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Time Is On Time Warner's Side

Posted: Jul 09, 2007 13:16 PM by Ben McClure

Tickers in this Article: TWX, TWC, CMCSA, AAPL, T, NWS, DJ

When you think of Time Warner (NYSE: TWX), it’s hard not to think of the company's struggle to make its merger with internet giant America Online work. Seven years after the merger, Time Warner's AOL cohort remains a drag for shareholders.

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It's easy to be overly AOL-centric. However, despite the high-profile nature of AOL, Time Warner remains a vast media conglomerate. The market is ignoring some promising parts of the company, notably the Warner Bros. Studios and newly spun-off cable systems unit Time Warner Cable (NYSE: TWC). By my reckoning, these businesses could be the sparks that ignite a turnaround for the stock.

A Little Magic From Harry Potter
At first glance, it's hard to get thrilled about Time Warner's film business. Warner Bros. Studios continues to deliver negative to only modest top-line growth. Even with the surprising success of "Happy Feet", last quarter Warner Bros. revenue slipped by a percentage point.

However, big improvements could be on the way for the movie studio. The release of "Harry Potter and the Order of the Phoenix" this summer ought to give revenue a sizable - albeit temporary - boost in the back half of 2007.

Much more exciting are the hefty and sustainable gains from the company's expansive film distribution strategy. While Warner Bros. still relies mainly on theaters and DVDs for movie sales, it is now opening its vast storehouse of films to new technology platforms, including video-on-demand for TV and Apple (Nasdaq: AAPL) iTunes formats.

The way I see it, these convenient and accessible offerings are going to drive up incremental demand for the company's productions. At the same time, the marginal costs of meeting that growing demand through digital delivery should be minimal. The economic rewards of digital distribution are hard to ignore.

Cable Revenue Up 61 Percent
While Warner Brothers stands to profit from broader distribution of its productions, Time Warner Cable will surely gain from their increased penetration. Time Warner didn't break out "on-demand" sales in its last earnings release, but cable giant Comcast (Nasdaq: CMCSA) did. Comcast saw 26% growth in its on-demand revenue, compared with 12% cable top-line growth. That may offer a taste of what's in store for Time Warner's cable group.

The cable business is experiencing a rebound, with a jump in subscriptions that catapulted revenues 61% to $3.9 billion last quarter. There is ample of room for growth, considering that only 40% of customers subscribe to two or more of primary services and just 14% have signed up for the "triple-play" bundle of video, broadband and voice.

AOL Still has Potential
Of course, AOL saw massive losses in Q1. Revenues plummeted 25% to $1.5 billion thanks to the company's move away from paid subscriptions. Nevertheless, there is promise yet in AOL. A surge of 40% in advertising revenue suggests the free-subscription strategy may be working. Look for AOL to make more headway in advertising as the site grows in popularity this year.

Time Warner management - largely due to pressure from corporate raider Carl Icahn last year - has, by all accounts, streamlined operations and put the conglomerate's various businesses back on a more solid footing. Time Warner, which recently tapped out a buyback plan worth $20 billion, soon may have funds for a new repurchase plan as it pares debt to its target levels.

Conclusion
Time Warner's $21.05 valuation certainly looks attractive. At less than 2.5-times enterprise value to trailing revenues, the stock trades at a substantial discount to Comcast and even telecom players such as AT&T (NYSE: T). At 21-times 2007 earnings, Time Warner doesn't look cheap, but compared with News Corp's. (NYSE: NWS) bid for Dow Jones (NYSE: DJ) at 33-times earnings it's a bargain. Expect the stock to push the $25 mark later this year. Signals pointing to further spin-offs or restructuring could push the stock even higher.

AOL remains a drag on Time Warner's corporate performance. But it also conceals hidden value that savvy investors could see unlocked. Patience could pay off.

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By Ben McClure

Ben McClure is director of McClure & Co., an independent research consultancy. Before founding McClure & Co., Ben was a highly-rated European equities analyst at London-based Old Mutual Securities. He also spent several years as a business/technology journalist at the Economist Group. McClure graduated from the University of Alberta School of Business with an MBA.

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