Description
We believe there is an attractive opportunity in the TWX long-term call options. Currently, the market is charging very little premium for the January 2008 calls with a 15 strike of a company we believe to be significantly undervalued at the current price of $17.50. Even if the market simply doesn’t care in 2006, January 08 calls give you a two year timeframe for the company to increase value through operations and allow several catalysts to play out that will hopefully cause the market to revalue the shares. We believe the Jan08 15s (currently trading at $4.20) are an inexpensive yet highly leveraged way to double or triple your capital. Essentially, the key question with this idea is whether or not you believe that at any time between now and January 18, 2008, TWX will trade for 1) $23.40 (double); or 2) $27.60 (triple). Your breakeven is $19.20. If any of these scenario come to fruition before the January 2008 expiration, then you will get some premium throw in as well.
As most of you are familiar with TWX, this write-up will provide a brief overview of recent developments at the company, a short background of the various businesses along with our take on what each business is progressively worth through the end of 2008, and finally the catalysts that we believe will help unlock value.
RECENT DEVELOPMENTS
Over the past few years and presently, it appears that most investors have thrown in the towel on the cable and traditional media sectors. The concerns are across the board including: 1) middling growth in traditional media ad sales; 2) lackluster box office and DVD sales; 3) pressure on cable from satellite and forthcoming fiber to the home from the RBOCs; 4) the threat from digital video recorders (DVRs) to network ad dollars, 5) the threat from the Internet taking a rapidly growing share of the total ad spending pie; and 6) higher energy prices taking consumer dollars away from entertainment spending. If that’s not reason enough to run, specific to TWX investors worry about subscriber losses at AOL, a floundering publishing business, and ratings deterioration at the once dominant CNN among other things.
Our view is that the negative investor sentiment, particularly as applied to TWX, is overdone. Since Richard Parsons replaced Gerry Levin in May 2002, the company has dramatically changed for the better yet the share price is lower today than it was when Parsons began. The improvements include: 1) cost cuts; 2) rationalized business units; 3) debt reductions; 4) a planned $12.5 billion share repurchase; 5) favorable deals for AOL, Time Warner Cable (TWC) and the WB Network; and 6) a reasonable forward strategy to unlock shareholder value by floating 16% of TWC. Parsons still has a lot of work to do but we believe he has positioned TWX for a bright future as he continues to execute his strategy.
At least one investor thinks Parsons is not doing nearly enough. Unless you’ve been on a mushroom farm for the last five months you’ve probably read all about it. Carl Icahn along with JANA Partners, Franklin Mutual, and SAC Capital have engaged in a highly publicized brawl on what exactly is the best strategy for TWX. In short, Icahn wants the company to 1) buy in $20 billion shares rather than $12.5 billion; 2) spin-off TWC in its entirety; 3) and dramatically cut costs across the board. Icahn has hired Lazard and other media luminaries to help figure all this out and influence the company’s large institutional investor base. The group’s position paper outlines today's per share value at $26-28. It can be found at www.sec.gov in Exhibit 3 of the filing dated 9/12/2005.
With less than 3% of the total shares outstanding and not the most pristine reputation among large institutional investors, we handicap Icahn’s chances to actually win a proxy contest at 20:1 odds. But you have to give Icahn due credit because he has succeeded in doing two important things: 1) he influenced management’s decision to raise the buyback from $5 billion to $12.5 billion; and 2) he shined a glaring light on the value of TWX’s underlying businesses. While Carl and the gang may be a bit aggressive in their appraisal of the business units today, we believe they are closer to the appropriate valuation than what the market is currently assigning to the company and certainly within the range of value by 2008. Forgive me for implying that the market isn’t always right.
TWX reports across five business units: Cable, Networks, Filmed Entertainment, AOL, and Publishing. Below I’ll provide a brief description of each segment and walk through our take on valuation.
TIME WARNER CABLE
TWC is the second-largest cable operator in the U.S. with around 10.9 million subs across 27 states. Roughly 85% of subs come from TWC’s five largest markets which include NYC, Philadelphia, Los Angeles, Houston and Dallas. In April 2005, TWC and Comcast announced they would collectively acquire the assets of Adelphia for a total of $12.7 billion in cash (TWC - $9.2 billion and Comcast - $3.5 billion) and 16% of TWC stock. Following the transaction and after system swaps with Comcast, the deal will add 7.5 million homes passed and around 3.5 million subscribers. Total TWC subs will come in around 14.4 million. TWX will own 84% of TWC and a $1.9 billion separate interest in the NY subsidiary of TWC. TWC will become publicly traded when the Adelphia deal closes.
Floating shares of TWC should be a positive step in unlocking shareholder value as investors will be forced to put an independent value on the cable assets. So what would be a reasonable valuation for TWC on a stand-alone basis? Comps currently trade between 8-9 times 2006E EV/EBITDA which is historically low for the group. We believe TWC is one of the better cable companies out there. They have: 1) attractive, highly clustered markets; 2) above average growth; 3) all of the heavy spending for digital and telephony upgrades behind them (Adelphia is 85% of the way there); and 4) significant margin improvement from Adelphia integration ahead of them.
We believe TWC will generate around $5 billion in EBITDA (including Adelphia) in 2006 and grow to $5.5 and $6.0 billion in 2007 and 2008 respectively. We also assume: 1) a conservative 25% of EBITDA will convert to FCF and be used to pay down debt; 2) $16B debt will include $9.2B (Adelphia purchase) and $6.8B back to TWX for buybacks; 3) $7.5 billion in TWX share repurchases in 2006 at average cost of $19 (394.7M shares) and 4) the remaining $5 billion will be used to repurchase shares in 2007 at an average price of $21.00 (238M shares). If this plays out, then the value to TWX accrues as follows:
2006 2007 2008
------ ------ ------
EBITDA $5,000 $5,500 $6,000
Multiple 8.5x 8.5x 8.5x
EV $42,500 $46,750 $51,000
(Net Debt) $16,000 $14,750 $13,400
Equity Value $26,500 $32,000 $37,600
TWX Share (84%) $22,260 $26,880 $31,584
TWX Shares 4,724 4,329 4,091
Net of Buyback 4,329 4,091 4,091
Value/Share $5.14 $6.57 $7.72
Add NY Interest $0.44 $0.46 $0.46
Total Value/Share $5.54 $7.03 $8.18
You might be asking why I use an 8.5x multiple in 2008. The reason is that the call options don’t require you to discount the multiple in 2008 back to today. You pay for that with the premium. We simply think it is reasonable to assume that when we are in January 2008, the market will place today’s historically low 8.5x on one-year forward numbers.
AOL
It’s no secret that the AOL merger began its life as an unmitigated disaster. However, it appears that this misstep may turn out to have a silver lining – but it won’t happen this year. Simply put, AOL has an internet access business that is losing subscribers and an internet content business that is rapidly gaining advertising dollars. Management recently entered into two initiatives to get AOL back on track.
The first is the Google deal. In December 2005, TWX and Google announced that the former would invest $1 billion for a 5% stake in AOL and that the two would form a comprehensive strategic alliance. In a nutshell, we think it’s a good deal short-term and long-term in that it provides a valuable search element to AOL’s great content assets that should result in: more traffic to AOL and more exposure to search dollars. While the investment implies a $20 billion value to AOL, we think a lot of premium was baked into that number to keep Microsoft and Yahoo away.
The second deal is between AOL and several DSL providers including Verizon and BellSouth among others. The gist is that AOL will attempt to shift dial-up subscribers to broadband subscribers in an effort to maximize long-term subscriber value. While long-term subscriber value is higher for broadband, there will be some short-term pain. Monthly contribution of a broadband subscriber under these arrangements is less than dial-up but with half the churn. Therefore the conversion will hurt near-term EBITDA but improve long-term value of the customer through reduced churn and a more stable subscriber base. If anyone is interested in the numbers, we can walk through it in the follow-up.
To put a progressive value on AOL through 2008, we break out access and content and assume a 15% annual decline in access EBITDA through 2008 and a 20% annual rise in advertising EBITDA for the content side. For access, we will use 4 times EV/EBITDA which is the midpoint of comparable companies. For the internet advertising side, we are not going to use comps because they seem a bit inflated (we’re talking well north of 30x). We instead use a reasonable 18 times for 2006-2008 which is just below the expected EBITDA growth rate and certainly a major discount to what comps are sporting today. In addition we’ll assume FCF conversion rates of 20% for access and 50% for advertising which will be added back to per/share year-end value.
Access Advertising Combined
------------ ------------ ------------
EBITDA
2006E $ 1,153 $ 724 $1,877
2007E $ 980 $ 869 $1,849
2008E $ 833 $ 1,043 $1,876
TWX Value
2006E $ 4,610 $13,032 $17,642
2007E $ 3,920 $15,642 $19,562
2008E $ 3,333 $18,774 $22,107
TWX/Share Value
(Pre FCF)
2006E $1.06 $3.01 $4.07
2007E $0.96 $3.82 $4.78
2008E $0.81 $4.59 $5.40
(Post FCF)
2006E $1.11 $3.09 $4.19
2007E $1.01 $3.93 $4.94
2008E $0.85 $4.72 $5.57
So here we are, it’s January 2008 and we have an AOL asset that is conservatively worth $5.57 per TWX share. TWC has been trading on a standalone basis for a year and a half and TWX’s ownership interest is worth $8.18 per share (including the separate $1.9 billion NY sub interest). In short, we think it’s reasonable to assume that both AOL and Cable combined are worth around $13.75 per TWX share by the turn of 2008.
TWX MEDIA STUB
The remaining business units include Networks, Filmed Entertainment, and Publishing. In addition, we’ll back out corporate and inter-company items and add back ancillary investments and the PV of the NOLs. In the interest of brevity, we will take the midpoint of comps on an EV/EBITDA basis.
NETWORKS
Growth Rate: 7% EBITDA Multiple Value
2006E $2,990 12x $35,880
2007E $3,215 12x $38,580
2008E $3,456 12x $41,472
FILM
Growth Rate: 3% EBITDA Multiple Value
2006E $1,381 10x $13,381
2007E $1,422 10x $14,220
2008E $1,465 10x $14,650
PUBLISHING
Growth Rate: 3% EBITDA Multiple Value
2006E $1,250 8x $10,000
2007E $1,287 8x $10,296
2008E $1,326 8x $10,608
INVESTMENTS/NOLs
GS Value*
2006E $5,438
2007E $5,438
2008E $5,438
(*Simply the mid-range value suggested by Goldman Sachs with zero growth)
INTER-COMPANY/CORPORATE
Growth Rate: 1% Expense Multiple Value
2006E ($450) 8x ($3,600)
2007E ($463) 8x ($3,704)
2008E ($477) 8x ($3,816)
TOTAL EV Net Debt Equity Value
2006E $61,099 $10,900 $50,199
2007E $64,830 $10,900 $53,930
2008E $68,352 $10,900 $57,452
We didn’t add back Media FCF generated during the period as we assume it will all be used to fund the remainder of the $12.5 billion share repurchase program that is not funded through TWC recap. Please note that we attribute $6.8 billion to the net debt position of TWC for TWX buybacks (in addition to the $9.2 billion cash requirement for Adelphia).
TWX VALUE/SHARE
2006 2007 2008
Cable $ 5.54 $ 7.03 $ 8.18
AOL $ 4.19 $ 4.94 $ 5.57
Media $11.60 $13.18 $14.04
TOTAL $21.33 $25.15 $27.79
We believe the above analysis is a reasonable estimation of the progressive value of TWX. Our 2006 valuation is toward the lower end of what Wall Street has put out for the company. And the 2007 spike mainly comes through the Adelphia intergration at TWC which most analysts haven't incorporated. So if you can believe the above, the next question is what will make the market agree with us.
CATALYSTS
1. The TWC Spin-off
The FTC has closed its investigation of the Adelphia deal so we are hopeful that things will come to a close by the end of Q2. Once the shares float, investors have no choice but to place an independent value of the TWC franchise. As we explain above, TWC deserves at worst a mid-range comp, but we think it may do better which will help our case. Either way, one major piece of TWX value puzzle will be marked to market every day.
2. Icahn Gains Momentum.
With the Icahn Group at 3% of the outstanding, we give them little chance to win a proxy contest. That’s does not mean however that Icahn has lost all of his ability to be a change agent. Already he has influenced the board to jack up the buyback 150%. He recently put the spotlight on costs which we hope will act as a swift kick in the pants for management to make a move in that department as well. I hope Icahn’s tenacity stays around for a while because his constant spotlight on management ought to get the wheels in motion for more value creating activity. In addition, he is beginning to recruit some very powerful allies as evidenced by today’s announcement of a large derivative investment in TWX by a Dubai firm. This idea is not predicated on Icahn getting his way but I do like having him around.
3. Media and Cable returns to favor.
Who knows? Maybe energy and resource plays will cool down on of these days and companies with solid franchises and consistently high returns on capital will come back into favor. Don’t really know what to say here other than sentiment in the media and cable sectors are as negative as they have been in long while. Nothing lasts forever (or at least on Wall Street).
4. A split of the AOL access business.
Management has not yet ruled out a split of the AOL access and advertising businesses. Access would be an atractive asset to a low-cost network provider. The split would allow TWX to allocate capital at higher return.
5. Assets sales.
There is a ton of non-core crap under the hood here. Even many of the assets within the core business units could be monetized and the proceeds used to reinvest at higher returns. Book publishing comes to mind.
6. Higher volatility environment.
Not something to really care about in direct equity investments. But it does matter with options. A reasonable spike from today's historically low volatility levels could change the attractive nature of these options in hurry. And that’s a good thing if you already own them.
CONCLUSION
Owning long-term options can be a great way to make a levered bet on an attractive opportunity in an inexpensive way. We think TWX is one of those opportunities. The company has great assets that are undervalued and several catalysts that we believe will eventually change the market’s perception. And we have two years to wait.
I recognize that I haven’t addressed many of the risks in the story and would be happy to do so in the follow up. I also recognize that I am posting this idea on the eve of the earnings announcement. If the stock falls for a immaterial reason, remember you will get the calls cheaper and still have two years for all the catalysts to play out.
Catalyst
1. Time Warner Cable Spin-off;
2. Icahn gains momentum;
3. Traditional media and cable return to favor;
4. Potential split of AOL access business;
5. Assets sales; and
6. A higher volatility environment.