Shares of Time Warner Inc (NYSE:TWX) have fallen sharply since Rupert Murdoch controlled 21st Century Fox (NASDAQ:FOXA) said it was dropping its plans to acquire TWX. After having turned down an offer which would resulted in a significant premium for TWX shareholders, Jeff Bewkes needs to do something to boost returns for TWX shareholders. I believe TWX needs to act soon because an activist could begin to accumulate TWX shares and push for a deal with Fox. In my view, the best way for TWX to boost shareholder returns is to spinoff HBO.
HBO Could Sell Directly To Consumers
Under current agreements, consumers can only gain access to HBO if they have cable. Due to this arrangement, HBO is not able to sell directly to consumers. This is a major difference between HBO and Netflix (NASDAQ:NFLX). HBO is sometimes cited as a reason why many people continue to keep their cable subscriptions even as services such as Netflix and Amazon Prime continue to provide increasing amounts of content. Recently, some cable providers have started offering extremely limited cable plans which still include HBO. Perhaps the most important catalyst behind Netflix's surging stock price and user count over the past year has been the success of Netflix exclusive content such as House of Cards and Orange Is The New Black. HBO's strength is the quality of its content and thus I believe the company would be able to operate a similar business model to Netflix.
HBO Would Become A Takeover Target
A freestanding HBO would likely be a takeover target. Potential companies that would I believe might interested in buying HBO include Amazon (NASDAQ:AMZN), Google, Apple, Facebook, and Netflix. Of these, Amazon and Netflix seem to be the most likely interested parties. HBO recently agreed to a distribution deal with Amazon Prime. While this deal is a positive for both Amazon and HBO, exclusive rights to HBO content would be major game-changer for Amazon Prime. A deal between HBO and Netflix would, in my view, make the most sense. Netflix could use its extremely highly valued stock as a currency to acquire HBO. A combined HBO/Netflix offering would offer so much to consumers in the way of exclusive content that the combined company would have significantly more pricing power than each company currently has on its own.
HBO Spinoff Would Create Significant Value
HBO reported an operating profit of $1.7 billion for 2013. Comparably, Netflix reported net income of $112.4 million. Netflix currently has a market cap of $26.8 billion and trades at 67 times forward earnings. Based on this valuation, HBO would be worth significantly more than TWX as a whole is currently worth. While Netflix is growing at a much fast rate than HBO, 21% vs 4%, I believe HBO is currently being undervalued. To unlock value, TWX should spinoff HBO so that the company can adopt a business model more similar to Netflix. I firmly believe that, as an independent company, HBO would command a significantly higher valuation than it currently commands buried within the media conglomerate TWX.
Given TWX management's recent decision to turn down Rupert Murdoch's bid, and the sequent decline in TWX shares, the pressure is now on TWX to do something big. I believe TWX should announce plans to spinoff HBO into its own company. By becoming an independent company, I believe HBO would likely evolve into a Netflix type product and command a significant valuation. The simple decision to spinoff HBO could vindicate TWX management's view that Murdoch's bid significantly undervalued TWX. While I continue to believe that Murdoch and Fox could come back to the negotiating table, TWX is a buy based on its own fundamentals. In particular, I believe the market is overlooking the potential value that could be created by spinning off HBO into its own company.
Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in TWX over the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.