Time Warner's News Isn't All That Good

With a new management team, a fresh earnings report, a new strategic direction, and likely changes to the corporate asset base, Time Warner (TWX - commentary - Cramer's Take) is once again in the news. As a result, I thought I'd provide a closer look at the company.

My opinion is that the shares are modestly undervalued but lacking a catalyst to close the gap. Furthermore, I find the shares of peer companies Disney (DIS - commentary - Cramer's Take) and News Corp. (NWS - commentary - Cramer's Take) more attractive. For the same price, at DIS and NWS you get better assets, stronger and proven management, and much better operating momentum.

TWX is undervalued, and there is no reason that the new management team couldn't create a stronger asset base and improved operating momentum. In particular, the new focus on creative content and strict cost controls is a big step in the right direction -- the same direction that has worked so well for Disney in the last five years. Those are reasons you should pay close attention to TWX. But for now, you are better off with your large-cap media investments in DIS and NWS.

Valuation

Let's start by looking at comparative valuation:

As you can see from the table, TWX, DIS and NWS trade at roughly similar valuations. TWX's valuation is heavily influenced by its cable systems division (publicly traded Time Warner Cable (TWC - commentary - Cramer's Take)). TWC represents about 46% of TWX's projected 2008 EBITDA and will account for close to 60% of TWX's 2008 EBITDA growth.

Cable pulls down TWX's EBITDA valuation on the basis of current multiples for the cable industry that reflect slowing growth and worries about the competitive landscape and its impact on free cash flow. Cable also makes TWX's price-to-earnings ratio a bit overstated because of the high depreciation charges on the expensive cable plant that serve to reduce EPS via a noncash charge.

NWS' valuation has some similar discrepancies. In this case, NWS has many assets that are under-earning their potential or are in an early development stage. Current earnings growth is being driven by SkyItalia, MySpace and Fox News. Each of these businesses is moving to a new higher level of profitability more in line with peers following several years of below-average margins.

NWS earnings are also depressed (and P/E overstated) by new investments in what the company hopes will be the next generation of growth assets. These include Fox Business News, the Big Ten Network, TV stations in Central and Eastern Europe, a restructuring of the U.K. newspapers, and the Dow Jones acquisition.

Disney's earnings are not depressed by any unusual factors. In fact, on the basis of industry-leading and all-time high operating margins, you could make an argument that it as good as it gets at Disney. If there is any factor that is affecting Disney's valuation, it is that there is a low level of confidence in the earnings estimates due the higher economic sensitivity of the company due to its exposure to theme parks. Disney also deserves credit in its valuation for having the best and most consistent earnings growth over the last several years.

With that as background, let's take a closer look at TWX to understand why it is undervalued but unlikely to close the valuation gap in the near future. Here is the breakdown of TWX's EBITDA by segment:

The 2008 estimates are my own, but they closely parallel Street estimates and the guidance commentary provided by management yesterday when the company reported its fourth-quarter 2007 results.

Most investors understand that the key issues TWX faces surround its AOL and cable segments. AOL has yet to prove it has long-term growth potential, and recent and current trends in advertising suggest it may not be a valuable asset beyond the current level of visitors and pageviews it generates.

Cable is still growing, but the growth rate is decelerating due to the combination of increased competitive intensity with the telcos and satellite companies and the unexpected impact of a slowing economy on subscriber growth. Furthermore, these two factors are weakening confidence in the projected free cash flow.

Publishing is less discussed, but it is another problem business. Magazines face deep challenges from the Internet, and despite TWX's leading titles such as Time, People and Sports Illustrated, growth has been anemic for several years. Adding publishing to the list of troubled businesses pushes their EBITDA contribution up to 67%.

Given that TWX is facing issues with so much of its asset base, it is not surprising that much of the focus of investors is on a potential restructuring of the asset base. On the company's fourth-quarter 2007 conference call, CEO Jeffrey Bewkes said that his initial steps would include a split of AOL's access business from its advertising business and the possible complete separation of TWC from TWX.

An AOL split might be just the first step, as Bewkes said it is designed to increase flexibility toward strategic options for the entire AOL business. Analysts also asked questions about publishing, but beyond pruning and acquiring a few titles, it does not appear anything is going to happen with that segment.

With TWX likely to undertake some major restructuring, the final thing to consider is sum of the parts valuation. This is where I feel that TWX shares are undervalued. Here is my math:

I believe that the multiples I am using reasonable multiples. I am not providing a premium for theoretical private market value. Rather, I am using comparables from the public realm. On this basis, TWX shares have 32% upside. Looked at another way, TWX is trading at a 25% discount to a conservative measure of its sum-of-the-parts value.

I believe this puts analysis puts a floor under TWX shares very close to the current price. The floor is stronger if the cable business stops decelerating, and that's a real possibility thanks to initial signs that acquired systems in Dallas and Los Angeles are finally making progress.

However, TWX lacks operating momentum, and the initial round of restructuring actions has already been announced and digested. The bottom line is that there are better places to invest in big media.

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At time of publication, Birenberg was long DIS and NWS, although holdings can change at any time.

Steven Birenberg is president and chief investment officer of Northlake Capital Management, LLC. Northlake specializes in managing equity portfolios using a combination of exchange-traded funds and special situation stocks. Birenberg appreciates your feedback; click here to send him an email.