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Time Warner Inc. (NYSE:TWX)

Q3 2009 Earnings Call

November 4, 2009 10:30 am ET

Executives

Doug Shapiro – Senior Vice President, Investor Relations

Jeffrey L. Bewkes – Chief Executive Officer

John K. Martin – Chief Financial Officer

Analysts

Spencer Wang – Credit Suisse

Benjamin Swinburne – Morgan Stanley

Michael Nathanson – Sanford Bernstein

Jessica Reif-Cohen – Band of America Merrill Lynch

Richard Greenfield – Pali Research

Michael Morris – UBS

Douglas Mitchelson – Deutsche Bank Securities

Anthony Diclemente – Barclays Capital

Operator

Welcome to the Time Warner Third Quarter 2009 Earnings Call. (Operator instructions.) I will now turn the call over to Doug Shapiro, Senior Vice President of Investor Relations.

Doug Shapiro

This morning we issued two press releases, one detailing our results for the quarter, the other updating our 2009 business outlook. Before we begin, there are two items I need to talk about. Results refer to certain non-GAAP financial measures. Reconciliations of these historical non-GAAP measures to the most direct and comparable GAAP measures are included in our earnings release and trending schedules.

These schedules are available at our Website at timewarner.com/investors. Reconciliations of our expected future financial performance are also included in the business outlook release available on site. Second, today's announcement includes certain forward-looking statements, which are based on management's current expectations.

Actual results may differ materially from those expressed or implied through these statements due to various factors. These factors are discussed in detail in Time Warner's SEC filings. Time Warner is under no obligation and, in fact expressly disclaims any obligation to update or alter its forward-looking statements, whether as a result of new information, future events or otherwise. With that, I will turn it over to Jeff.

Jeffrey L. Bewkes

As you read this morning, we have good news for you today. We are executing very well in spite of the tough environment. We're raising our guidance and we're on track to complete the AOL spin this year. We're making a lot of progress toward our longer term strategic priorities. So I'm increasingly confident that we are well positioned to deliver steady, attractive stockholder returns in 2010 and beyond that. Our third quarter results were better than expected.

In spite of the advertising climate and difficult comparisons in film and networks versus last year's high performance, adjusted OIBDA for our content groups held flat in the quarter and is now about 2% year-to-date. This strong performance was broad-based, coming from HBO, Turner and Warner Brothers.

As you saw this morning in our business outlook these results gave us the confidence to raise our full-year outlook for 2009. We now expect adjusted earnings per share of at least $2.05. This even includes as much as $100 million or about $0.05 per share in new restructuring charges at Time Inc. that we announced today. I'll tell you more about that in a minute.

For the first time we've also provided an outlook for just our Content Group, adjusted earnings per share of at least $1.75. That's up around 25% on a reported basis versus last year and it's at least a mid-single digits increase, if you take out a big legal reserve we had at the end of last year.

We provided guidance this way because we are confident that we will complete the AOL spin this year. This separation is an important milestone for both companies. It will enable both AOL and Time Warner to focus even more on our core business moving each of us toward our ultimate goal of improving our return on capital.

Looking forward, we'll stay focused on increasing returns in two ways, growing our profits and allocating our capital for the best risk-adjusted returns. To boost profit growth, we're focused on the key operating priorities that I talked about before.

First, continue to leverage our scale, our brands to deliver high-quality content consistently; second, to keep improving efficiency of our operations; third, expand internationally, and, fourth, continue to drive the development of business models to capitalize on changes in consumer usage and technology.

We're making progress on each of these objectives every quarter. Let me start with our great content. I've talked before about our firm belief that hits are growing in value, even as consumption keeps [inaudible]. I've also told you that we think it is possible to institutionalize success in a hit driven business. We do that by capitalizing on a virtual cycle of scale, distribution, brands and creative and managerial talent.

One of the best examples is Warner Brothers who's consistency and return profile may not be fully appreciated may not be fully appreciated. Warner is having another fantastic year. It is currently ranked number one at the box office. Harry Potter and the Half-Blood Prince and the Hangover are two of the four highest grossing films domestically in 2009.

Even recent releases like Where the Wild Things Are, Final Destination and The Informant have all exceeded expectations and we're very excited about upcoming films, particularly Sherlock Holmes and Clint Eastwood's In Vegas coming out before the end of the year.

Now although we're releasing fewer movies this year, we're on track to match or exceed last year's domestic box office gross of almost $1.9 trillion. Our TV production business has also had a great year with 12 new shows ordered by the networks and 14 returning shows. That makes us the leading provider of broadcast TV programming this season.

Two and a Half Men and Big Bang Theory are now in the top two comedies on the networks' schedules and in light of the scarcity of comedies they are two of the most valuable shows on television. These results aren't just grid-lock. This year will mark the eighth time in the last nine years that our studios have led the domestic box office.

We've had the number one share of the home video business every one of those nine years and, worldwide, we've produced 8 of the top 15 grossing films ever, while no other studio has produced more than two.

And we have more of the top running franchises than anybody. In TV this year we'll mark the 18th time out of the past 23 years that we've been the top producer of broadcast network programming and all this without owning a major broadcast network.

Sometimes this track record is overlooked because there's a perception that film is inherently the lower term or volatile business. That's certainly not true and hasn't been true for Warner Brothers. I can tell you that Warner Brothers' return is well above its costs in capital, excluding the asset write-off sides of the AOL Time Warner merger.

Just as a glimpse, Warner's level of profit consistently surpasses its peers by far. This year will mark the ninth straight year it has generated in excess of $1 billion in annual adjusted OIBDA with a very high cash flow from [inaudible].

In fact despite the softness in home video overall this year, Warner's on pace to report its highest profits ever this year. Based on the unparalleled track record of our studio under Barry Meyer and Alan Horn, we have every expectation that Warner will continue to lead the industry in the next years coming up.

The second priority I mentioned is improving the efficiency of our business. As you know, that's been a focus of ours since I took over as CEO last year. Many companies have reduced costs during the down time raising questions about how fast expenses will grow as the economy rebounds.

We set out to reduce our expenses structurally before the economy faltered, so we intend to keep our fixed cost base down even when the economy improves. We're continually looking for opportunities to make ourselves more efficient.

As I mentioned a few moments ago, we expect to incur as much as $100 million in restructuring charges at Time Inc. in the fourth quarter. Last year we undertook a broad-based reorganization at Time Inc. to centralize our domestic magazines into three clusters.

The restructuring we're announcing today is much more targeted, most of it occurring in our news group. We believe that much of the downturn in magazine ad revenue has been cyclical. Readership is still strong. In the United States, 85% of adults read magazines. That's unchanged over the past decade.

In fact, readership in the 18 to 34 demo is actually growing. Magazines still offer advertisers unparalleled reach and relevance. Every week more consumers read People than watch the American Idol finality and more people read Sports Illustrated than watch the World Series.

At the same time, however, consumers are changing the way they access news, sports and business information. They want immediacy, but our research shows they also face increasing value on the depth of analysis, so besides reducing costs there are a number of things we're trying to achieve through this restructuring.

We're aiming to increase consumer utility and at the same time the financial sustainability of some of our key brands. For instance we're reducing the frequency of Fortune Magazine, while investing more in the quality of each issue and focusing our reporting even more on the largest and most important companies. We'll also promote much greater sharing of editorial and management resources across the newsroom and that will both improve efficiency and enable a more fluid allocation of resources to the biggest and most topical issues.

And as we have done, we'll continue to take a hard look at non-strategic and less profitable types. We expect the restructuring will pay for itself in expense savings starting next year. I would also like to touch on the last priority I listed, developing new business models that capitalize on changes in technology and consumption.

I think that one our most important jobs is to make sure, wherever possible, that new business models are additive and not cannibalistic. One example is our support of TV Everywhere, which is progressing really quite rapidly. We have several trials underway with major distributors and several more pending with commercial launches expected soon.

Many other programmers have also signed distribution agreements and many are involved in all of these tests. All of us are working with several third parties to develop open authentication systems that could be used by any distributor and by any program.

We've always made tremendous progress toward a single sign-on for consumers that would enable consumers to move between multiple unaffiliated Web sites without reregistering, making TV Everywhere a completely seamless user experience. An analogous example is the way we're approaching e-readers in the publishing business where we've also been working hard to help flush these [out of the bottle].

We view the emergence of e-readers as a critical opportunity for magazines to migrate their dual revenue stream models to a digital environment. There's no question about consumer willingness to buy quality content on their IPod or on their Kindle.

With the coming wave of new devices with new features, we think that will only increase. On the advertising side, a large screen color device with new functionality including support for video would provide an even richer consumer experience and a compelling advertising [device].

At the top of the call I talked about two ways that we intend to drive returns, profit growth and capital allocation. Before I turn it over to John I'll remind you of how we think about our capital. Our first priority is always to make sure that we've taken advantage from all internal investment opportunities, which usually offers us the best returns.

We already do that to date, but we still generate significant free-cash flow. And after that we look to allocate our excess capacity towards turning capital to shareholders - and where appropriate through acquisitions. As you know we currently pay a meaningful dividend.

We intend to maintain this same dividend after the AOL separation and we would like to grow it over time in line with underlying business trends. I also view a steady consistent stock buyback as an important compliment to the dividend. As you saw this morning, since we resumed our buyback in May we repurchased almost $1 billion worth of stock.

We will also continue to evaluate potential acquisitions against the three hurdles we discussed before. First, strategic value, second, execution risk, and third, any deal must offer an appropriate risk adjust return relative to alternative pieces of capital including buying back our stock. At Time Warner we know that capital allocation decisions are just as important as operating performance and driving returns.

We take this responsibility very seriously. Our goal is to consistently produce earnings per share growth that exceeds our operating income growth, which should in turn exceed our revenue growth. That will require both strong operating performance and careful stewardship of the balance sheet.

Previous approach coupled with our ongoing dividend, we're committed to delivering consistent and superior returns to our shareholders over the long-term and with that, I'll pass it over to John.

Doug Shapiro

This is Doug; actually it's come to our attention that there are some sound problems on the call. If you can bear with us we're going actually try dialing back in, please stay on the line we'll be back to you very shortly.

[Break in audio]

Jeffrey L. Bewkes

This is Jeff, apparently the sound coming out of the telephone company was fairly garbled and I hope that we're sounding all right to you now. If you would – anybody who hears distortion in the line please email as you did before. We apologize on behalf of the carrier and I won't repeat all of my remarks for your benefit and I'll pass it to John Martin.

John K. Martin

As usual there are slides that are now available on our website to help you follow along with my remarks. The first slide contains several financial highlights. Coming into the year we had several goals that we wanted to accomplish in the face of a difficult economic environment.

First, to deliver strong relative financial performance by focusing on our operations, second to complete the spin of Time Warner Cable and third to maintain a strong balance sheet while both investing fully in our businesses and increasing returns to shareholders.

With only two months to go in the year we are on track to deliver on or exceed each of these goals. Through the third quarter, our content group's adjusted OIBDA is up 2% despite an over $500 million drop in advertising revenue. As Jeff mentioned, this performance has allowed us to raise our full year outlook.

From a structural standpoint, we're not only completed the separation of Time Warner Cable in March, but we're also on track to spin out AOL by the end of this year. So as you might imagine it's been a very busy year and our strong free cash flow generation has left our balance sheet in terrific shape.

Our leverage ratio was below two times despite increasing investment in our businesses and providing a higher direct return to shareholders. We're currently on track to return about $2 billion this year through both dividends and share repurchases.

Moving over to the next slide which shows our consolidated third quarter financial highlights, just a couple of things to point out here. We knew coming in to the third quarter that our year-over-year comparisons were going to be very difficult.

And while this quarter was our most challenging of the year, results were actually quite a bit better than we had anticipated. And we saw upside come from the strong performance of our film slate and improved advertising environment and continued focus on cost.

Revenues declined 6% which reflected a 12% decline in advertising. Note that more than half of the total revenue decline was a result of the continued drop in AOL subscription revenue and the negative impact of FX.

Advertising revenue declines actually improved somewhat sequentially and our content group revenues were down only 3%, that's the smallest decline so far this year. Adjusted OIBDA was down and that was primarily due to continued challenges at AOL, and our publishing division, as well as in almost 700 basis point drag related to pension, FX, and restructuring charges. As I mentioned earlier, content group adjusted OIBDA was down 1% for the quarter but up 2% year-to-date.

Notwithstanding revenue declines and the impact of unfavorable FX and higher pension expenses, consolidated margins were relatively flat compared to last year as we continue to focus on cost management across the company. Our content group margins were up again in the quarter as a result of margin expansion at each of our film and networks divisions. And lastly on this slide, our adjusted EPS was $0.61 in the quarter and we've now generated $1.51 year-to-date through September.

Let me move briefly on to each of our divisions and I'll begin at our networks. Advertising revenues were almost flat to the year ago quarter. Domestic entertainment networks posted another quarter of low single-digit growth but this was more than offset by continued softness at our international networks including the impact of unfavorable FX and the difficult comparisons at our domestic news operations. Please recall that our domestic news ad revenue was up 19% in the third quarter of last year.

Subscription revenue growth reflected the consolidation of HBO Latin America had higher affiliate fees at each of Turner and HBO. Unfavorable FX remained a drag in the quarter. The decline in content revenues this quarter was largely a result of lower ancillary sales of HBO's original programming. Last year included the sale of the final season of the Sopranos into syndication and this revenue decline was offset in part by the effective lower than anticipated home video returns of roughly $25 million.

Looking beyond 2009, we're optimistic that HBO's slate of original programming will again boost content sales. In addition to higher revenues, adjusted OIBDA of $1.1 billion benefited from lower marketing and news gathering costs and the consolidation of HBO Latin America. As expected, year-over-year margin expansion was more modest this quarter as compared to what we experienced in the first half of the year, and that was a result of higher programming expenses at Turner, which reflected the timing of our original programming launches in the summer. So that was planned for.

Other cost declines offset the higher programming expenses and through the third quarter our networks adjusted OIBDA is up 11% with 200 basis points of margin expansion. Scatter is pacing very well with pricing solidly up double digits above upfront levels right now. However, we expect advertising revenue to decline in the fourth quarter and that will be due to the lower upfront pricing even more difficult comparisons at our CNN division against lat year's U.S. presidential election and to a much lesser degree recent entertainment ratings trends.

Turning to our film group. As Jeff described, Warner Brothers is having another standout outstanding year. Going into this quarter we fully expected our films adjusted OIBDA to be down year-over-year and that's due to at least three things. The first is in games tough comparisons where we had two highly successful Lego branded releases last year. Second, a continuing softness in the home video environment. And third, the negative impact of FX as Warner Brothers is our most international division.

However, the film slate performed quite a bit better than what we had expected resulting in film actually posting a small 1% OIBDA growth rate in the quarter. Expenses also continue to run favorable to a year ago. In fact, excluding restructuring charges of $85 million this year and $130 million in 2008, margins have expanded by over 150 basis points year-over-year through the third quarter at our film division.

We also continue to expect very strong results in the upcoming fourth quarter as our successful summer films, Harry Potter and The Hangover will be released on home video. We also have promising theatrical releases in the quarter, including Sherlock Holmes and Invictus.

Moving over to publishing. Difficult advertising conditions continue with this division with ad revenues down 22% in the third quarter. That was an improvement, however, versus earlier quarters in the year and we expect that the fourth quarter will show even more improvement. Bookings have been generally improving. In fact, based on current bookings food, auto and beauty categories are now pacing to show year-over-year increases in the fourth quarter, and that is very encouraging.

Subscription trends also continue to improve relative to the first half of this year. About a third of the subscription decline was driven by unfavorable FX with the rest a result of lower domestic newsstand sales and the lingering impact of lower renewals during the height of the credit crisis. Similar to last quarter, renewal rates have improved from the lower rates experienced at the height of the credit crisis.

Management is also continuing to focus on costs here but the magnitude of the revenue declines pushed margins lower in the quarter. Looking ahead to the fourth quarter, we expect to see additional improvements in the pace of revenue declines due to easier comparisons and improving business fundamentals. Fourth quarter results will also reflect the charge of up to $100 million and that's tied to the restructuring initiatives that Jeff described a little earlier.

Moving over to AOL. We saw only a slight improvement in advertising trends in the quarter down 18%. That compares to a 20% decline in the first quarter and a 21% decrease in the second quarter. Looking at the components, AOL Media, which includes both display and page search, remain soft. Display declined less than the overall category with domestic advertising showing a sequential improvement relative to the second quarter.

We continue to see declines, however, in page search revenues from Google, which fell 24%. As has been the case in recent quarters, the decrease is primarily due to lower query volume and lower click through rates on the AOL client. Additionally, cost per click at certain properties continue to be adversely affected by algorithmic changes made by Google.

The biggest sequential improvement came from our third party network where year-over-year revenue declines improved substantially relative to the second quarter of this year and that was due to higher demand from brand advertisers.

Shifting to the rest of AOL's results. Subscription revenues continued to decline as AOL lost 438,000 subscribers in the third quarter. That's the lowest quarterly subscriber loss since the start of the transition to a free service back in 2006. Margins declined both year-over-year and sequentially as continued cost declines were not sufficient to offset revenue declines. AOL is currently weighing some additional restructuring plans but pending those steps it will be challenging to materially reduce its fixed cost base much further.

Even with meaningful additional restructurings, however, we expect AOL will face margin and earnings pressure for some time in light of projected declines and high margin subscription and search revenue. Year-to-date, AOL has incurred $83 million of restructuring costs and that includes $10 million in the third quarter. The next slide, which I'll just touch on briefly, shows our corporate expenses which were essentially flat year-over-year.

Let me turn now to our business outlook. As both Jeff and I previously mentioned this morning, we raised our 2009 adjusted EPS outlook to at least $2.05. and as Jeff described, our new outlook now takes into account anticipated restructuring charges of up to $100 million in publishing.

We're also providing a full year outlook for the content group and because of our expectation that AOL will be spun off before the end of the year and if we meet that goal, AOL will be reflected as a discontinued operations in our consolidated financial statements following the spin-off and will no longer be reflected in our adjusted EPS figures.

We expect content group adjusted EPS to be at least $1.75. that also includes the fourth quarter charge and that's off a base of $1.42 last year. So that's up around 25% or at least mid single digits when you exclude 2008's legal reserve. This outlook obviously implies a significant increase in fourth quarter adjusted EPS relative to a year ago, but please recall that last year's fourth quarter it includes both the $271 million legal reserve, as well as $160 million of restructuring charges at publishing.

Moving on to free cash flow on the next slide which highlights the detail. Our cash generation remains quite strong and we delivered over $1 billion in free cash flow this quarter now above $3 billion year-to-date. Through the third quarter, our conversion ratio was over 60%. As expected, this is lower than last year's third quarter as a result of higher cash taxes and fluctuations in working capital.

Our cash taxes have increased due to the reduction in our NOLs and recall that our working capital benefited last year in part due to the writer's strike. You can also see from the slide that we're pacing favorable on CapEx and product development and we expect those trends to continue throughout the end of the year as well.

The next slide looks at our net debt. We ended the third quarter with $10.4 billion in net debt and that's about flat with the second quarter. That's because our free cash flow that I just discussed a little earlier was offset by our ongoing dividend, our share repurchase program and the repurchased of Google's 5% stake in AOL. And as I noted earlier, we are committed to maintaining a strong balance sheet while both fully investing in our businesses and increasing direct returns to shareholders.

Our strong free cash flow through September has allowed us to accomplish each of these goals. We've invested more in our businesses this year than last year, and as of today, we have returned around $1.6 billion to shareholders this year.

This includes both the dividend and nearly $1 billion in share repurchases. We ended the quarter with about $7 billion of cash on hand. However, as I've discussed before, we don't intend to operate at these types of cash levels over the longer term and in fact, we expect cash to decline by at least $2 billion this quarter, due to a debt maturity later this month.

And I'd also point out that we don't plan to shift debt over to AOL prior to the separation, so once we spin AOL, our leverage ratio should be around two times, and that's a little closer to our long-term target of about two and a half times.

Leverage will also move probably a little bit higher in the fourth quarter, as a result of our continued returns to shareholder through both dividends and share buybacks. So that concludes my proactive remarks, and as always, thanks for listening in and again, apologies for the audio difficulties. Let me turn it over to Doug and would be happy – Jeff and I'd b happy to answer your questions.

Doug Shapiro

If you could please when we go to the Q&A please try to hold yourself to one question so we can get to as many callers as possible.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Spencer Wang - Credit Suisse.

Spencer Wang – Credit Suisse

I just have one question on the Turner Cable Networks that comes in two parts. I think it was John, you mentioned that some of the entertainment ratings are a little soft. So maybe, Jeff, could you talk a little bit about what the plans are to address the issues and maybe what the issues are specifically? And then the second part is you indicated that scatter pricing is up double digits versus the upfront. Could you just share with us what scatter pricing is doing on a year-over-year basis? Thank you.

Jeffrey L. Bewkes

At Turner Entertainment Networks, we have seen some rating softness in September and October and we're not happy with it. But let me give you the context for it because both those networks are having a very successful time, generally, and Turner's having a great year.

Ratings can vary over short periods of time, and we think that September and October were anomalies. We had different, basically different programming. And it amounts to different comparisons last year, in the sense that the programming lineup that was on TBS, TNT had fewer premieres of original episodes in September and October than it had last year.

We ended up with three fewer major league baseball playoff games in 2009 versus 2008. We had fewer new series on the key comedy launches at TBS this year and we didn't have at TBS any network premiere movies in October, whereas we had two the prior year. Now there is – so those are essentially scheduling that we'll move around and some will show up in the current month.

On acquired programming, we're watching that carefully because sometimes it takes a while for new acquired shows to find an audience and some of our newer acquired shows haven't had as much of an out-of-the-gate burst as previous year launches have.

And in addition to that, we're making some changes and expect some improvements in this. TNT, for example, just acquired Southland from Warner Brothers. And that is a pretty big statement that TNT can air a critically acclaimed show that broadcast networks dropping audiences and economic structures can't any longer support.

Lopez Tonight, George Lopez is launching next week on TBS, and we think that is going to be quite a big change in late night. And Ray Romano's Men of a Certain Age is premiering in December. We are also making some scheduling changes for our acquired series in terms of when they air.

And the NBA season is starting strong. The 2009 and 10 NBA season began with its most-viewed opening night in the history. It was up in NBA. It was up about 40 to 45% from last year's opening night doubleheader.

So this kind of September-October ratings weakness would have an impact if it was a sustained trend, but we don't think that it is and whatever effect it will have, I don't think it's likely to be large and it won't be immediate.

On the question of scatter, I think what you're asking is how is the scatter this year versus the scatter last year? And basically, in the fourth quarter what we're seeing is scatter up mid-single digits over last year's. In fourth quarter scatter, we're seeing up mid-single digits over last year's up-fund.

And compared to last year's fourth quarter scatter is stronger, but it's offset a little bit, not much, by the fact that the upfront for everybody was down slightly from last year, so scatter-on-scatter, year-to-year is up somewhat.

Scatter versus upfront is up solidly as you heard from the [peers] that reported in the last few days, versus basically up in the double digits. So it is true the business is looking a little closer to air than usual, some visibility's limited, but we're seeing basically upward pressure.

Doug Shapiro

Yes, I just want to clarify one thing because I might have confused myself. But in terms of characterizing up versus not up, scatter versus upfront is up solidly. It was in my remarks, basically strong double digit and scatter versus scatter is also up.

Jeffrey L. Bewkes

Yes.

Doug Shapiro

But not as much.

Operator

Our next question comes from Ben Swinburne – Morgan Stanley.

Benjamin Swinburne – Morgan Stanley

Jeff, I wanted to ask you about the film segment, when you look at the two businesses there, Warner Brother's T.V., Warner Brother's Film, how you think about just sort of the secular growth of those two businesses? Obviously, the revenue mix in film is changing a bit as we go through changes in the home-video market.

And on the T.V. side, international syndication's been a big opportunity. How do you think about putting capital to work in those two somewhat different businesses? Do you think the cost structure in each are appropriate, and where are the bigger opportunities between the two, maybe bigger challenges?

Jeffrey L. Bewkes

On the long-term home-video outlook I think that home entertainment environment is stabilizing and will continue to next year. The retail environment's still challenging as little less shelf space that some of the big retailers are putting to DVDs and home video. But I think we're going to see the pressure on physical sell-through moderate a bit. We do expect continued growth in rental electronic sell-through, VOD and blu-ray. And we think that the net contribution ratios will increase, due to the higher margin digital elements of home video.

Staying on film, we've been seeing, which we were saying in our remarks, if you can hear mine through the tech difficulties. We've been seeing very strong and consistent performance, partly because of the really long-term advantage that Warner has built in having so many franchises, partly because we have streamlined the slate to fewer releases with big economics tied to them.

So on film, we basically are very optimistic about, in our case, unlike every other studio, very consistent performance of film slates year-to-year and we think that will continue. If you go over to television, we've got a production business growing very strong despite the challenges in some markets. It really is, if this answers your question, a high-profit business for us, and it's lower risk than film but you don't want to overproduce into what the envelope of bios, which has something to do with network T.V

And we all know that the business has changed a bit but gradually over the years as the broadcast networks look towards in-house programming. But that has worked out, and this is not new as an advantage for us, because we are the supplier of second choice to all four of the big networks.

And we increasingly have a buy pressure about demand coming from cable networks. Some of them are our own but not only our own. If you go to your, I think you asked a little bit about syndication and overseas. We've got a pretty healthy market for our network series production overseas.

And on the syndication business, we're fairly happy with what we've been able to do, to the extent that syndication, if it's true, it's not clear what will happen. If it goes kind of vertical to in-house supplies, we've got a pretty good position and it's not a huge part of our revenue business. So all in all, I would give you a summary on television that says we think we can continue to grow it and continue to produce fairly consistent earnings and cash flow.

John K. Martin

At the risk of making a longer answer slightly longer, I do just want to just add on from a capital deployment standpoint, we do think a lot about the absolute level of capital that we're committing to this business. And we feel like we are at or about the right range at this moment in time with the right split between theatrical and TV, and we're going to continue to focus on improving the returns in the studio business and it's going to not only come from top line growth, but by also managing the operational efficiency of the business.

So let me just give you one example. One of the reasons why Warner is having such a great year this year against the backdrop of a tough home entertainment environment is because they've done a phenomenal job this year of cutting out costs in their home entertainment division.

And if you just think about the initiatives that they've undertaken. They've cut SG&A double-digit percentage over a year ago level. They've cut marketing and improved the efficiency of marketing spend by even more as a percentage of total spend, and they don't feel like it's really impacted their sell-through units.

And they've taken a much more stringent approach to their shipment of good which has resulted in lower returns, which you've seen us make some slight adjustments to our returns reserve, all of which is a reflection of improved profitability against the business. And we got to continue to take that approach.

Operator

Your next question comes from Michael Nathanson – Sanford Bernstein.

Michael Nathanson – Sanford Bernstein

I have one for John and Jeff, you guys can choose it. I'm trying to figure kind of a core expense growth rates for your domestic Turner networks and domestic HBO, the first three quarters of the year. So what has been a kind of the core growth rate, let's say, for Turner and HBO separately, first three quarters of the years? And what's a sustainable rate into the future on an expense basis?

John K. Martin

I could take a crack at it; Jeff can fill in where I miss something, but the one thing, Michael, and I think this has been a consistent message with us all along which I that it's always we would caution against looking at particular quarters. And we're really managing the business over annual cycles. And so we had really favorable expense trends in the first half of this year, and a lot of it was tied to two things.

Number one was sports where we had lower amortization of sports costs this year versus they year ago first half of the year, and a lot of that fell in the second quarter. And then we also had a lot of our original and newly acquired programming airing and broadcasting in the third and fourth quarters of this year. So we would see a natural lift in programming costs more on the third and fourth quarter side.

I think generally speaking, though, if you think about just the way that we're trying to run the networks, and that's true for each of Turner as well as HBO over the longer term, is to try to have expense growth be contained at a percentage that's lower than revenue growth. I think we've been doing that. We're on track to do that again this year. We expect margin expansion at each of HBO and Turner and I would continue to expect to see that going forward in 2010 and beyond. Although, again, just we can be lumpy or volatile within year just in particular quarters, so hopefully that helps.

Jeffrey L. Bewkes

If you're asking whether margins will go up, they will.

Michael Nathanson – Sanford Bernstein

I guess the follow up would be would there be any more per end spend if you had to spend more on TNT or readdress your programming strategies? What would that necessarily mean a change in the programming spend into next year?

Jeffrey L. Bewkes

No, that's just a question of where we direct the allocation of essential a rough envelope of programming spending.

Operator

Your next question comes from Jessica Reif-Cohen – Bank of America Merrill Lynch.

Jessica Reif-Cohen – Bank of America Merrill Lynch

It looks like you recently expanded your cable network footprint in Japan as well as Central Europe. So can you help us think about your international expansion strategy in the cable networks and how large of an investment you intend to make over the next year or so. Which brands could see the most expansion? Do you intend to develop any new brands? And what parts of the world would most interest you?

Jeffrey L. Bewkes

We have been looking to grow internationally, but in a targeted way. We're essentially in general focused on either of the fast growing regions which would be if you're doing geographic, Latin America, Eastern Europe, India. Or the fastest growing sectors within even developed economies which essentially would, because those are slowing growing in the long run. And those sectors would essentially be some local production and TV networks.

If you look at what we've done and what you see in HBO's recent activities, we have been buying in our partner shares in HBO, which is number one wherever it operates and it operates across Latin America, Eastern Europe, and Asia, and we're now in a majority ownership position in all of those that would be one.

Two is we have worldwide launch and distribution of most of our big recognized networks, CNN, Cartoon, HBO, little more the Turner classic movies, less consistently TBS TNT and what we've been doing, CME being an example, is in targeted regions buying into those network companies that we think are ones that can be leaders in both broadcasting and multi-channel cable satellite broadband distribution.

CME is one of those, and we got in a position where we have a pretty good participation in the economics of it now and we believe we have a fairly good position if we were to acquire a larger stake in it or manage it in a more coordinated fashion with Warner, Turner, HBO, and other kinds of channels.

Last, I would say there's a fairly long established and increasing every year effort at Warner's to do local production of films. We're one of the larger producers, net negative cost plus distribution, of local language films in Europe, South America, and Asia. And we have now started unit for TV series and format production as well. So that is essentially the current scope of what we're doing internationally.

Operator

Your next question comes from Richard Greenfield – Pali Research.

Richard Greenfield – Pali Research

When you think about AOL, obviously John's comments were that they were pretty disappointing in terms of the lack of improvement and you're kind of running out of major cost cuts. And I'm just wondering, you seem very confident in continuing to move forward with the AOL spend. How do you think about the prospects for AOL post-spend given the environment? How should people be thinking about that entity as a separate entity given the difficulties the business is clearly having?

And then two, just a quick follow-up on the whole [inaudible] franchises. You've got the Sherlock Holmes, just curious what your long-term rights to Sherlock Holmes are if that is successful. I think you've got Happy Feet 2 coming in 2011. And do you have all rights to follow ups to The Hobbit if that work in 2011 as well? I just would love to get some color on kind of upcoming franchises that you might have.

Jeffrey L. Bewkes

On the franchise question, I think we have there's some complexities with The Hobbit in terms of whose got what. We have about half of it at this point. But everything else we have.

On your AOL question, basically AOL has a lot of scale and they've got some very successful consumer products inside the AOL experience. Essentially the new management has identified several opportunities where AOL has competitive advantages, and they're going to do a road show in the next couple of weeks which I think will provide everybody a lot more insight than I should give on this call.

Essentially they're focusing on core strengths in Web content, communications, and ad monetization, and the key areas are to expand their content properties, some of which really do have a lead position against all the competitors to pursue local content initiatives and mapping opportunities. They've got some fairly lead share communication offerings that they want to enhance. And as you know, they have a very strong and leading third party network for ad sales, which admittedly there are a lot of competitors in that now. But that's a significant platform on which to build.

So if you take that and add to it the cash flow from the subscription business and some of the fairly advantaged user habits that the subscribers to AOL have in terms of traffic use and monetization, they've got those building blocks on which to compete in the new company.

The only thing I would add, I think the first part of your question asked about our commitment to continuing to spit it out now, we remain fully committed to complete the spin because it's our firm view that AOL is going to be better off being on a separate footing as opposed to be being part of Time Warner. So there's nothing as it relates to the state of the business that it would be enhanced by virtue of continuing to remain part of Time Warner.

And one of the decisions that we made in terms of our initial balance sheet capital structure of AOL, basically sending it out debt free, is we want to make sure that AOL is in the best position to succeed and we want it to have more than adequate flexibility as it moves forward to be able to make the decisions that it needs to do. The right size, the cost structure of the business and continue to make the right investments going forward.

Operator

Your next question comes from Michael Morris – UBS.

Michael Morris – UBS

My question pertains to the relationship between Warner Bros. Television and the Turner Networks. Specifically, you spoke to moving Southland, which was on NBC over to Turner. The question is it seems like a logical progression for a show like Southland why hasn't it happened more in the past?

What will it take for Southland to work and can we expect more changes like this in the future? Are there some synergies between owning those two entities that can be taken more advantage of going forward? Thank you.

John K. Martin

Yes well first of all I agree with the idea of the question. I think the premise isn't right. We're the number one company right now and have been for awhile at buying and selling programming to ourselves. So it's not why it hasn't worked better, it's why haven't others done it as well as we have?

And that's essentially why we've got the number one position in program sales, to other people have worked and to our own. We buy about 25% of Turner programming coming from our own company Warner.

And Warner is selling about 25% of their sales out to Turner. Similar numbers for HBO and you can't really be number one as a consistently as we are in both the film side of Warner's and the series sales side of Warner's unless you are both selling to everybody that's in the buyer's market, meaning all the other networks and optimizing your sales to the leading network company which is us.

So I would just urge you because I keep saying it. I hope everybody kind of checks it and realizes that the number is substantiated, that you can't have which is why our competition doesn't have the kind of consistency and the high level of earnings unless you can do both, and so the most recent examples are Mentalist and Southland, huge hits from Warner's onto the broadcast networks and award critically acclaimed.

There are some very high profile examples of times like Sopranos when we made a decision to sale the program for a lot of money to another network. Not in other words having had it on HBO and not sold it to Turner which we could have, but we frankly thought that Turner could buy more appropriate programming for it and we could sale Sopranos for more money to A&E which is what we did.

So we, basically, will continue to optimize that and the good news for us is because we've got the leading basic networks and the leading pay networks we can be the advantaged buyer and so that when we sale to ourselves we'll do it and not have any kind of subsidy problems.

But as the leading seller we absolutely need to keep alive the other customer, which are the four broadcast networks and other cable other networks, because that's the only way between them and our own networks that we can keep the lead level of sales in both theatrical and TV.

Just to finish, because I hope you can tell I'm a little focused on this point and have been for more than five years. We basically have more franchises than any other company if you look at films and part of the reason is the way that we mix internal buying and external buying.

Operator

Your next question comes from Douglas Mitchelson – Deutsche Bank Securities.

Douglas Mitchelson – Deutsche Bank Securities

You just actually mentioned Jeff the need to keep your broadcast customers alive in a sort of interesting details and my question I am interested in your view as to whether the balance of negotiating leverage between Turner and HBO and their pay TV distributors is or might be shifting.

I ask that because the broadcast TV groups are dramatically expanding their retransmission consent, compensation, CBS started the process of course by asking for cash which FOX and soon ABC are going to be pushing that up to 75 cents a sublevel.

When I asked the cable and satellite companies how they are going to push through that, they all they're going to be much tougher on cable network rates, drop networks, pay lower prices or no price increases and so I'm wondering as that waves or it hits the beach how do you feel about your position with HBO and Turner?

Jeffrey L. Bewkes

I feel it's getting stronger. So we think the big must have, big reach networks will gain bargaining leverage in the coming years. I think some of what I think that you're asking if you're conveying what some of the distributor level companies are saying I would not agree with which is that there essentially and this is good and it's also the direction of public policy in Washington.

They are competing with evermore distribution choices. So Telco's, cable, satellite, broadband and all of those as they compete need the strong identifiable brands like CNN, HBO, TNT and so forth, so if you have the strong and lead brands in those categories with a lot of reach you're going to see the leverage go up.

If the issue that we're talking about here is whether an attempt long waited for by broadcasters to move to some retrans consent is going to be increasing rather than weakening competition for strong cable networks I would go with the cable networks not the broadcasters and I would just site the record low shares for broadcast networks which has stabbed down into the mid 20s.

Cable being at its highest level, broadcast now being at its lowest and as you know the economics of those things they are basically unable increasingly to finance and schedule compelling programs. So I think we have a very clear few on it and I would just finish by saying it may be possible for distributors, cable, satellite, Telco, to do some efficiencies in their program buying to weaker networks.

But I think what you'll see is a bigger separation between the strong branded networks which is what we have and some of the niche weaker ones that were frankly carried in the past by momentum, by their ownership, by the broadcast companies that were essentially porting retransmission from broadcast over to some associated co-owned cable network and I think that's what happened.

Douglas Mitchelson – Deutsche Bank Securities

Okay, let's follow that up with would you see HBO seeking fixed rate contract deals like Showtime and Starz have been doing?

Jeffrey L. Bewkes

No.

Operator

Your next question comes from Anthony Diclemente – Barclays Capital.

Anthony Diclemente – Barclays Capital

Jeff I just have one more broader industry question for you if I may. It sounds like there is an increasing concern out there that media measurement isn't keeping up with new technology for viewership of content both on TV and online. So maybe could just talk a little bit about what the concerns are in the industry exactly and what the goals are that you have for the new coalition that's been formed? Thank you.

Jeffrey L. Bewkes

Yes, I think the entire network industry simply wants to keep the measurement technology in practice, keep it up with the reality of consumers watching, first of all on demand so in delay and secondly across multiple devices, both of which things are not that easily or well measured by the old sample based viewing that Nielson has done.

Now Nielson knows all that and is trying to upgrade and modernize and improve their methods and I think everyone welcomes that. What the industry, the network and show producing industry wants to see is to have them move forward, which they are trying to do and to investigate any other methods, including census based methods that use either set top boxes or obviously broadband views of video are highly trackable just like everything on broadband is highly trackable, and you can do those things on more of a minute-to-minute interact of [inaudible] targeted basis.

So I think it's just a natural effort by the industry as consumption and platforms change to keep the measurement capabilities up to speed with what's happening in all these different methods of distribution and it obviously would strike everyone that if you simply had one entity doing that you're not likely to get as much innovation as if you have several doing it.

John K. Martin

All right, thank you very much for dialing in today and again I apologize for the audio problems at the beginning of the call. Take care.

Operator

Thank you that does conclude today's conference you may disconnect.

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Source: Time Warner Inc. Q3 2009 Earnings Call Transcript
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