By the end of the year, Time Warner Cable (TWC) will be a stand alone entity after being spun off from Time Warner Inc. (NYSE:TWX). TWC is a publicly traded company, and as it currently stands, 84% owned by its parent, Time Warner Inc. The carve-out occurred early in 2007, trading between $36-43, but has plummeted down into the $20’s since.
I’m still in the early stages of looking at the mechanics of this transaction, and the businesses involved. While I can’t say I have am loaded with knowledge about the cable industry, I’ve been learning about it recently, due to the fact I now own Echostar Communications Corp (NASDAQ:SATS), the satellite and set-top box business spun off from from DISH Network (NASDAQ:DISH) on Jan. 1 of this year. One basic mental filter I always utilize before moving forward is “Can understand this with a little work?” In the case of Time Warner, I think I can.
What has drawn me closer so far? Number one is that spinoffs, in general, are an alluring draw for those of us trying to find mispricing. As a group they tend to be overlooked and oversold by major institutions. I hope you’ve all read You Can be a Stock Market Genius! by Joel Greenblatt, and if you haven’t, well you should. (Click the link in the sidebar)
While the profile of spinoffs has been raised over the years, and the “cat is out of the bag” as to their attractiveness, they remain a compelling class of investment. Take, for example, Freescale Semiconductor (NYSE:FSL). Spun off from Motorola in 2004 at a time of weakness for technology stocks, FSL was initially viewed as a pretty ugly investment by the institutions. I mean no one wanted to own Freescale.
The result: FSL was bought at the end of 2006 by private equity for $40/share. What was that about ugly?
The mechanics that make spinoffs attractive are well laid out by Mr. Greenblatt in his book, but the major point is this: spinoffs are subject to irrational selling pressures due to institutional constraints. What the heck does a major Motorola holder want with some semiconductor company? Forced selling, combined with absent buying from major institutions, can create bargain opportunites for entrepreneurially minded investors.
For this exact reason, Time Warner Cable could be a compelling opportunity. Not only is it a spinoff, but TWC is going to be loaded with the unwanted debt of its parent, TWX. It looks like TWX is going to effect this through a special dividend prior to the spin. Similar to the “special dividend” an upcoming IPO will often pay to its private equity sponsors, TWC will pay ~$10.0B to its shareholders before the spinoff. As its major holder, TWX will reap 84% of that dividend, using the proceeds to pay down its debt.
TWX, which now has $35B in net debt, will only retain $12.3B after the spinoff. TWC, with $13.3B currently in net debt, will see that load double to $24.2B.
Leverage = Bad?
Por lo general, I stay away from highly leveraged institutions almost exclusively. While debt can provide incentives to ‘drive carefully,’ as we’ve seen with the success of many LBO firms, massive leverage is often akin to driving with a knife built into the steering wheel. Sure, you’ll drive carefully, but watch out if you hit a bump in the road. (thanks to Warren for the analogy).
In the case of TWC, this leverage could be beneficial for two reasons:
1. Institutions will, and already have, championed the move as a panacea for TWX, the parent. Here’s an example:
“Everyone was happy about the separation of cable, allowing Time Warner to focus on its core businesses,” says a significant institutional shareholder who requested anonymity. As a result, “Time Warner will have a ton of liquidity. It could buy back a third of its stock, and that option is attractive at this price. I would encourage them to consider that.”
That quote, from a Deutsche Bank analyst in this weeks Barron’s, is a thought that will pervade institutional thinking as they spin off TWX. While not incorrect, my hope is that the above thinking will cause institutions to lose sight of, or better yet disdain, the leveraged TWC spinoff.
2. Small improvements in pre-tax cash flow will allow TWC to rapidly de-leverage, making the company less risky in due course. This will have a few effects. One, as TWC brings down the debt load, annual free cash flow will increase by an amount corresponding to the decrease in annual interest expense. Two, investors will raise the amount they are willing to pay for that cash as TWC goes from “unwanted leveraged spinoff” to “stable cash generating cable company.”
What’s the debt load going to look like, relative to earnings and equity? Well, according to some pro-forma statements TWC has released, the $24B in debt will be about 4x ‘08 EBITDA. Checking with their 10-K from last year, and their expected 8-10% EBITDA growth for this year, the number checks out. The debt will be approximately 60% of their total capitalization. Those are big debt numbers, but not “2006 LBO” big. They are managable.
If there is one thing that good cable companies enjoy, it’s stable cash flows. Due to those recurring cash flows, I’m willing to look at a company like TWC, one who carries leverage at those levels. One thing I’ve yet to determine, in the course of my research, is just how well the interest is covered, and how fast TWC could bring it down. With a massive subscriber base, the checks roll in month after month. However, if this subscriber base, and thus their cash flow, is in danger of deterioration, caution is the order of the day. This is something I’ll take time to examine in the coming months.
So, we’ve got a spinoff that may not be wanted by institutions, with leverage, stable cash flows, and a viable franchise. These are all characteristics of a potentially bargain security. What to do now? Well, basically nothing. The transaction has at least another 5-6 months for it will close. Between now and then, we will see more SEC documentation released, news coverage, and analyst reports from various brokerage firms. The hope is that the filings look good, the news coverage skeptical, and the analysts screaming “Sell.” In the meantime, a little reading about the media industry, TWX, TWC, and their competitors, is in order to judge the opportunity. It may well turn out that the institutions are comfortable owning TWC, or that TWX ends up being the better investment. My opinion on TWC is merely a preliminary hypothesis. Lastly, the motivations and actions of relevant insiders, like CEO Jeff Bewkes, is yet to be determined.
Some documents to consider at this point:
Barron’s Article (subscription required)
If anyone has more information or thoughts on the transaction between now and the time of the spinoff, feel free to send us an e-mail.