By The Valuentum Team
Time Warner's (NYSE:TWX) collection of content is hard to rival. Its lineup of Warner Bros (The Big Bang Theory, The Voice), HBO, and Turner (TNT, TBS) makes it an entertainment powerhouse--its release of Batman v Superman: Dawn of Justice and the biggest original program in HBO's history, Game of Thrones are two other prime content examples. In fact, its content was once the focus of acquisition rumors involving Apple (NYSE:AAPL). Such speculation may not come to fruition, but we think the idea of such potential speaks to an advantage Time Warner holds in content creation.
However, navigating the ever-changing US television industry will not be an easy task for any cable network or pay-TV service operator such as Time Warner. Consumers continue to change how, when, and where they prefer to view video content, and Amazon Prime (NASDAQ:AMZN), Hulu, and Netflix (NASDAQ:NFLX) continue to capture the cord-cutting trend. We aren't particularly fond of the amount of debt on Time Warner's balance sheet, net debt was more than $22.1 billion as of the end of the first quarter of 2016, and would like to see more effort from management in deleveraging.
Management at Time Warner continues to place working to increase the amount of cash it returns to shareholders--buybacks will be ongoing and 2016 marks the seventh consecutive year of a double-digit dividend increase--ahead of more rapid deleveraging of its balance sheet. We're not convinced of the safety of the firm's payout, it registered a Dividend Cushion ratio of 0.5 at last update, and its yield (~2.1%) is not appealing enough to entice us to take on such risk.
Time Warner's Investment Considerations
• Time Warner has businesses in television networks, film and TV entertainment and publishing. It owns Turner Broadcasting, and its premium pay television services consist of the multi-channel HBO and Cinemax premium pay television services. The company was founded in 1985 and is headquartered in New York, New York.
• Key contributors to the firm's success are its strong brands and continued investments in high-quality popular programming. Its networks consist of TBS, TNT, Cartoon Network, truTV, and Turner Classic Movies--a solid portfolio.
• The company's operations continue to perform well. Adjusted revenues are expanding nicely, and so is adjusted operating income. Warner Bros has benefited from the LEGO Movie franchise and HBO from Game of Thrones. 2015 marked the 14th consecutive year HBO received the most Primetime Emmy Awards of any network; Game of Thrones took home 12 awards, a record for a series in a single year.
• Though free cash flow generation improved in 2015, the company's large net debt position also increased. Share repurchases, dividends, investments, and acquisitions all contributed to the firm spending more cash than it was able to generate, something we are not fond of.
• Time Warner continues to emphasize investment in its geographical expansion. Warner Bros. is the firm's most popular international segment. Expansion of HBO in Latin America in 2016 should help in this growth area as well.
Economic Profit Analysis
In our opinion, the best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital.
The gap or difference between ROIC and WACC is called the firm's economic profit spread. Time Warner's 3-year historical return on invested capital (without goodwill) is 90.3%, which is above the estimate of its cost of capital of 9.2%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT.
In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Time Warner's free cash flow margin has averaged about 10.8% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG.
The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At Time Warner, cash flow from operations increased about 17% from levels registered two years ago, while capital expenditures fell about 30% over the same time period.
We think Time Warner is worth $81 per share with a fair value range of $65-$97.
The margin of safety around our fair value estimate is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of them. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of 4.2% during the next five years, a pace that is higher than the firm's 3- year historical compound annual growth rate of -0.7%.
Our model reflects a 5-year projected average operating margin of 25.9%, which is above Time Warner's trailing 3- year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For Time Warner, we use a 9.2% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $81 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values.
Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for Time Warner. We think the firm is attractive below $65 per share (the green line), but quite expensive above $97 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate Time Warner's fair value at this point in time to be about $81 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of Time Warner's expected equity value per share over the next three years, assuming our long-term projections prove accurate.
The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change.
The expected fair value of $104 per share in Year 3 represents our existing fair value per share of $81 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.