I recommend a long equity position in Time Warner Cable (ticker TWC), as a somewhat un-loved, mis-understood, and under-valued (stock trades at ~5.9x 2014E EBITDA and ~9.4x EBITDA – capex) opportunity which presents a compelling risk-reward proposition with a total return potential of >30% over the next 6-months (on a standalone basis) and >50% in the event of cable consolidation (more discussion below but John Malone’s explicit interest in TWC makes this “option” valuable).
TWC is the second largest cable operator in the US, providing residential video, residential data, residential voice, and commercial services to over 12 million customers across 29 states. TWC was spun out of Time Warner Inc. in March 2009 as part of a larger restructuring of Time Warner. Prior to that, the company was the product of numerous transactions that assembled the footprint the company has now, most notably when Time Warner purchased many of Adelphia’s cable assets out of bankruptcy in 2006. TWC was spun out because of pressure from investors to separate Time Warner Inc.’s media & entertainment assets from its cable business given the differing capital intensity profiles.
Over the past couple of quarters, TWC has suffered from operational hic-cups, the biggest of which has been subscriber retention from promotions put in place in 2012. Given operational overhangs, the market has penalized TWC with a discounted multiple to its peers (TWC trades at a -15% discounted multiple to its closest peers and -25%+ discount to recent private-market transactions). In addition, Street expectations for TWC have moderated over the past few quarters as consensus now expects ~3% EBITDA growth (versus >4% at Comcast) and ~1% FCF growth (versus >9% at Comcast). The market’s growth assumptions are punitive especially when compared to TWC’s historical performance of 5.6% annualized revenue growth, ~6% EBITDA growth and ~9% FCF growth since 2008. Given muted earnings power expectations and the punitive valuation multiple being applied by the Street, the set-up for TWC stock in the near-term is attractive. The TWC investment thesis has a few legs including: (a) attractive industry, (b) cheap valuation, (c) low expectations, (d) additional avenues to win.
First, TWC operates in a stable and rational industry (even during the recession, top-line for all the large cable companies expanded). Additionally, I like cable because the cable operators have a significant advantage in broadband speeds relative to traditional wireline providers at a time when demand for that product is growing explosively, and they will continue to grow their HSD business. I believe this speed advantage will drive market share gains for cable in residential video and voice, and they will take previously lost share from the satellite providers. In addition to an attractive residential offering, cable’s entry into small and mid-sized business services is attractive, where they have been able to grow high margin revenues at ~20% per annum but have still only penetrated ~10% of the market.
Second, at current prices, TWC trades for ~5.9x EBITDA multiple based on 2014E estimates (~9.4x EBITDA – capex). Given TWC will generate >$2.5Bln of FCF (~8.5% FCF yield assuming continued share repurchases). I believe this is too cheap for a predictable non-cyclical asset that operates in a monopoly / duopoly framework. On a relative basis, TWC trades for a -15% multiple discount to its closest peers and ~25%+ discount to recent private-market transactions.
Third, after reporting weak net adds for the past few quarters, the Street has reduced growth expectations materially with consensus expectations in the sub-3% EBITDA growth range. Given the favorable outlook for data services (~5% volume growth from improved penetration + pricing power) and commercial services (>20% growth given under-penetrated) and considering the significant fixed costs to the business model yielding >40% incremental flow-through to the bottom line, I view ~3% EBITDA growth and ~1% FCF growth as an easy hurdle to exceed. Regarding the recent operational hic-cups, my research suggests many of the issues are temporary (but require time / $ to improve). These items include (a) pension expense step-up (Street penalizes in the out years, but I view as one-time in nature), (b) investments in regional sports networks that will result in incremental costs in the near-term (but Street fails to recognize an aid to the top-line in the future), (c) programming cost inflation (Street worried about low teens inflation but management is confident it will range in the 7 – 9% range as it mostly contractual), (d) retention of subscribers from heavy promotions during 2012 (Street views as structural but management has put in place efforts to retain subscribers and improve the product offering at the end of the promotion). Overall, my research suggests that the assets are very well maintained and properly invested in, and the operational issues largely fall on management … which leads to the final leg of the thesis …
Fourth, I think that there are many ways to win beyond just the fundamentals. While I applaud management’s capital allocation over the last few years (repurchasing shares and paying a ~2.3% dividend), the recent operational hic-cups in recent quarters have opened the window to … (a) activist shareholders to catalyze a change in the management team, (b) consolidation play for Charter to acquire TWC, (c) optimizing the balance sheet with shareholder-friendly actions and/or (d) buying other cable assets. On the first point, there has been recent press speculation of a proxy fight approaching at TWC (perhaps being led by Icahn or an Icahn-“cub”) - http://blogs.wsj.com/corporate-intelligence/2013/10/01/coming-soon-to-time-warner-cable-a-proxy-fight/?mod=WSJ_qtoverview_wsjlatest. On the second point, earlier this summer, the news media reported that John Malone’s investment vehicles approached TWC about a potential combination with Charter Communications (of which Malone owns a ~27% stake) but was ultimately rebuffed. As recent as 1-week ago, Malone mentioned he thinks the “TWC deal still makes sense”. While difficult to speculate on an M&A transaction, Malone’s history around cable and M&A suggest he is implicitly taking a “soft bear hug” approach to align TWC shareholders’ more in the camp of consolidation. Given the very real question of succession at TWC (i.e. who best to manage), I believe the TWC board has a fiduciary obligation to weigh all the options and think a merged TWC / CHTR would be a compelling combination. On the third point, I believe TWC is under-leveraged with less than ~2.8x net debt / EBITDA based on 2014E estimates (compare this to Charter at ~5x). If TWC were to increase leverage to ~4x, they could buy back >30% of the shares outstanding. On the fourth point, if TWC decides to go-it alone, there are opportunities for TWC to drive upside through acquisitions. For example, in 2011, TWC purchased Insight Communications for less than 5.8x EBITDA on a synergized basis, far lower than current cable valuations.
I do not hold a position of employment, directorship, or consultancy with the issuer. I and/or others I advise hold a material investment in the issuer's securities.
1) improving results and better than expected financial performance in 2014
2) activist involvement driving increased leverage and share repurchases
3) TWC acquired by Charter or TWC does accretive acquisitions