I would like to preface that this idea is not as timely as the ideas I usually post.  While I am confident in TWX's long term ability to make money, I would have preferred to post the idea at a lower valuation. However, I am at the deadline for a submission requirement and believe this investment offers the best idea available to me given the market's recent run. It is also worth noting that this write-up is much more qualitative in nature than some of my past posts. Enjoy. 

 

Time Warner Inc. (TWX) 

TICKER: TWX	EBIT: $6,081MM	EARNINGS YIELD: 8.1%
PRICE: $62.50	EBITDA: $6,832MM	EV/EBITDA: 10.96x
MARKET CAP: $58,260MM	EPS: $3.59	ROE: 10.56%
EV: $74,892MM	P/E: 17.4x	DIVIDEND YIELD: 1.84%

*Data is calculated using LTM financials and a share price of $62.50 USD of 07/23/2013

 

Estimated 2017 Earnings: $7.80/share

Estimated Total Return: 88% to 149%

 

Investment Thesis

Time Warner Inc. (TWX) offers a compelling opportunity to invest in a pure play content producer capable of doubling its earnings in 4 years. Time Warner is uniquely positioned to benefit from the secular trends developing in the media industry.

Industry Disruption

The media industry is in the early innings of a secular change.  Due to the rise of Netflix and over-the-top (OTT) video, the traditional three way relationship between content producers, distributors, and consumers is under disruption. We believe that over the next decade the media industry will be driven by three major changes: 1) The potential for traditional consumers to “cut the cord” via a subscription to an OTT supplier or through an a la carte content offering. 2) The emergence of multiple devices (tv, tablets, phone) through which consumers will demand to receive content at a time of their choosing. 3) The rise of emerging market users 4) The growth of consumer demand for high speed broadband.

Time Warner - Background

Time Warner is comprised of 4 main divisions: Turner, Warner Brothers, HBO, and Time Inc. Turner is home to several of the country’s most popular TV networks including CNN, TNT, TBS, and the Cartoon Network.  In addition, the Turner networks produce live sports programming for the NBA, MLB, NASCAR, PGA, and NCAA tournament. 

Warner Brothers is the key franchise to Time Warner’s film and TV entertainment division.  Recent movie franchises include Harry Potter, Sherlock Holmes, Superman, and the Lord of the Rings. Warner Brothers licenses its feature films and film library for distribution to various networks and video services including Amazon, Netflix, and Hulu. Warner Brothers is also responsible for its home television group, which produces and distributes various network shows including The Big Bang Theory, Two and a Half Men, and Revolution.

HBO is the world’s premier premium network, hosting 114MM subscribers to its HBO and Cinemax premium television services.    Both mediums produce and distribute a host of award-winning original programming, as well as host uncut and uncensored feature films. HBO’s award winning series include Game of Thrones, Boardwalk Empire, Sopranos, and The Wire.

Time Inc. is the primary publisher for Time Warner’s publishing division.  It is the largest magazine publisher based on US advertising revenues, and includes publications such as Time, People, Entertainment Weekly, Southern Living, and Sports Illustrated.  In March 2013 Time Warner announced the strategic spin-off of Time Inc.  For the sake of this analysis we will not be valuing the Time Inc. Stub.

Why the Street is Undervaluing Time Warner – HBO

In Netflix’s whitepaper “Netflix Long Term View” Reid Hastings describes HBO, Netflix, and ESPN as leading the way in OTT.  He describes HBO Go as an “amazing app” and applauds the company calling it their biggest long-term competitor.  The reason for this is simple.  Consumers will subscribe to a service as a ‘must have’ if they believe the content to be unique and compelling.

HBO is the unchallenged leader in the television programing industry.  In 2013, HBO received 108 Emmy nominations, more than 4 times the amount of the next closest competitor.  A review of IMDB’s highest rated television counts three of the top ten television series of all time as belonging to HBO (#2, GOT, #4 Wire, #8 Sopranos).

Wall Street is undervaluing HBO’s likeness to Netflix as well as its ability to easily expand into new markets via the HBO Go platform.  At the Liberty Media annual meeting John Malone paints a picture in which OTT content goes wholesale to the cable operators, but also a la carte via direct to consumer.  Should this occur, HBO Go could easily become available to a new world of emerging market consumers who never before had cable, but are now entering the modern age via broadband / spectrum devices.  In more mature markets, HBO Go could easily be sold as a Netflix alternative / addition.  In the current arrangement the psychological implications of price anchoring keep many middle class consumers from purchasing HBO given the extra cost it adds to an already expensive cable bill. However, in an a la carte world, new subscribers could easily justify $10/month in order to receive the best of breed content.  Bears might argue that in an a la carte world HBO will simply find itself competing with other OTT programming but this is not the case. The transition or HBO to an a la carte world is akin to the rise of consumer flight.  Suddenly individuals where offered a whole new option for travel and vacation.   Did this result in high popularity travel areas losing tourists to new areas? No.  Rather popular areas became even more popular as they offered the best option to a now broader range of people. In HBO people will continue to seek and demand the highest quality content. 

Last month the HBO Go app became available on Apple TV.  With full-screen access to hundreds of movies and nearly every HBO series produced in the past 15 years, a consumer is hard pressed to find a difference between it and Netflix. The library may not be as deep, but the content is just as good if not better. In HBO Time Warner has an incredible franchise with deep market penetration, a sticky consumer, and the potential for rapid, low capital intensity growth. 

While we do not deem Netflix’s current valuation to provide a reasonable comp, Netflix’s per subscriber valuation currently stands at $374 per subscriber.  An equivalent comp would value HBO at $42.63 billion –70% to 100% higher than the valuation currently assigned to it by most sell side research.

 

Untapped Growth – Growing demand for content

Turner affiliated networks currently occupy 3 of the top 20 FCC ranked television standard cable networks; CNN at #3, TNT at #4, and TBS at #8.  While each station is a heavyweight in their own right, their consolidated affiliation (along with HBO and Cinemax) place Time Warner in a powerful position to negotiate with cable distributors. 

Recent headlines indicate a growing number of entrants into the media space (Google and Microsoft for example) that are now vying for consumer viewership and advertising revenue.  While some OTT services are now expanding into original content, the recent increase in demand has a caused a choke point from which too many dollars are bidding for premium content.  Two recent examples include Verizon’s 25% premium contract to stream NFL games to smartphones (was $187.5M per year, now $250M), as well as Amazon’s recent outbid over Netflix for Viacom’s Nick Jr.  We believe this trend will continue well into the future, positioning companies like Time Warner at the head of an expanding bargaining table.  Finally, the growing demand for content will cause new distributors to search deeper and deeper in order to bid on and secure exclusive content.  This will provide a boon of a tailwind to the thousands of movies currently sitting in studio vaults.

 

Management

Time Warner’s senior management is led by Jeffrey Bewkes.  Mr.Bewkes took the helm in early 2008 following a long and successful career within Time Warner, having spent nearly a decade building HBO. I believe Mr.Bewkes is an incredible leader with amazing insight into the future of media. Accordingly, since his first year in office he has harnessed his role as chief capital allocator to position Time Warner as a pure play on content.  Since 2009 Mr.Bewkes has led the successful spin-off of Time Warner Cable (Q1 2009), AOL (Q4 2009), and now Time Inc. (Q4 2013E). The final standalone entity will now be positioned to offer a best of breed pure play on TV and video content.   It is worth noting that Time Warner Cable (TWC) and AOL (AOL) have offered considerable value to shareholders, appreciating over 340% and 60% since their respective spin-offs.  In regards to this analysis, we will not offer a post-spin value to Time Inc. given our lack of understanding and applicable valuation model for the industry.

 

Shareholder Return

Since its spin-off of TWC an AOL, Time Warner has begun an aggressive shareholder return policy.  Over the past three years alone Time Warner has returned over $11.4 billion to shareholders: $8.4 billion through share repurchases and $2.9 billion through dividends. During this time share repurchases have accounted for an 18.3% reduction in the float, not counting the board’s 2013 decision to authorize an additional $4 billion in repurchases.  With the upcoming spin-off of Time Inc, Mr.Bewkes will be left with a cleaner, more predictable compounding machine. This will allow Mr.Bewkes and management to continue their engagement in share repurchases, and possibly allows greater access to the debt markets to accelerate their pace. It is worth noting that many 2013/2014 analysts estimates underestimate the pace of Time Warner’s share repurchase program, as well as its ability to accelerate repurchases given the businesses’ potential for margin expansion.

 

Valuation

We believe Time Warner is capable of doubling its earnings over the next four years.  While do not give much clout to models, we believe the qualitative factors surrounding OTT video distribution and the margin expansion inherent in its operating leverage will be enough to grow cash flow at a high single digit rate. Coupled with Time Warner’s repurchase program earnings should grow at a high teen rate over the next several years.  (At 5% revenue growth, Time Warner management has indicated 15% EPS growth). Furthermore, we believe Time Warner’s transition to a pure play content provider with stable earnings will allow it to seek an above-average market multiple.[1]

 

Earnings Estimates

	2013E	2014E	2015E	2016E	2017E
Revenue	-	-	-	-	-
Network	$15,125	$16,130	$17,350	$18,855	$20,460
Film & TV	$12,565	$13,118	$13,870	$14,680	$15,530
Total	$27,690	$29,248	$31,220	$33,535	$35,990
(Cost of Revs.)	$20,147	$21,142	$22,211	$23,816	$25,375
Adj OIBDA	$7,543	$8,106	$9,008	$9,719	$10,615
D&A	$900	$917	$934	$951	$969
EBIT	$6,643	$7,189	$8,074	$8,768	$9,646
Interest	$1,220	$1,240	$1,260	$1,280	$1,300
Tax	$1,844	$2,023	$2,317	$2,546	$2,838
Net Income	$3,579	$3,926	$4,497	$4,942	$5,508
Shares Outs.	938	880	825	774	726
EPS	3.82	4.46	5.45	6.38	7.59

Financial Estimates – In Millions

Value

2017E EPS	$7.59	$7.59	$7.59
Multiple	15x	17.5x	20x
Share Price	$114	$133	$151
Dividends	$4.60	$4.60	$4.60
Total Price	$118.6	$137.6	$155.6
Total Return	88.8%	120%	149%
4-YEAR CAGR	17.4%	21.8%	25.6%

 

Base Total Return: 120% / 4-year CAGR: 21.8%

Risks

• The economy enters a slowdown and causes a drop in advertising revenues. A drop in consumer content spend may be possible in a harsh economic downturn.
• Warner Brothers and HBO lose key writers, producers, and staff to new entrants with large financial resources (GOOG, MSFT)
• Consolidation in the content distributor space offers enough scale for distributors to dampen revenue growth for Time Warner’s network channels.  We see this as less of a risk for HBO given its best of breed status.
• Network channels lose exclusive sports rights to more competitive bidders.

 

Final Note

The media industry is clearly headed for change.  Internet TV will replace linear TV and content will be in greater demand than ever before. While Time Warner offers a best of breed investment on content, we believe an investor will be well served to also examine Liberty Media (LMCA) and Charter Communications (CHTR) for their ability to take advantage of the increase in consumer demand for broadband.

OTT disruption of the media industry