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September 29, 2005

Changing To A Buy On Time Warner

Over the past few weeks based on my own reading and the action in the stock, I have become more attracted to Time Warner (TWX) shares. As of today, I am dropping my cautious view and adopting a constructive three-to-six-month view of TWX shares....

Since Carl Icahn announced he was accumulating TWX shares to try to convince the Board to break up the company, there has been a lot of debate on Wall Street on how much upside exists for TWX shares. To try to provide some numbers for the debate, below please find a link to my valuation model based upon Wall Street's usual measure for valuing media stocks: total enterprise value to EBITDA:

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Attractive Based on Sum-of-the-Parts

As you can see, I believe that over the next 12 months, fair value for TWX is close to $22, a full 20% above yesterday's close. The EBITDA estimates are the average of several of my favorite Wall Street analysts. The multiples for each division reflect my own opinion of where each would trade as an independent public entity. Other assets include some equity holdings and the company's stake in Court TV and unconsolidated cable holdings. Please note the cash is increased by $3 billion in 2006 to reflect free cash flow. The minority interest represents Comcast's (CMCSK/CMCSA) 21% stake in Time Warner Cable assuming the cable company is leveraged about 2.5 times EBITDA.

Multiples Under Pressure

Others may disagree with my multiples on various divisions, but I think they are realistic. In fact, I think that I am probably a little optimistic on Publishing and Filmed Entertainment. I'd also point out that Comcast, which is the only cable company larger than Time Warner's Cable segment, presently trades at under 9 times 2006 EBITDA. In fact, this has been part of my prior argument for a cautious stance on TWX. I think the multiples the Street is willing to pay for TWX's traditional media businesses are under pressure and below the levels that most sell-side analysts include in their valuation models. I am especially fearful of potential multiple contraction at Filmed Entertainment and especially Cable Networks.

So Why Have I Turned Bullish?

Given these concerns, what has changed to make me more bullish on TWX over the near term? First, I think that my concerns over multiples on traditional media are likely to play out over a longer time horizon. Additionally, the punk action of late in all traditional media stocks has already compressed multiples and suggests that sentiment is getting a little one-sided.

Second, I found the timing of Dick Parsons' latest comments that the AOL division is the key to driving TWX value to be very interesting. From what I have read and heard, I think the fourth-quarter advertising results for the AOL division could be quite good as advertisers appear to be buying ads on the new AOL.com portal. In fact, Parsons probably knows this and is positioning so that when this turns out to be the case, the Street will respond and impute a higher multiple on the AOL division sooner rather than later.

AOL Advertising Could Provide a Boost

It is widely noted that Yahoo! (YHOO) and Google (GOOG) trade at over 20 times EBITDA, while AOL has an implied valuation of no more than the mid-to-upper single digits. If analyst estimates for 2006 are correct, each multiple point in AOL's valuation is worth about 45 cents per TWX share, potentially adding about 2.5% to my valuation target. Therefore, all it might take to push TWX shares toward my target is one decent quarter out of AOL in terms of advertising. So even if I remain bearish on the long-term potential of AOL, a trading opportunity exists as the Street tends to get excited and forget about the long term when there is some short-term momentum.

A Plethora of Other Catalysts

It appears to me that the Street wants to take TWX shares higher. All that is necessary is a catalyst. AOL could be that catalyst. Cable could be the catalyst. Pressure from the Icahn group could be the catalyst. It seems there are multiple ways to provide the Street with what it wants, which means a move towards my 2006 target could occur by early 2006. That is enough to reach my usual hurdle rate of 30%-40% potential gains over 12 to 18 months, so I am adopting a bullish stance.

Posted by Steve Birenberg at September 29, 2005 12:13 PM in TWX