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February 02, 2006

Time Warner: The Street Will Like It, But Not Me

Time Warner (TWX) reported 4Q05 earnings pretty much inline with expectations with revenue and EBITDA both coming in very close to analyst estimates. As usual, the mix at the segment level was a little different than expected. The company also provided EBITDA growth guidance for 2006. EBITDA is expected to grow in the upper single digits, inline with current analyst expectations, but the 2005 base is being reset lower so I am not quite sure if the apple-to-apples comparison is OK. I think it is. At the segment level, management provided limited commentary on 2006.

TWX shares are trading up over 2% which you might find a little surprising relative to the comments I am about to make on the segments. I think the rise is being fueled by the announcement that the company will dramatically up the pace of its share repurchase program starting this quarter. One year ago, the Board authorized a $12.5 billion repurchase program, of which $3 billion was purchased by the end of 2006. In my opinion, given the lousy performance of the stock, the discount to my target value of $22, and sustainable free cash flow of over $3 billion annually, the pace of buying has been too slow. CEO Dick Parsons announced on the call that the company would double the pace of buying beginning immediately....

I also think that since the fourth quarter had some pimples and the 2006 outlook for AOL is muddled the shares could be moving higher because the pressure on Parsons to boost the stock price is higher today than it was yesterday.

Looking at segment results in 4Q05 shows that AOL was light on revenue and EBITDA, Cable inline on revenue and light on EBITDA, Film was light on revenue and inline on EBITDA, Networks was inline on revenue and better than expected on EBITDA, and Publishing was inline across the board.

Digging a little deeper, AOL had an 8% revenue decline with EBITDA up 3%. Subscription revenue fell 13% and the pace of subscriber loss did not change on a sequential basis. Networks costs fell significantly again and advertising grew by 21%, which together drove the slight EBITDA boost. While 21% ad revenue growth is pretty decent, it still shows significant market share loss relative to other major internet companies. The shift to promoting broadband subscribers announced last week acknowledges that AOL.com is going nowhere if it continues to rely on the dial-up subscriber base. Unfortunately, this shift is not guaranteed to be successful and will mean that 1H06 numbers at AOL will get even worse on the EBITDA line due to the costs of advertising and promotion for the broadband initiative. The bottom line is that 4Q05 and the 2006 guidance for AOL is worse than expected.

Cable was also a small concern in 4Q05. Revenue growth hit its target at up 13% based on strong subscriber metrics. However, margin contraction held the EBITDA gain to 11%. Additionally, if I understand correctly, programming expenses were understated in the quarter, rising just 6%. This suggests that other expenses were higher than expected. As with AOL, I find this troubling for the shares.

Film had big gains as expected with an 11% revenue gain translating into a 42% EBITDA gain. Both figures matched estimates. The EBITDA gain was driven by an easy comp related to the timing of home video sales and theatrical releases. Management did note that 2006 will face a tough comparison in this division.

Networks was the bright spot in the quarter with a 6% revenue gain turning into a 22% EBITDA gain. Obivously, cost controls were quite good. I either missed it or it was not asked but given a trend of rising programming expenses, I wonder about the big margin expansion. For the full year, Networks produced 11% EBITDA growth, which I think is more reflective of the growth rate to expect in 2006.

TWX gets a lot of attention but maybe we should all remember that in 2006, the company had revenue growth of 4% and EBITDA growth of 8%. In 2004, revenue growth was 6% and EBITDA growth was 11%. Now management is guiding for upper single digit EBITDA growth in 2006 most likely fueled by a mid-single digit gain in revenue. Looking at these growth rates, it is no wonder the stock has experienced such a dramatic multiple contraction over the past few years. TWX is a mature company. Further, each of its businesses face secular challenges to their growth rates.

Thus, while I still believe the shares are undervalued based on the fact that investors are overly discounting the secular challenges, particularly in Cable, I understand why the stock has gone nowhere. I am not that optimistic that the next few months will lead to significant price appreciation but I support a long position in the stock as I think the downside is limited by the share repurchase and depressed valuation, setting up a favorable risk-reward trade-ff, even if the upside is modest.

Posted by Steve Birenberg at February 2, 2006 12:01 PM in TWX