead to 2007 where easy comparisons, a good movie slate, and improved DVD sales off of successful 4Q06 should lead to a big rebound.

Cable Networks: Rpeorted results had revenue up 10% and EBITDA up 12%. Jessica Reif of Merrill Lynch asked a good question about pro forma results given that Court TV and SPorano's syndication were included in the quarter. HSe wonder what core growth was. I remain concerned that this division is moderating to mid single digit long-term growth. If so, it has negative implications for valuation as this the second largest EBITDA producer at TWX.

Publishing: Boring. Revenues -1%, EBITDA -3%. This divison represented just 14% of EBITDA in the quarter. It will be drag on corporate growth but its small and shrinking contribution should not have any investment impact.

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.

Time Warner Working Higher

Time Warner (TWX) closed at a 52 week high yesterday. In fact, it was the highest close since January 2005. I suspect that investors are looking ahead to 2007 and ignoring the poor performance of the total company in 2006. In 2007, the company’s fastest growing and largest division, cable distribution, will become an even larger part of the company now that the Adelphia acquisition is closed. Cable stocks have performed very well this year and M&A activity has supported even higher than current public market valuations.

TWX’s other divisions have much worse outlooks, although investors seem willing to look past their issues for now. AOL’s situation is well known. For now, investors appear willing to accept that cost cutting will limit the near-term damage to operating profits and that advertising growth will keep up with industry averages....

Cable network growth has really moderated of late. This is the company’s second largest division. Investors appear sanguine based on documented strength in scatter advertising over the past few months.

Filmed Entertainment has had a terrible year with especially weak performance from the movie studios. A strong slate of movies from this November’s Happy Feet through next year’s Harry Potter and Ocean’s Eleven sequels seems to have softened investor fears.

Publishing is a very slow growth business facing intense secular challenges. Again, investors concerns have been put aside by something to look forward to. In this case, a slimming down of the magazine portfolio is doing the trick.

Finally, I think investors are getting more comfortable with the overall scope of TWX’s restructuring actions. A recent report by Bernstein provided a unique and insightful look at this aspect of the TWX story. The basic theme of the report was that restructuring actions including the acquisition of Adelphia and Court TV, the sale of AOL Europe, and the magazine titles, and the closing of the WB Network effectively net out to TWX adding hundreds of millions of EBITDA at a multiple of less than 6 times. This analysis has the flaw of focusing on EBITDA and not considering the EPS dilutive of these transactions. However, in the long run, adding EBITDA translates into future earnings power from wholly controlled operating businesses. Investors are smart enough to value the long run over the short term in this case.

I’ve been back and forth on TWX. Most recently, I felt there was a good set up for a long side trade. Unlike many others I think the upside is limited to the low $20s. If the market remains decent, I think we might get the rest of the move sooner rather than later. Sentiment has finally turned on TWX and once a supertanker gets going in one direction it takes awhile for the momentum of the movement to stop.

Time Warner Gets Good Price For AOL Germany

Investors have responded favorably to the nice price that Time Warner (TWX) received for its AOL access business in Germany. Citigroup is projecting total proceeds of $2 billion once all of the European access business is sold in the next few months. I consider that a good price, better than I expected, and enough to continue recent momentum in TWX shares.

One negative to watch for is falling estimates and potential write-offs following a horrible summer for Warner Brothers feature films. This will cut into 2006 and estimates. For now, though the trend for TWX seems upward as several analysts upgraded the shares and are looking out to 2007 and 2008.

Time Warner Selling Some Magazines

Time Warner (TWX) announced the details of its plan to slim down its magazine division. The company will sell 18 smaller titles in a deal expected to raise $300 million, according to an article in today's Wall Street Journal. The big titles, including Time, Sports Illustrated and People, are staying put.

The article quotes Anne Moore, CEO of Time Inc., the magazine division, stating, "Time wanted to concentrate on its biggest brands because those titles are likely to be more successful online."

I think Ms. Moore's viewpoint is a reflection of consensus thinking regarding traditional media and the Internet. But I challenge you once again to offer a single leading Internet brand that has translated directly from traditional media. Google (GOOG), eBay (EBAY), Yahoo! (YHOO), YouTube, MySpace, Amazon (AMZN), ESPN and some news sites come to mind as having effectively translated to the Net, but I'd say that Time Warner probably has a better chance of creating shareholder value on the Internet by turning its small, niche magazine titles into big, new Internet properties than just continuing to maintain online versions of their big magazines.

Icahn Ups His Stake In Time Warner

The Wall Street Journal is a few days late in reporting that Carl Icahn has upped his stake in Time Warner. When this news first broke on Monday, I wrote the following brief comment for StreetInsight.com:

The facts that Time Warner (TWX) is giving back most of its post-earnings pop and the lack of positive reaction to the news that Carl Icahn increased his stake might indicate that bullish sentiment is getting completely washed out. I know the crappy action over the past year in the stock would tell us that there has been no bullish sentiment, but there are still plenty of models that assume the shares should be trading at least in the low $20s.

It appears investors may finally be accepting that the shares are correctly valued based on trading multiples for key peers like Comcast (CMCSA/CMCSK) and Viacom (VIA/VIA-B). Consequently, the shares might finally be poised to move up toward a more realistic target of $18-$20.

Today, I commented further with a slgihtly more bullish tone towards TWX:

The Wall Street Journal is finally getting around to mentioning Carl Icahn's increased stake in Time Warner (TWX). Assuming the reporting in the article is accurate, the key quote is:

"Mr. Icahn may wait until the end of the year to see if these measures (AOL's new strategy and cable spin-off) improve the stock price before deciding whether to pursue another takeover attempt, according to a person familiar with the matter."

I still think upside is far less than bullish investors believe but the potential for renewed interest by Icahn and the continued poor action in the shares probably have set up a low-risk entry point.

I haven't pulled the trigger yet and may not but I am thinking aobut it for the first time in a very long time.

Time Warner Still Offers Little Upside

Time Warner (TWX) shares have responded well to 2Q earnings, regaining much of the losses since early July. However, the shares still remain well below the $17.50 level of early June. I think further upside is limited unless the market continues to revalue the cable industry upward. Cable is by far the company’s largest business and is the only business with strong operating momentum. In fact, outside of cable TWX is not growing as Publishing and AOL are flat, Filmed Entertainment is struggling at the box office and in home video, and Cable Networks growth continues to moderate to the mid single digits.

Looking at valuations of pure play companies in each of TWX’s businesses suggests minimal upside for the stock. I think this is the correct way to value TWX despite many analyst reports which assume higher multiples based on historical valuations that are no longer applicable given the challenges to traditional media that are causing a secular slowdown in growth.

Here are some brief comments on TWX's operating divisions....

Cable had another great quarter. Between Comcast’s revived growth and TWX’s great results it should be clear that for the time cable is in the sweet spot of its growth profile. With the closing of the Adelphia division and eventual spin-off of Time Warner Cable, improved valuation for cable assets is the best chance for TWX shareholders to see a move above the mid $17 level that has capped the stock for most of 2006.

Filmed Entertainment has some near-term issues. Tough comparisons at the box office, fewer syndication sales, sharply slowing home video sales, and a horrible summer box office for Warner Brothers will likely pressure results over the next 12 months. I still think we could see writedowns on some of the summer film slate, especially Poseidon.

Publishing had a weak first half but guidance implies growth will resume in the second half. Given revenue trends it seems like this must be driven by cost cutting. That is acceptable but investors won’t pay a premium multiple for this business unless top line growth returns.

Networks looked like it had a big quarter with growth of 9% but adjusting for some acquisition activity growth was morel likely around 5%. This is TWX’s second largest business and the growth slowdown evident over the past year is a big issue for valuation. Cable networks have held a premium valuation but with slowing growth the lift to TWX overall is no longer significant.

Finally, the AOL announcement largely paralleled press reporting form a few weeks ago. I still think that AOL is a weak brand and the strategy will ultimately fail. However, cost cutting and improved advertising monetization should limit negative impact through 2007. The old AOL was doomed to declining subs, declining page views, and severe market share loss in advertising. The new AOL will lose more subs but has a chance to stabilize or grow page views. In turn, the advertising reliant has a chance. Yahoo no longer has a huge valuation and I think we can all agree that AOL doesn’t hold a candle to Yahoo. Consequently, I still believe that implied valuations on the AOL business leave little upside for TWX shareholders.

The bottom line is that 2Q06 results changed little. TWX is still growth challenged leaving little potential for multiple expansion. Since operating results are only growing modestly this leaves little upside for TWX shareholders.

One More Stab At AOL - Time Warner Heading Lower

Time Warner (TWX) shares fell for the 7th straight day yesterday, no doubt continuing the negative reaction since word spread that AOL might switch strategies again. The stock has dropped 5.1% in total, erasing about $3 billion in market value.

As I noted in a post last week, the shift away from a subscription model could have an immediate EBITDA hit of $200 million. Since investors were probably not valuing AOL at 15 times EBITDA, I think the reaction is reality settling in that AOL is worth a lot less than previously assumed and might not be salvageable.

Reading analyst research about the AOL situation, I was intrigued by a comment from Jessica Reif about AOL's declining page views. Remember that the idea behind giving free access to all the features at AOL.com to any user with a broadband connection is to keep subscribers that are deserting the dial-up business on the AOL site and maybe even attract some new users. The goal, of course, is to turn AOL.com into Yahoo and build an advertiser driven business that more than makes up the EBITDA loss from the dying dial-up subscription model.

Personally, I think it is a hopeless case because AOL is a weak and stale brand. To justify my harsh view, I asked Jessica for data on AOL's page views and unique visitors. I know that internet stock investors are probably very aware of this data but what I found was pathetic.....

First, based on May data, the Time Warner Network of sites (includes AOL, CNN, and others) had the worst growth rate of any of the top 12 sites. In fact, vs. year ago figures it grew just 1%, worse than total internet unique user growth of 4%. Even a "mature" site like Yahoo had 9% growth, while MSN, which is often compared to AOL for its futility in advertising growth, had 8% unique user growth. Second, turning to page views, the data is really startling. AOL, excluding instant messenger, is down 27% year-over year, and down 35% from April 2005 when AOL page views last had any meaningful sequential monthly growth.

This data clearly shows that the prior strategy to build AOL.com into a leading portal was failing. While I think that strategy was hopeless due to the weakness of the AOL brand in the online world, at a minimum, the steady loss of dial-up subscribers was too much to overcome. The data also shows that AOL doesn’t have a huge amount to lose with the new strategy. The prior approach to grow AOL.com against the dial-up tide rolling out was hopeless. And looking at the rate of loss for page views and loss of market share with internet users, it is pretty clear that the path to complete irrelevancy and massive EBITDA declines was etched in stone.

What's the worst case scenario for TWX? If I assume AOL is worth $0, adjust the capitalization for the huge share buybacks driven both internally and by Carl Icahn, and use comparable EBITDA multiples to TWX's divisions such as Comcast and Viacom, I get to a price of $14.41 based on 2007 estimates.

Of course, the reality is that AOL is not worth $0. Each $1 billion in EBITDA the division can produce is worth about 30 cents per TWX share at a multiple of just 1 times. I had been assuming that AOL would do around $1.6 billion in EBITDA next year. So even if that number is $500 million too high, there is some value to the asset. Anyone for a $1.50 per TWX share at 5 times EBITDA?

Consequently, I think the downside for TWX is a meaningful break to a new 52 week low, which would be below $16. I believe that is a realistic worst case scenario assuming current estimates hold at the other divisions. Of course, I don’t see much upside from that price unless a successful strategy to slow the demise of AOL is found and/or comparable multiples across cable, cable networks, publishing, and filmed entertainment expand.

Wall Street Journal Confirms AOL Rumors

Yesterday's Wall Street Journal carried an article confirming the rumors I have been writing about concerning major changes at AOL. The most important takeaway is that AOL wouldn't be considering such drastic action unless the deterioration in fundamentals was accelerating. That means dial-up subscribers are still leaving at a fast clip, broadband subscribers under the company's latest offer are falling short of expectations, and traffic and advertising at AOL.com is failing to hold market share. Regardless of how management spins the numbers when the strategy shift is formally announced, AOL is in big trouble and worth a huge discount to the $20 billion implied value from Google's acquisition of a 5% stake.....

Let's start with the basic numbers. AOL has a run rate of about $8 billion in revenue and $1.75 billion in EBITDA for a margin of about 22%. At the end of the first quarter, AOL had 18.6 subscribers paying a monthly ARPU of $18.43. According to the Journal, the company anticipates losing 8 million subs and $2 billion in subscription revenue by shifting to a free service for users with a broadband connection. Those numbers imply the subs that will walk away pay about $21 per month. The article makes little mention of lost profits but at the total AOL margin of 22%, lost EBITDA on $2 billion in revenue is $440 million. My guess is that the loss will be higher than that because dial-up subs probably have above average profitability.

Another way to look at it is that operating expenses at AOL are $6.3 billion (revenue minus EBITDA). Therefore, to breakeven on EBITDA, AOL would likely have to cut at least 10% of its cost base. The Journal says the new "free" strategy will come with huge cuts in marketing and customer service. Spencer Wang of Bear Stearns had a note out yesterday stating that headcount could be but by 80% in call centers and 50% in non-call centers. Marketing spend will likely go to $0 other than what is spent to acquire traffic via the internet. Given this math, it seems to me that the cost savings could be there.

However, that really doesn’t solve the problem. In 2005, AOL had subscription revenue of over $6.7 billion, representing over 80%of total division revenue. Essentially, this new strategy acknowledges that over time, except for a few million stragglers, all of the subscription revenue is going away. That means advertising is the sole revenue stream available to replace and grow the $1.75 billion EBITDA base. That is a huge hurdle when you consider that in 2005, advertising at AOL was $1.4 billion. Assuming advertising grew at 25% annually for three years, it would be approaching $3 billion. Yahoo (YHOO) had an EBITDA margin of 42% in 2005 (Google was much higher). It is doubtful that the AOL as the #3 or #4 portal player could approach industry leading margins but even if they matched YHOO, advertising EBITDA would only reach about $1.2 billion. At that point, subscription EBITDA would be just a fraction of what it is today so the best case scenario might allow AOL to just maintain its EBITDA over the next several years.

Given the alternative, which is a slow draining of EBITDA until it drops by 50% or more in the next five to ten more years, I suppose AOL has no choice but try something different. But different doesn’t necessarily mean success. Execution risk will be very high and there is a good chance that near-term EBITDA takes a big step down before it is rebuilt on advertising. And there is no guarantee advertising will carry the day. AOL is a weak and stale brand. It just might not be salvageable.

For TWX, I think the implications are dire. Essentially, management is admitting that as currently structured, AOL has much less value than many analysts and investors had assumed. My model uses a 10 multiple for AOL and I still value TWX at little more than $20. The reality is the failure of the current AOL strategy means that a mid-single digit multiple is more appropriate. Each multiple point is worth about 50 cents per TWX share. Put a 6 multiple on AOL and you shave $2, or 12%, off the value of TWX. Ouch.

I see no reason to get involved in TWX. AOL is a depreciating asset. Advertiser supported businesses at publishing and cable networks are growing very slowly and face secular challenges. That leaves cable. I like cable but I am not sure that upside to cash flow and valuation at cable is enough to drive TWX shares significantly higher. Better opportunities exist elsewhere in the market and in media stocks. Maybe when he folded his fight, Carl Icahn realized that the value at TWX is not really what it seem

Major Layoffs Coming at AOL? If So, It Is Bad News For Time Warner

I read a post on Henry Blodgett's blog about two weeks ago alluding to the major layoffs at America Online (AOL). I do not know the writer, but I have found the discussion at Henry's blog to be quite good. SInce then, more outlets are reporting rumors of large layoffs and weak advertising growth. There is no confirmation yet from management of AOL's owner, TIme Warner (TWX), but I think major layoffs at AOL are a big negative for TWX shares.

Major layoffs at this point are a sign of weakness given that some key new strategies for saving AOL have been in place for almost a year. Layoffs indicate that the broadband rollout is either not getting enough subscribers or not producing enough profits or both, and/or that dial-up subscriber losses remain elevated. Any of those outcomes is menas that advertising growth at AOL.com, the key to AOL's turnaround strategy, is falling short of expectations.

I think there is a risk that implied valuations in TWX shares of up to $20 billion for AOL may implode. This has serious downside implications for TWX, since any meaningful downgrade of AOL's value across TWX's 4 billion-share base is significant relative to a $17 stock....

Is it possible that AOL is worthless beyond the liquidation stream associated with the remaining dial-up subscribers? It could be. Keep in mind that AOL.com advertising revenue is largely driven by AOL dial-up and broadband subs. If those disappear, the value destruction implications are real.

Remember that the sum of the parts at AOL, using comparable multiples for its key division on real companies like Comcast (CMCSA) and Viacom (VIA), only creates value of about $20 even after the share base shrinks from the big buyback. Unless you think the market is going to revalue the multiples upward on cable, cable network, film and TV production, and publishing assets, there isn't that much value at TWX.

Another Mixed Quarter For Time Warner

Time Warner (TWX) reported mixed results. The headline numbers looked real good but after adjustments it was just another quarter of mediocre growth with flat revenues and mid-single digit EBITDA growth. Free cash flow continues strong and the share buyback has been very aggressive, both of which provide near-term support for the shares and add to the long-term upside. However, without a pickup in the corporate growth rate for revenue and operating cash flow, I don’t see a lot of upside in TWX shares.

After adjustments TWX reported 20 cents in EPS, matching consensus and a penny ahead of some recently lowered estimates. Revenues were actually light at $10.5 billion vs. consensus of $10.9 billion. EBITDA matched estimates after adjusting downward for several beneficial one-time items. Management reaffirmed guidance for high single digit EBITDA growth and 35-45% free cash flow conversion of EBITDA. I care mostly about segment level trends so here is a brief recap.

AOL had much worse than expected subscriber losses in the US and Europe but advertising growth was better than expected leaving revenues in line with expectations. AOL.com advertising sales strategies seem be gaining some traction but I don’t see how they hold up with the drain of page views as more dial-up subs go bye-bye. Further, AOL.com is at best #3 in online advertising, not a position investors will pay for. Management was mum on subscriber data for the broadband initiative but seeing as dial-up sub losses accelerated and every cable company reported better than expected high speed data subscriber additions, I don’t see how AOL could be gaining an unusually large number of subs....

Cable revenue and subscriber trends looked great. Revenue was up a better than expected 15% and every subscriber estimate was easily exceeded. However, after adjustments, EBITDA rose 12% indicating some margin contraction. I didn’t think a clear explanation was provided. Management referenced higher sub adds equaling greater costs but that explanation won’t be greeted well by investors concerned about competition with AT&T (T) and Verizon (VZ). Comcast (CMCSA/K) could feel a little pressure today on this news.

Filmed Entertainment fell short on revenue but still met EBITDA estimates. This might indicate that cost cutting at the studio is underway as promised.

Networks continues to show decelerated growth form a few years ago with revenue up just 3% and EBITDA up 8%. This is an important business at TWX in terms of size and valuation. I remain concerned that analysts are placing too high a multiple on this business because the industry is maturing. This is especially true for non-niche networks like those owned by TWX.

Publishing is TWX's smallest business but it still fell meaningful short of estimates with enough of a shortfall to impact the corporate figures. Magazines are having a tough year throughout the industry. I have long-term concerns about growth as the internet can easily attack magazine ad budgets.

One other topic of interest on the call was Dick Parsons' comments on Unvision (UVN). He basically dias "no comment" but I took his comments to mean that if management felt the return on a UVN acquisition met their hurdle rates it was oemthing that could get done.

I still have to update my spreadsheet. Depsite the mixed quarter I think my 2006 target may rise slightly due to the accelerate share repurchase. Nevertheless, I'll stay on the sidelines at TWX as I prefer Disney, Comcast, NTL, Regal Entertainment, and Central European Media Enterprises in the media sectors. Each has superior near-term growth relative to TWX.

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.

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.

Time Warner: The Icahn Report

I was talking with a good friend last week who runs a media-centric hedge fund. I was doing my usual rant regarding the mounds of analysis about Time Warner (TWX) coming from analysts, website commentators, and CNBC and noting that it had to be the most overanalyzed stock on the planet. My buddy noted it also hadn't gone anywhere staying in a pretty narrow $2 range for the past twelve months. He then noted that TWX must have the highest "chatter to beta" ratio of any stock he followed.

Of course, today the chatter about TWX has heated up again thanks to the unveiling of the Icahn report. I have not read the report yet, just a few news stories about it, but from what I have read I stand by my analysis that the problem with all the analysis claiming that TWX is massively undervalued is that it just isn’t true. Break it apart or leave it together and you got the same businesses. The company is well enough analyzed to value those businesses efficiently and for the last year, or last three years, the market has valued them between $16 and $19.

The only way that value goes up significantly, is if Wall Street decides to value these businesses higher. That will happen in one of two ways. First, multiples on traditional media businesses rise as the Street gains confidence that growth rates of operating and free cash flow have stabilized. Second, growth rates of operating cash flow accelerate because fundamentals improve in the company's business – ad growth picks up, cable capital spending declines, AOL makes headway as a portal or broadband distributor, home video picks up, etc...

Icahn wants us to believe that breaking apart the company will make the pieces more nimble and thus accelerate the growth rates of each individual business. He also claims there are "hundreds of millions" in overhead savings. He might be right about smaller is better as it relates to growth rates. However, that is no overnight panacea for the stock price. Investors won’t reward the company just for breaking up. They haven’t done that at Viacom (VIAB) or Cendant (CD). Investors will wait for proof that on their own growth rates pick up.

As for the overhead savings, let's say he is right and the company can save $500 million in operating expenses. Let's be generous and put a 10 multiple on the savings, above the 8.5 multiple that all of TWX is trading at on 2006 estimates. The value enhancement is $5 billion, or $1.07 per share, just 6% of the current stock price.

TWX is worth $21-22 valuing the individual businesses at the current trading multiples of their peers using 2006 estimates. Modest upside, but not enough to justify or alter the "chatter to beta" ratio.

Time Warner: The Street Will Like It, But Not Me

Time Warner (TWX) reported 4Q05 earnings pretty much inline with expectations with revenue and EBITDA both coming in very close to analyst estimates. As usual, the mix at the segment level was a little different than expected. The company also provided EBITDA growth guidance for 2006. EBITDA is expected to grow in the upper single digits, inline with current analyst expectations, but the 2005 base is being reset lower so I am not quite sure if the apple-to-apples comparison is OK. I think it is. At the segment level, management provided limited commentary on 2006.

TWX shares are trading up over 2% which you might find a little surprising relative to the comments I am about to make on the segments. I think the rise is being fueled by the announcement that the company will dramatically up the pace of its share repurchase program starting this quarter. One year ago, the Board authorized a $12.5 billion repurchase program, of which $3 billion was purchased by the end of 2006. In my opinion, given the lousy performance of the stock, the discount to my target value of $22, and sustainable free cash flow of over $3 billion annually, the pace of buying has been too slow. CEO Dick Parsons announced on the call that the company would double the pace of buying beginning immediately....

I also think that since the fourth quarter had some pimples and the 2006 outlook for AOL is muddled the shares could be moving higher because the pressure on Parsons to boost the stock price is higher today than it was yesterday.

Looking at segment results in 4Q05 shows that AOL was light on revenue and EBITDA, Cable inline on revenue and light on EBITDA, Film was light on revenue and inline on EBITDA, Networks was inline on revenue and better than expected on EBITDA, and Publishing was inline across the board.

Digging a little deeper, AOL had an 8% revenue decline with EBITDA up 3%. Subscription revenue fell 13% and the pace of subscriber loss did not change on a sequential basis. Networks costs fell significantly again and advertising grew by 21%, which together drove the slight EBITDA boost. While 21% ad revenue growth is pretty decent, it still shows significant market share loss relative to other major internet companies. The shift to promoting broadband subscribers announced last week acknowledges that AOL.com is going nowhere if it continues to rely on the dial-up subscriber base. Unfortunately, this shift is not guaranteed to be successful and will mean that 1H06 numbers at AOL will get even worse on the EBITDA line due to the costs of advertising and promotion for the broadband initiative. The bottom line is that 4Q05 and the 2006 guidance for AOL is worse than expected.

Cable was also a small concern in 4Q05. Revenue growth hit its target at up 13% based on strong subscriber metrics. However, margin contraction held the EBITDA gain to 11%. Additionally, if I understand correctly, programming expenses were understated in the quarter, rising just 6%. This suggests that other expenses were higher than expected. As with AOL, I find this troubling for the shares.

Film had big gains as expected with an 11% revenue gain translating into a 42% EBITDA gain. Both figures matched estimates. The EBITDA gain was driven by an easy comp related to the timing of home video sales and theatrical releases. Management did note that 2006 will face a tough comparison in this division.

Networks was the bright spot in the quarter with a 6% revenue gain turning into a 22% EBITDA gain. Obivously, cost controls were quite good. I either missed it or it was not asked but given a trend of rising programming expenses, I wonder about the big margin expansion. For the full year, Networks produced 11% EBITDA growth, which I think is more reflective of the growth rate to expect in 2006.

TWX gets a lot of attention but maybe we should all remember that in 2006, the company had revenue growth of 4% and EBITDA growth of 8%. In 2004, revenue growth was 6% and EBITDA growth was 11%. Now management is guiding for upper single digit EBITDA growth in 2006 most likely fueled by a mid-single digit gain in revenue. Looking at these growth rates, it is no wonder the stock has experienced such a dramatic multiple contraction over the past few years. TWX is a mature company. Further, each of its businesses face secular challenges to their growth rates.

Thus, while I still believe the shares are undervalued based on the fact that investors are overly discounting the secular challenges, particularly in Cable, I understand why the stock has gone nowhere. I am not that optimistic that the next few months will lead to significant price appreciation but I support a long position in the stock as I think the downside is limited by the share repurchase and depressed valuation, setting up a favorable risk-reward trade-ff, even if the upside is modest.

Time Warner Earnings Preview: Will The Boredom End?

If there were an equation that measured media and analyst coverage vs. stock price volatility, Time Warner (TWX) would probably produce an answer nearing infinity. Dare I say a google.

Tomorrow provdes the stock another chance to offer some excitement when TWX reports 4Q05 earnings. The results are expected to be quite strong, consistent with analyst expectations and management guidance. Year-to-date, revenue and EBITDA growth are an anemic 2.5% and 3.9%, respectively. All year management has stated that EBITDA growth would be in the upper single digits for the full year, so much is riding on the fourth quarter. Due primarily to an easy comp and strong quarter in theatres and home video in the Filmed Entertainment division, analysts are expecting EBITDA growth ranging from 16-20% in the quarter. Continued steady growth at Cable and Networks should also contribute while growth in Publishing and AOL may lag. For the record, revenue is expected to come in at $2.87 billion, EPS at 22 cents, and EBITDA up 18%....

The bigger question for TWX shares is what commentary the company will provide on 2006. Over the past week, several analysts have lowered their EBITDA growth assumptions from the upper single digits to 6-8%. Tougher comps at film due to slowing DVD growth, ongoing challenges at publishing, and higher expenses at AOL due to the broadband rollout are the primary culprits. I am confident Cable will enjoy another year of low double digit growth in 2006, but I remain a lonely voice worried that Networks will continue to slow as cable channels like TNT, CNN, and TBS no longer gain a big benefit from subscriber growth.

I still believe that on a sum of the parts basis TWX shares are undervalued by 20-25%. I also believe that the undervaluation is not so severe as to warrant all the consternation from investors, analysts, and Carl Icahn. TWX is a mature traditional media company with a lagging and poorly positioned online business at AOL. The only way the stock will shows significant appreciation above the 20% level is if multiples across all media businesses begin to rise. It is hard to expect that given the growth challenges posed by the internet and media fragmentation. However, that view is widely held so some consideration should be given to the contrarian call.

I'd rather own more narrowly focused media companies in each of TWX's main businesses than own the diversified, slow moving giant that is TWX. For Cable, givem me Comcast. For Filmed Entertainment, give me Lionsgate, for Networks give me E.W. Scripps or Viacom or CBS, for internet exposure give me Yahoo or Google. And if I want a diversified play, give me Disney, which offers steady double digit growth and has all its major businesses contributing to the growth at the same time.

AOL-Google Deal Not That Big A Deal For Time Warner

I am generally unimpressed by the AOL-Google (GOOG) deal as far as Time Warner's valuation is concerned. I value Time Warner (TWX) on a sum of the parts basis and due to the compression in multiples throughout media over the past year I just don’t see a huge valuation discount for TWX unless all media multiples rise. That said, I believe the shares could be as much as 25% undervalued....

I base this opinion on the following table which was first published on Media Talk back in September. I have not yet adjusted for debt reductions or the Adelphia deal but I believe that my debt and cash figures net to an amount that is currently accurate.

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This table differs from the one I posted in September because I made two adjustments to multiples. First, I am now using 9.8 for AOL vs. 5.0 previously to reflect the implied value of the GOOG investment. Holding everything else equal this added $2.21 to my target value. Second, I dropped cable from 9.0 to 7.5 to reflect the fact that Comcast is trading at less than 7 times 2006 EBITDA. Holding all else equal, this reduced my target value by $1.33.

To be perfectly honest, in anything short of an asset sale, I think my multiples for Filmed Entertainment and Networks are a bit too high. The box office has been terrible this year and with DVD sales slowing sharply and potentially declining in 2006, I am not very confident that if Warner Brothers were public it would trade at 12 times EBITDA. Each multiple point is worth just 33 cents for the studio, however.

As for Networks, a 13 multiple seems aggressive given that the new Viacom (VIA.B), which is dominated by the faster growing MTV Networks, is trading at closer to 12 times EBITDA. Another comparable, Discovery Communications (DISCA), trades nearer to 10 times EBITDA, although there is clearly some discount warranted for the complicated structure, and both the company's leading channels, TLC and Discovery, are having very poor ratings years. Another potential but flawed comparable is E.W. Scripps (SSP), which now gets over half its cash flow from its cable networks. SSP is trading at less than 11 times 2006 EBITDA and if you put upper single digit multiples on the broadcast TV and newspaper cash flow, the implied valuation for the cable nets is closer to 12 times. Back to TWX, Networks is the second largest business after Cable, and each multiple point equals 69 cents of TWX share value.

The bottom line from this analysis remains that TWX shares look undervalued by about 25%, with a legitimate target in the $22-23 range. However, one could argue that to get to that target multiples on some of the businesses must be assumed that are slightly above current public comparables.

Finally, the key to realizing big value at TWX is for the markets to upwardly value cable industry cash flow. Cable is by far the largest business at TWX and likely to get larger when Adelphia closes in 1H06. AOL matters and a big multiple expansion will certainly help but for AOL to be valued anywhere near Yahoo (YHOO) and GOOG is probably a multiyear workout.

I am happy to share my rather simple spreadsheet with subscribers. Just email me here at Street Insight and I'll send it along. I intend to bring it fully up-to-date after the company files its 2005 10-K early next year.

Latest Harry Potter Film Tracking Above Expectations

Despite widely expected success, executives at Time Warner (TWX) have to be happy with the $102 million opening weekend for the latest film in the Harry Potter series. Even adjusting for ticket price inflation, the opening of Goblets of Fire was the strongest of any film in the series since the first movie. International box office is also off to a fast start and looks set to match or exceed prior films in the series.

Click here for tables comparing the Potter films opening weekend and full box office runs.....

All of the data in the tables was pulled from BoxOfficeMojo.com. The ticket price data reflects total nationwide average ticket prices for all shows and all ages. It is not specific to the Potter films which may have a lower average ticket price due to the high number of tickets sold at matinees and to children. Nevertheless, for purposes of comparison, the tickets sold column (box office divided by average ticket price) functions as an equalizer.

Not to be overlooked is the international box office, which for these films exceeds the domestic box office. The table shows international box office along with estimated production and marketing costs for each film in the series. It is probably fair to assume that the marketing budget for the latest film is at least as large as any of the prior films.

It is really not possible to gauge profitability to a studio for any particular film as important items like residual payments and participations are never made public. However, it is fair to assume that for a big budget film like those in the Harry Potter series that the studio will receive as revenue slightly over half of the box office. Thus films, in this series are highly profitable based solely on their box office run.

Ancillary revenue comes from the merchandising, DVD sales, DVD rentals, and sale of TV rights. I have never seen any good data on merchandising revenue and profits but DVD sales for a family film can easily exceed 20 million units. At a wholesale price of $15, this could represent another $300 million in revenue to the studio. Typical margins historically have been in the 40% range for DVD sales.

So TWX execs awake today to the guarantee of several hundred million in profits over the next couple of years from the release of just this one film. Furthermore, there are still three films remaining in the series. Given that the Filmed Entertainment division is projected to have operating cash flow of about $1.4 billion in both 2005 and 2006, it is easy to understand why the Street and the media obsesses about the box office numbers.

I remain optimistic that TWX shares can move into the low $20's over the next few months.

AOL Doesn't Come Through But A Solid Quarter for Time Warner

Just a quick follow-up to my earlier post about AOL and Time Warner (TWX). AOL did not come though on the ad line as I thought might occur. I still believe we will see strength in 4Q when AOL.com really launches but for now the push-pull between subscriber loss and advertising growth is too large an obstacle to overcome. Interestingly, paid search grew nicely in the quarter which does suggest the GOOG numbers were something of a tip-off. However, branded advertising was sub par, maybe growing less than 10%, and this is where the AOL.com launch is supposed to help.

Beyond AOL, I thought the TWX numbers were solid but not as good as an initial review suggested. As mentioned, numbers at AOL were not that good. Additionally, adjusting for one-time items, growth at Cable was 12%, not 15%. Margin actually contracted slightly at Cable, although top line growth of 12% was excellent. I am also still concerned about the Cable Networks portion of the Networks division. Networks was the source of the positive surprise but it all came from Content which was mostly syndication revenue at HBO for Sex and the City. Subscription revenue grew just 5% and advertising grew just 8%. Cable Networks have been the fastest growing portion of TWX and get the highest implied valuation. I think that business is maturing across the industry and that multiple contraction could become apparent in 2006. Look at the multiples at E.W. Scripps (SPP) and Discovery Communications (DISCA) to get a sense of why I am concerned.

I still think TWX can head to the low $20s off a strong fourth quarter driven by improved advertising growth at TWX. I think the Street will quickly forget 3Q AOL trends as the focus shifts to the seasonally strong 4Q.

Time Warner: Will AOL Finally Show Good Advertising Growth

Given the critical role that AOL will play in the perception of TWX's quarter I wanted to mention an interesting piece of research Bernstein put out last week about advertising revenue at the MSN division of Microsoft (MSFT).

I switched to a bullish position on TWX in September based primarily on my belief that the relaunch of AOL.com as an open portal was going to be well received by advertisers in its first few quarters. Given that AOL is the key swing factor in the value of TWX shares and multiple expansion for AOL is largely dependent on the Street's view of organic advertising revenue growth, any uptick in AOL's organic advertising growth is likely to be well rewarded by the Street. My impression from reading analyst research and checking with another non-Street contact is that advertisers are willing to give AOL.com an opportunity over the next couple of quarters. In fact, I've read that AOL largely sold out its advertising on AOL.com for the fourth quarter.

This foots back to the Bernstein report where the analyst noted that in MSFT's just reported quarter, MSN advertising growth was just 20% year-over-year vs. over 100% for Google (GOOG) and over 40% for Yahoo (YHOO). On a sequential basis, ad revenue at MSN actually fell by about 10% vs. a gain of over 10% at GOOG and over 5% at YHOO. The Bernstein report suggested that MSN's growth probably lagged due to paid search. MSFT management said that display was up sequentially, which implies that search had be down significantly on a sequential basis.

The report did not mention AOL. However, my first thought was that if what I am reading about advertiser reception to AOL.com is true, maybe AOL is also partially responsible for the loss of market share at MSN. In fact, since AOL represents a significant portion of GOOG's paid search revenue, maybe GOOG's 3Q revenue growth explosion is a tip-off of a pickup at AOL.com that began to appear in TWX's 3Q. I am not saying that AOL is driving GOOG, not by any stretch, but one way to analyze the numbers from GOOG, MSFT, and YHOO is that AOL may be performing better on advertiser revenue than it has in recent quarters. Remember that after adjusting for the Advertising.com acquisition, AOL has lost market share so far this year as its ad revenue has sharply lagged GOOG, YHOO, and MSN.

I am not sure if this thesis is correct. We'll learn more once TWX reports. In fact, the thesis may be accurate but early as 4Q might be when a pickup in AOL ad revenue is first evident. TWX is guiding to a sluggish 3Q and a big pickup in 4Q for the entire company. The street sees most of the 4Q strength in Filmed Entertainment but AOL advertising will contribute to 4Q strength as well.

If AOL ad strength happens to appear in the 3Q numbers, it will be a pleasant but not wholly unexpected surprise. Remember, each multiple point increase in AOL's valuation is worth 45 cents or about 2.5% to TWX's share price. My $22 target on TWX used just a 5 multiple for AOL. We all know that GOOG and YHOO trade north of 20 times EBITDA.

Changing To A Buy On Time Warner

Over the past few weeks based on my own reading and the action in the stock, I have become more attracted to Time Warner (TWX) shares. As of today, I am dropping my cautious view and adopting a constructive three-to-six-month view of TWX shares....

Since Carl Icahn announced he was accumulating TWX shares to try to convince the Board to break up the company, there has been a lot of debate on Wall Street on how much upside exists for TWX shares. To try to provide some numbers for the debate, below please find a link to my valuation model based upon Wall Street's usual measure for valuing media stocks: total enterprise value to EBITDA:

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Attractive Based on Sum-of-the-Parts

As you can see, I believe that over the next 12 months, fair value for TWX is close to $22, a full 20% above yesterday's close. The EBITDA estimates are the average of several of my favorite Wall Street analysts. The multiples for each division reflect my own opinion of where each would trade as an independent public entity. Other assets include some equity holdings and the company's stake in Court TV and unconsolidated cable holdings. Please note the cash is increased by $3 billion in 2006 to reflect free cash flow. The minority interest represents Comcast's (CMCSK/CMCSA) 21% stake in Time Warner Cable assuming the cable company is leveraged about 2.5 times EBITDA.

Multiples Under Pressure

Others may disagree with my multiples on various divisions, but I think they are realistic. In fact, I think that I am probably a little optimistic on Publishing and Filmed Entertainment. I'd also point out that Comcast, which is the only cable company larger than Time Warner's Cable segment, presently trades at under 9 times 2006 EBITDA. In fact, this has been part of my prior argument for a cautious stance on TWX. I think the multiples the Street is willing to pay for TWX's traditional media businesses are under pressure and below the levels that most sell-side analysts include in their valuation models. I am especially fearful of potential multiple contraction at Filmed Entertainment and especially Cable Networks.

So Why Have I Turned Bullish?

Given these concerns, what has changed to make me more bullish on TWX over the near term? First, I think that my concerns over multiples on traditional media are likely to play out over a longer time horizon. Additionally, the punk action of late in all traditional media stocks has already compressed multiples and suggests that sentiment is getting a little one-sided.

Second, I found the timing of Dick Parsons' latest comments that the AOL division is the key to driving TWX value to be very interesting. From what I have read and heard, I think the fourth-quarter advertising results for the AOL division could be quite good as advertisers appear to be buying ads on the new AOL.com portal. In fact, Parsons probably knows this and is positioning so that when this turns out to be the case, the Street will respond and impute a higher multiple on the AOL division sooner rather than later.

AOL Advertising Could Provide a Boost

It is widely noted that Yahoo! (YHOO) and Google (GOOG) trade at over 20 times EBITDA, while AOL has an implied valuation of no more than the mid-to-upper single digits. If analyst estimates for 2006 are correct, each multiple point in AOL's valuation is worth about 45 cents per TWX share, potentially adding about 2.5% to my valuation target. Therefore, all it might take to push TWX shares toward my target is one decent quarter out of AOL in terms of advertising. So even if I remain bearish on the long-term potential of AOL, a trading opportunity exists as the Street tends to get excited and forget about the long term when there is some short-term momentum.

A Plethora of Other Catalysts

It appears to me that the Street wants to take TWX shares higher. All that is necessary is a catalyst. AOL could be that catalyst. Cable could be the catalyst. Pressure from the Icahn group could be the catalyst. It seems there are multiple ways to provide the Street with what it wants, which means a move towards my 2006 target could occur by early 2006. That is enough to reach my usual hurdle rate of 30%-40% potential gains over 12 to 18 months, so I am adopting a bullish stance.