By Michael Corty, CFA
Time Warner (TWX) is our favorite domestic media stock as a result of its strong competitive position in content creation as well as its cheap valuation; it currently is trading at just under 12 times our 2012 earnings per share estimate. And Time Warner is the least cyclical of our entertainment companies with only 22% of sales from advertising, so the stock is well suited for investors concerned about the macroeconomic environment or looking for dividends (current yield 2.8%).
Time Warner's collection of assets, including crown jewel HBO, is outstanding and we trust the management team to wisely manage the distribution of content and to continue returning capital to shareholders via buybacks and dividends. Time Warner is well positioned to take advantage of many of the emerging opportunities we see in the television industry and fits well into our overall media sector thesis that quality video content is king.
Still in a Position of Strength
We are bullish on content owners and the pay-TV ecosystem in general. Each of the vertically integrated television video content firms we cover--those that create and own video content as well as highly valuable cable and broadcast network platforms--benefits from high barriers to entry. The broadcast industry is consolidated in four networks (CBS, Fox, NBC, and ABC). There are hundreds of individual cable channels. We estimate that more than 85% of cable network sales (affiliate fees and advertising dollars) are owned by seven companies: Disney (DIS), News Corp. (NWS), Comcast/NBC Universal (CMCSK), Time Warner, Viacom (VIAB), Discovery (DISCA), and Scripps (SNI).
We recognize that the emerging changes in how consumers view content (laptops, tablets, smartphones, and so on) are leading some pundits to forecast severe harm for the pay-TV industry. We disagree. These additional ways to consume programming actually make quality content more valuable, as we predict a lot more competition among companies that make the hardware on which to consume content than among the companies that generate fresh programming on an annual basis.
Deep-pocketed companies like Apple (AAPL) and Google (GOOG) are often cited as significant threats to content-generating firms. Obviously, it can't be ruled out, but we think playing in the big leagues of quality video content is a huge stretch. We don't see the cycle of the best content flowing through established pay-TV ecosystem changing anytime soon, with the existing studios maintaining their competitive advantage even with some new entrants.
Keep Watch on Time Warner's TV Studio
The television side of the content studio, Warner Bros. Television Group, is often overlooked and under appreciated, especially as it becomes evident that owning quality content is becoming the most valuable part of pay television. This is especially true with the additional viewing options made available by Netflix (NFLX), Amazon (AMZN), and video on demand from traditional distributors. Time Warner does not specifically break out the operating profit between movies and television, but management has disclosed that over the last 10 years, television has averaged about 33% of sales and 50% of overall studio segment operating income. We expect the TV studio to generate average annual sales growth of 6% through 2016.
Warner Bros. has been the top provider of TV series for 21 of the last 26 years (and nine out of the last 10), even though Time Warner does not own a major broadcast network. Most of its programs are produced for nonaffiliated networks; this is different than the studios owned by CBS, Fox, ABC, and NBC, which focus almost exclusively on in-house production. Going back a decade, Time Warner had been perceived to have a disadvantage versus the Big Four studios. However, we believe this independence has turned into a competitive advantage for Warner Bros., which has positioned itself as each major broadcast network's second-favorite supplier. Heading into the 2012-13 television season, Warner Bros. has 25 broadcast network programs, with 16 returning and nine new shows.
We don't think it is an accident or luck that Warner Bros. TV consistently attracts the best creative talent. Top Hollywood writers and producers want to maximize the value of their output, which means access to all bidders. They want to place their shows on the network where they have the best chance of succeeding, that will give them the best prime-time slot, and will pay the most. Placing a show on the right network also affects its future economic life cycle, as a hit show that gets syndicated can generate cash flows for a decade (or in the case of Warner Bros.-owned Seinfeld and Friends, multiple decades).
Currently, The Big Bang Theory is an example of television content flowing through to other parts of the Time Warner empire. The hit program is currently running on CBS, entering its sixth season this fall. Warner Bros. Television Group sold the syndication rights to TBS and the show started running on the basic cable network last year with great ratings success. TBS’ syndicated programming had become stale, but The Big Bang Theory helped it become the number-one cable network for adults aged 18-49. We think a similar turnaround can occur at TNT by using the same formula; first-run syndication of The Mentalist started airing on TNT this summer.
The big-picture trend that should continue to serve as a tailwind for general entertainment cable channels like TBS and TNT is that prime-time viewing is gradually moving away from the Big Four broadcast networks to the cable networks, especially as cable networks invest more in original programming. So combined with its sports rights, which include the NCAA basketball tournament, we think Time Warner has pricing power when its new affiliate deals are struck in 2013 and 2014. We expect Time Warner's cable networks to increase revenue at a 5.6% compound annual rate for the next five years.
HBO: Time Warner's Crown Jewel
HBO is a great business (celebrating its 40th anniversary) with strong pricing power, thanks to its high-quality and differentiated programming. At the end of 2011, HBO had about 93 million worldwide subscribers, which consisted of approximately 39.5 million domestic premium pay subscribers (we estimate 28 million for HBO and 11.5 million for sister network Cinemax). We attribute the international growth to the high-quality programming that travels well, along with the expanding growth of pay TV in Latin America and Asia.
The company reports combined HBO and Cinemax subscribers and does not officially disclose HBO subscription numbers. However, we estimate HBO had about 29 million subscribers before the recession, and only losing 1 million over this period is the sign of a great business, given the high cost to the consumer. HBO is only available to pay-TV subscribers, so if we assume the cost of a basic digital tier package is $65 per month, then the average cost to an HBO subscriber is essentially $80 (with the additional $15 cost of HBO). Given the consumer headwinds, we believe it's impressive that HBO has maintained its pricing power. We estimate that HBO revenue has grown at roughly a mid-single-digit clip over the last few years based on stronger pricing.
HBO has done an outstanding job of investing in original programming for the last few decades, and it is now defined by award-winning dramatic and comedy series, which include current hits like True Blood, Boardwalk Empire, and Curb Your Enthusiasm, as well as movies, miniseries, boxing matches, sports news programs, comedy specials, family programming, and documentaries. HBO's ability to continuously generate hits is undeniable, as the second season of Game of Thrones averaged more than 11 million viewers, making it the third-most popular show ever on HBO, behind The Sopranos and True Blood.
We view HBO GO as a key differentiator. This service, which allows paying HBO subscribers to access the network’s vast library of original programming on the device of their choice (iPad, iPhone, iPod Touch, and Android phone), was available to approximately 80% of its domestic subscriber base at the end of 2011.
Movies and Magazines
Roughly 80% of Time Warner's operating profit comes from television; the other 20% comes from the movie side of the studio and the magazine publishing business. Our outlook for television is brighter than for movies and publishing, but we still view both businesses as strong cash generators that are facing some near-term headwinds, given changes in product distribution. The movie studio has a long history of generating hits and profits. Warner Bros.' feature film strategy focuses on offering a diverse slate of feature films each year while building and leveraging franchises, such as Batman, The Lord of the Rings, and most recently the Harry Potter series, which was one of the highest-grossing franchises ever. We don't know when the next hit will emerge, but we think there are two potential blockbuster firms arriving in the next six months that could ease investors' minds: The Dark Knight Rises will be released this week and The Hobbit, a prequel to the Lord of the Rings trilogy, is scheduled for December.
Time Inc. is the largest magazine publisher in the U.S. based on advertising revenue and it remains a solid cash generator. We won't argue with investors who point out that the publishing segment is the least exciting or the most at risk from digital distribution. However, we will argue with those who say Time Warner should exit the business immediately, as this is short-sighted and not as easy as it sounds. The publishing business is a small part of Time Warner but a huge player in the magazine industry, so there is not a ready buyer willing pay full value for the business. We think management is making its best efforts to maximize cash flows, which started several years ago with two major cost restructurings that permanently reduced the cost base by $300 million.
Time Warner Is Shareholder-Friendly
Simply put, we think the Time Warner management team gets it. Before taking the reins as CEO, Jeff Bewkes led the HBO unit in the days when the AOL Time Warner conglomerate continuously destroyed shareholder value through acquisitions. Bewkes is focused on building the content business organically and through small bolt-on acquisitions. Based on recent history since the split from Time Warner Cable (TWC) and Bewkes' public comments, the priority for free cash flow is to repurchase shares and gradually increase the dividend.