Is Time Warner Inc. Stock A Buy Heading Into Q1 Earnings

  • There are competitive risks to Time Warner Inc.'s current business model.
  • However, the diversified revenue and lack of dependence on advertising meaningfully offsets some of the downside.
  • Moreover, the management commentary suggests that revenue/earnings estimates by the sell side are at least attainable.

I'm initiating coverage on Time Warner Inc. (NYSE:TWX), the company that sits at the intersection of Hollywood and Media. There are a couple of concerns I have with cable network operators in general due to the proliferation of skinny cable bundles and declining Nielsen viewership metrics across all day parts within the younger age category. That being the case, Time Warner Inc. seems strongly positioned across HBO, Warner Brothers and cable channels like CNN, Cartoon Network, TBS and TNT (Turner Network Television).

What’s kind of troubling though is the lack of focused execution in OTT (over the top) distribution as they have enough content between Cartoon Network, TNT, Warner Brothers and HBO to make a viable competitor to other online-only platforms like Netflix and Amazon Instant Video.

4-22-16 TWC pic 1

The launch of HBO Now barely moved the needle on HBO segment revenues. The lack of meaningful adoption of HBO Now as a standalone (roughly 800,000 subscribers) is due to the film/content budgets of entrenched competition within OTT and lack of size to the content catalog.  HBO’s online subscription also competes with itself via separate distribution channels like cable bundles for that matter. However, there’s enough evidence to suggest that Time Warner’s business model will eventually transition to both live and non-linear via an application given the staple of quality content and incremental progress via a consumer rather than the wholesale model.

Even so, I believe investors would want to see faster progress down this avenue, as it’s become increasingly obvious that many within the younger generation are transitioning to online-only channels with ad-ecosystems that are nearing the scale of broadcast television, as Alphabet Inc's (NASDAQ:GOOG) YouTube alone is projected to generate $27.4 billion in annual revenue by FY’20 according to UBS estimates (roughly $15.125 billion will go to content creators). The revenue from the world’s largest video streaming application and the non-standard approach to sourced content creates challenges rather than opportunities for conventional TV franchises.

Sure, many could argue that Time Warner Inc. can throw its weight around by boosting the affiliate fees it generates from cable subscriptions, but what happens when the entire ecosystem gets disrupted due to the sheer scale of Alphabet, Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN)) combined? These three companies have demonstrated leadership in online video streaming and are unlikely to relinquish their control. As such, Time Warner, CBS and Walt-Disney frequently mention a wholesale content licensing model that can still transition into online streaming even if cord cutting accelerates.

But, my question is whether that’s even viable given the expansive ecosystems of some of these larger mobile/desktop applications? Amazon has this nasty tendency of dumping billions into non-economical projects until they become profitable whereas Google pre-installs YouTube on 90% of mobile devices sold in the world. Meanwhile, Netflix has already penetrated into roughly 40% to 50% of all households in the United States and is on-track to sustain $20 billion+ in annual revenue by 2020 of which 70% will be dedicated to in-house content production or content licensing (roughly $14 billion/year).

Yes, Time Warner Inc. you have this all “figured out.” We just heard from Facebook recently that they have this unique way of replacing call center reps with some advanced AI chat technology, and now we’re wondering whether conventional cable can be disrupted via an online distribution model? Let’s get real here guys, technology has done a better job of emasculating prior industry incumbents than any other known force to mankind.

Let’s revisit the discussion of Amazon, it’s not that they’re unprofitable from retail. It’s just that they’re using all of the profits from its retail segment to invest into other opportunities like video, international retail and advanced logistical technologies. Amazon is projecting to increase its content licensing by $1 billion per year, which translates to $8 billion by the end of 2020.

When totaling the budgets of these three companies (by 2020), I’m anticipating roughly $37.25 billion in content spend by 2020. Of which Time Warner Inc. will be a part of, because they’re supplying content. But, it’s not yet clear if this co-existence comes without some disruption to their current business model, which explains why the company trades at a discount to the S&P 500 (PEG of 1.1 versus 4.1 for the S&P 500). Investors generally perceive the historical earnings growth rate to be less sustainable with much of the recent growth in earnings attributed to share repurchases via a debt-funded buyback and aggressive cost reductions. The company’s current operating margin of 27.82% (most recent quarter) is well above its historical five-year operating margin of 21.82%. There’s the risk that Time Warner won’t sustain this level of profitability given competitive risk factors, and non-existent sales growth for the past five years.

4-21-16 TWX pic 2Source: RBC Capital Markets

Time Warner Inc. has the lowest exposure to advertising, as roughly 16% is derived from advertising revenue. The vast majority of revenue comes from affiliate fees, movie ticketing sales and to a lesser extent subscription revenue via its online application. TWX also already generates revenue from content licensing to online platforms as well. That being the case, Time Warner Inc. is at least moving to de-risk the situation and has even announced reductions to advertising on its TNT channel in response to declining viewership. Therefore, the executives at TWX are moving to milk the last remnants of conventional cable/broadcast packages while also licensing content to industry dominants (Netflix and Amazon), and may even acquire Hulu.

Needless to say, I’m starting to view Time Warner Inc. as one of the best-looking houses on a bad street. I’d say Walt-Disney is another example of best in breed whereas I have reservations about some of its other peers due to the sheer dependence on TV-only in a world where time is being shared across multiple screens (PC, smartphone, tablet).

The full-year guidance of non-GAAP EPS of $5.35 to $5.40 is due to assumptions of 5% revenue growth combined with expectations of further accelerated cost reductions. Again, I’m caught being a little skeptical here. However, the analysts modeling these assumptions are relying on management commentary for 2016 outlook. The investor base could be caught off guard by a revenue miss, but the management team reassured investors that their revenue model is based on multi-year agreements (so revenue might be predictable).

The company is expected to report $1.29 non-GAAP EPS and $7.3 billion revenue in Q1’16. I believe estimates are beatable but have a hard time imagining the valuation expanding despite healthy growth rates due to competitive/business risk factors.

I’m initiating coverage with a buy recommendation and $87.9 price target (16.4x earnings).

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