Description

Current Price: $83

Target Case Price: $110

Downside Case Price: $74

Market Cap: $69B

Liquidity: $415MM per day or 5MM shares

Thesis

TWX represents a compelling risk/reward investment. If TWX executes on a growth strategy or pursues shareholder friendly strategic actions, TWX stock could rally towards $110, up 35%, in the next 12 months.  If they don’t, FOXA, or another strategic like DIS, will buy TWX at a significant premium to last sale.

TWX is a uniquely situated media company with multiple levers for growth over the next few years, including increased monetization of HBO, contract resets raising domestic affiliate fee revenues low teens through 2018, international revenue growth in the low teens, cost cuts, and an increased share buyback. These opportunities should result in mid-to-high teens EPS growth for the foreseeable future. If TWX management can successfully execute and make the case that EPS growth is sustainable, I believe TWX can earn $6 and trade a high teens multiple. Further, TWX is almost certainly worth more on a SOTP basis. If shares fail to respond to EPS growth, TWX could IPO or spinout certain assets.

Should TWX fail to execute, FOX’s hostile bid puts TWX “in play.” TWX’s assets (Warner Brother’s studio, Turner Networks, HBO) are consistent high single digit EBITDA growers with pricing power and international potential. Further, these are rare content assets in a media landscape where control of content is at a premium. FOX, DIS, CMCSA, and several others are all potential bidders for TWX. As TWX is the only large content company with a single shareholder class, the management and board ultimately report to shareholders who will demand a sale if TWX share price languishes.

Valuation

·        Target - $110 – I believe TWX can grow EBITDA 8% in 2015 and 12% in 2016, modestly above Street estimates. Further, I believe TWX will buy back ~$3-4B in stock per year, yielding $6 in 2016. I believe TWX’s rare assets and sustainable mid-teens EPS growth warrant an 18x multiple, a mere two turns higher than TWX’s forward multiple prior to FOX’s bid.

o   With the market at 17-18x for 8-10% earnings growth vs. TWX with highly probable, less-cyclical mid-teens or better EPS growth, I feel 18x is fair even in a rising interest rate environment.

o   TWX should earn $4.75 in 2015 based solely on run-rate topline/EBITDA growth.

·        Downside - $74 – If TWX EBITDA growth slows to 5% in 2015 and 2016, TWX could earn $4.40 in 2015 and $5.25 in 2016. 14x yields $74.

o   Given contractual affiliate fee resets and buyback accounting for 8% a year of TWX’s earnings growth combined with a strong history of execution at HBO and Warner Brothers, I struggle to see TWX growing less than this.

o   TWX would still remain a takeout a candidate with an antsy shareholder base….

·        Bull Takeout Price - $115 or better – TWX is a rare asset that trades at a discount to content peers such as NFLX and LGF/MGMb. It has an excellent history and its content would play a critical role if FOX, DIS, etc. ever wanted to launch an over the top network like Netflix to distribute content directly to consumers. If TWX grows mid-teens or better and FOX apparently already willing to bid $95-$105 in cash and stock, I believe TWX could warrant a $115 or better price.

Risks

·        Continued deterioration in ad dollars at Turner

o   Ad Dollars are 15-20% of TWX’s revenues, substantially less than most cable-net/broadcaster “peers”

·        Cord Cutters

·        The HBO Now rollout is a bust

o   More sentiment than real impact on numbers

·        FOXA/others failing to bid if TWX stock lags

Catalysts

·        HBO Now rollout

·        Potential bids

Hitting Numbers

TWX Earnings Growth Case

At their October analyst day, TWX management laid out an achievable plan to grow earnings from $4.15 in 2014 to $6 in 2016 and $8 by 2018, a 15-20% a year CAGR. I lay out my math to reach $6 in 2016, which is essentially in line with the Street.

I get 15-20% EPS growth via 8-14% organic EBITDA growth plus buyback (assuming leverage between 2.5x-3.0x). Here is TWX’s EBITDA growth by segment. Bloomberg numbers don’t entirely reflect all the spins TWX has done (TWX, AOL, TIME, etc.).

CHART ISSUE: Charts don’t convert, but in 2015 and 2016, I have Turner EBITDA of $4400 and $5000, HBO of $2200 and $2400, and WB EBITDA of $1800 and $2000. While EBITDA growth is slightly negative for 2014, that is due to the TIME spin in Q2. The remaining TWX segments have been growing EBITDA mid-to-high single digits over last few years, so this represents only a modest improvement from prior trends.

My EBITDA estimates for 2015 and 2016 are only modestly above the Street. For Turner, ad growth is LSD (low ratings, ad dollars shifting to digital, slightly offset by international growth ex-FX) while subscription revenues (very sticky) are contractually resetting 10-15% per year higher over the next 5 years, which should result in mid-single to low teens EBITDA growth over next few years. I model HBO to accelerate to 10-13% from 8-10% due to better monetization. I consider WB a 5% EBITDA grower, with some volatility around large TV and movie deals.

Limited Downside

My biggest point on TWX, is that even if my forecasts all suck, TWX is likely a low growth EBITDA story at worst. Historical numbers are a bit convoluted from all the spins and restructurings, but TWX in its current state (Turner, HBO, Warner Bros) didn’t even have negative EBITDA in the recession.

CHART ISSUE: Again, chart issue, but “core” EBITDA grew 1.2% in 2008, 15.8% in 2009, 12.0% in 2010, 7.3% in 2011, 6.1% in 2012, 6.1% in 2013. There’s some hair on the 2014 numbers, but it grew MSD adjusting for that.

My favorite thing about TWX is that it has particularly high EPS growth with solid visibility, low cyclicality, trading at a low multiple, so it’s just hard to see losing much money in TWX beyond random market volatility.

TWX Strategic Takeover Value

I discuss this further in the International Pay TV section, but TWX is a rare strategic asset for large media companies that are looking at video shifting from cable and broadcast TV to online video and over-the-top (OTT) platforms. Ignoring DIS which is too big for anyone to buy, TWX is the only large media company with a single share class structure, meaning TWX’s board reports to shareholders, not a megalomaniac 80 year old billionaire. Further, TWX is essentially a pure play content company, and “content is king”, particularly as the future of video distribution is rapidly changing (traditional linear TV through set top boxes, DVRs, streaming video on demand (SVOD) like Netflix, etc.). Warner Brothers is by far the largest content producer in the world, with the talent and experience to consistently produce high quality content, particularly in the growing TV business. HBO is a must have video product for many consumers, HBO is considered by many to be Netflix’s biggest competitor, including NFLX’s own CEO. Turner has three of the top ten highest rated cable networks.

When large “media” companies, such as FOX, DIS, CMCSA, look at potential threats their biggest fear are the change from traditional pay TV distributed by cable to SVOD and OTT platforms, consolidation of domestic TV distributors, and ad dollars moving online (to GOOG, FB, etc.). The best, quickest solution to these threats is to control the most content and ensure your relevance and ability to influence how things play out. Murdoch has been claiming for a few years that FOX needs size. As a pure-play content name with a single share class, TWX is the best asset to accomplish this. For FOX or DIS, TWX gives them critical mass to go over the top and sell a bundled SVOD package directly to consumers and/or significant leverage vs. advertisers, distributors, etc. Further, certain tech companies, such as GOOG, FB, AMZN, are growing in the media market. TWX would give any of those names immediate mass and credibility to make a big play. While TWX’s $80B EV leaves only a few buyers, I think it’s important to remember that TWX is the only thing they can buy.

HBO Opportunity

Note: The company refers to the segment as HBO, but the segment contains both the HBO branded networks and the Cinemax branded networks. However, the HBO branded networks are the vast majority of revenues and profits.

Beyond affiliate fee growth at Turner, the biggest driver of TWX’s EPS growth is faster growth from HBO. While there are numerous levers to pull, I will highlight three: international, increased domestic penetration/monetization, and HBO Now.

International accounts for 70% of HBO subscribers but only 20% of revenues. While HBO has international subscriber growth momentum (mid-twenties CAGR), HBO is not packaged as a premium channel internationally. As a result, the international ARPU is 60-80% lower than domestic. As the international TV markets develop, ARPU is likely to increase while subs growth low double digit, which should result in considerable international margin expansion and EBITDA growth.

Domestically, HBO has numerous growth engines. HBO has approximately 43MM domestic subs (2-5% CAGR) who pay ~$8 per month. ARPU is growing 3-4% at present, but given HBO’s “must have” status to many viewers, ARPU could significantly increase over next 5-10 years. Further HBO could penetrate additional households. HBO could grow by reaching the 10MM households who have broadband but not pay TV, mainly via the HBO Now OTT offering. There are another 70MM pay TV households who presently do not have HBO; a better marketing effort (and perhaps the expansion of HBO GO) could reach them. It is important to note that, ignoring the HBO opportunity discussed below, incremental HBO domestic growth should be very high margin, as HBO incurs little distribution cost and their content costs are essentially the same for one sub or 45 million subs.

HBO Now is the true “upside optionality” to the HBO model. Over the next few months, there will be plenty of headlines about this, and sentiment in TWX will likely move around the launch. The basic math is that there are 70-90MM households in the USA who don’t subscribe to HBO, plus hundreds of millions in the international markets who could be interested longer term. HBO Now could end up adding 5-10MM domestic subs which could add $1B in sticky, recurring EBITDA over the next decade… or it could really just be a flub and most people keep buying HBO through their cable company. However, the important thing is that, regardless of HBO Now’s success over next 12 months, it will at best/worst affect 2016 EPS by 10-15 cents. There’s a lot of optionality here, it gets a lot of headlines, but TWX has other engines to grow EPS.

My basic point is this: I think HBO is significantly undermonetized, with massive potential, and I believe the pressure from the FOX bid will force TWX to show results here sooner rather than later.

Domestic Affiliate Fee Growth

Turner is the midst of renegotiating its carriage contracts with domestic distributors. In layman’s terms, TWX is asking Comcast, Direct TV, etc. for more money to carry the Turner Networks, mainly TBS, TNT, CNN, and Cartoon Network. Turner has now negotiated with approximately half of the top distributors and will see affiliate fees contractually resetting at a low-teens CAGR through 2018. TWX does not directly breakout affiliate fees, but domestic affiliate fees account for the vast majority of the Turner Subscription Revenues line item, which is approximately 17% of overall TWX revenue.

It is worth noting that in my bear case, TWX only grows EBITDA 5%. As ~20% of TWX revenues will be contractually expanding ~12% for next five years with no associated expense increases, I only need the rest of TWX’s businesses to grow EBITDA ~3% to reach my bear case estimates. The rest of TWX’s businesses have averaged an 11% EBITDA CAGR over the last eight quarters.

SOTP Valuation - $105B - $100 per share

HBO - $35B - NFLX is currently valued at a $26B EV. That is 45x 2015 EBITDA of $580MM and $560 per existing sub. Most sellside SOTP models currently estimate HBO to be worth ~$20-$30B, or 10-15x EBITDA and $145-$218 per existing sub. NFLX is outgrowing HBO and the stock clearly discounts expectations of strong future sub growth and better monetization. However, considering that HBO is widely viewed as the biggest competitor to NFLX, including repeated public comments by the NFLX CEO himself, I find it highly unlikely HBO would trade at a discount to NFLX in a public market. On 2014 EBITDA estimates, FOXA trades 12.5x. DISCA trades 11.7x with substantial ad fears.

While I doubt they do, if TWX were to spin HBO, I believe the market will value HBO closer to 17.5-20x EBITDA. While this might seem high, if you assume HBO receives ~25% of debt, corp expense, and interest costs, that’s about $1.25 in 2015 and $1.40 in 2016 EPS. 25x 2016 EPS on ~850MM shares yields $30B in equity value with $6B in net debt. I struggle to see HBO trading below that.

WB - $20B – Should do close to $2B in 2016 EBITDA. LGF and MGMb are 14x-17x. 10x my modestly bullish 2016 seems abundantly fair, as the comps are difficult to value against given content libraries.

Turner - $50B – 11x my 2015 EBITDA estimate. It’s basically slightly above solely US focused cable-nets/broadcasters (CBS, VIA) at 9.5-10.5x and slightly below international exposed ones at 11.5x-13x (FOXA, DISCA).

Buyback

TWX ended Q4 with Net Debt/EBITDA of 2.5x and is expected to generate ~$8B in FCF by year end 2016. Management is willing to increase leverage to 2.75x, which on 2015 EBITDA of ~$8B implies $2B in additional leverage. TWX will pay ~$2.4B in dividends in the next two years. Putting it all together, TWX has room to buyback ~$8B in stock by year end 2016. At $85 per share, that is a 11% reduction in TWX’s float.

International Pay TV

Note: I often talk about TWX’s “TV content”, but a more accurate way to describe that would be “short form video content that has traditionally been distributed via TV.”

I believe the market is giving little credit to TWX’s international growth, which should be a significant driver of growth over the next 10 years. (Admittedly a long time, but my near term estimates rely little on this.) Ten years ago, the only way someone could view TWX’s TV content was to view it on a TV station at a given time scheduled. Besides videotaping the channel, consumers couldn’t rewatch the content and TWX had to negotiate with distributors for bulk content purchases. Video over the internet was slow and impractical for long clips due to download speeds. In the decade since, we have seen a significant increase in internet download speeds and an explosion of intelligent video-watching devices (tablets, smart phones, smart TVs, etc.). The result is that consumers can now directly access content libraries whenever they want (SVOD – streaming video on demand, aka Netflix, HBO GO), pretty much wherever they want. At the same time, the emerging market middle class is growing rapidly and pay TV penetration is significantly behind the US and developed Europe. For example, ~85% of Americans pay for TV, while only 25% of Brazilians do.

The results is more people who can afford to pay for video content, more opportunities for these consumers to watch video content, and direct access between content creators like TWX and consumers (which implies better leverage over distributors and/or the ability to cut distributors out entirely via OTT platforms). This creates a powerful backdrop for TWX to experience strong secular international growth. While TWX doesn’t provide explicit international breakdowns, TWX indicates they are growing international revenues in the high single digits to low teens, depending upon FX, and that international TV revenues are 20-25% of total revenues.

Catalyst

Catalysts

·        HBO Now rollout

·        Potential bids

Hitting Numbers