Icahn, Time Warner: Not Just Fishing Expedition

Allying with Ted Turner would lure bigger game to the financier's shake-up efforts, which look like a win-win from the outset.
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So Carl Icahn wants to try to force

Time Warner

(TWX)

to break up, perhaps by spinning off the cable and publishing companies. This kind of effort always offers plenty of intriguing subplots. Today, I want to break down whom Icahn really wants on his side, and then analyze the prospects for this activist effort, which looks like a winner in almost any outcome.

Chasing Big Game

The various articles that have been written have noted that he owns only 0.1% of the company and that he might try to pursue other shareholders, such as Ted Turner. However, this morning

The Wall Street Journal

reported that Turner is not part of Icahn's group.

First off, Icahn could have zero shares of Time Warner and still be able to throw his weight around (although the fact that he owns $100 million worth of the media giant's stock is certainly further motivation). However, the key in an activist play on a company of Time Warner's heft is not amassing shares but amassing clout and influence with the key players.

I have no doubt that Icahn was pursuing Turner, and maybe Turner really has spurned him by this point. But keep in mind that at this point, according to recent filings, Turner owns only 1.5 million shares after mass-selling them over the past few years.

So why would Icahn bother pursuing Turner, a smaller stakeholder? It all boils down to fly-fishing.

Turner regularly fly-fishes with Gordon Crawford, who runs Capital Management & Research, a huge money management firm. Unlike Turner, Crawford is mostly unknown outside the media investing world, but owns large stakes in just about every media company. He owns 243 million shares of Time Warner and, at a 6.7% stake, is the largest shareholder.

To be sure, Crawford's primary fealty is to the investors of Capital Management, and he will not blindly side with management, no matter how cordial he has been with them. In fact, he has participated in activism in the past, with perhaps his best-known effort being the call he made to Steve Case in 2002, asking him to resign as chairman of the board of the then-called AOL-Time Warner.

Prior to that, Crawford played a key role in getting Adelphia to reorganize its management as it plunged into bankruptcy, and he was subsequently involved in Time Warner's recent acquisition of Adelphia's assets. A vote by Crawford recommending a spinoff of cable assets would carry a lot of weight for the other TW board members.

And while he may have good relations with Time Warner CEO Dick Parsons (everyone seems to) he is not afraid to go head-to-head against management, as he did in 1995 when he voted against CBS head Larry Tisch's slate of directors and was ultimately instrumental in forcing CBS to sell to Westinghouse. And in 1996, he was very critical of

Cablevision

(CVC)

when the company started going outside of its core business by buying Madison Square Garden and Radio City Music Hall. It was Crawford who also brought Turner and Gerry Levin to the table when the two competitors agreed to merge their disparate businesses.

Why Break Down the Prize?

So that's whom he wants on his side. Now why would Icahn press for a breakup?

Let's look at each division of Time Warner to determine that. The company breaks its revenue down into five categories: AOL, cable, filmed entertainment, networks and publishing. While there are some synergies between the different divisions (in particular, a much-hoped-for synergy between cable and AOL), the actual effect of these synergies is negligible.

For instance, HBO-created content doesn't necessarily find its way to TNT for cheap and can just as easily end up full price on Fox or NBC (a la "Everybody Loves Raymond," created by HBO Independent Productions). Although Parsons has stated that he does not believe in any financial "magic bullets" to unlock value, it's not clear that there is any benefit for the company keeping any of these divisions together.

However, each division is flourishing (more or less) on its own and a breakup would present a less-confusing picture for Wall Street in terms of valuing the components. (See the recent breakups at

IAC

(IACI)

and

Viacom

(VIA.B)

for proof of this.)

Cable

Cable is the division Icahn would like to get rid of first. The group had EBDA, or earnings before depreciation and amortization, of $1.7 billion in the six months prior to June 30, up from $1.5 billion in the same period in 2004, and cable is exhibiting solid growth. This group could potentially be valued similarly to

Comcast

(CMCSA) - Get Report

, at 11.5 times EBITDA, or Cablevision, at 19 times EBITDA. Investors in the industry in general have been troubled by the onset of new technologies and competition from satellite, but at 10 million subscribers and growing, Time Warner is not currently sweating it.

Filmed Entertainment

Filmed Entertainment experienced slowing revenue over the past six months vs. the year-ago period ($5.5 billion vs. $5.9 billion) but this is a more volatile area and was hurt by the fact that in 2004 there were DVD sales from the

Matrix

and

Lord of the Rings

franchises, which were only partially offset by the Harry Potter franchise this year.

That said, Time Warner has a long way to go before running out of Harry Potter movies, and the

Batman

and coming

Chronicles of Narnia

movies should provide a solid boost for years to come.

Pixar

(PIXR)

,

Disney

(DIS) - Get Report

(respectively at 15 times and 11 times EBITDA), or even

Lion's Gate

(LGF)

(at 23 times EBITDA), could provide reasonable comps to a spun-out Warner Brothers.

Networks

For the purposes of valuation comparisons, it's helpful to combine the Networks segment with the above "filmed entertainment" segment, although Time Warner breaks them out. They do this for historical reasons even though there are common areas in both segments (for instance, television production.) The filmed entertainment segment comes from the old Warner Brothers units and the networks segments come from Time Inc. (which owned HBO) and Turner. The network segment this year had slowing growth but primarily because "Everybody Loves Raymond" went off the air, so HBO had smaller licensing revenues. However, all the basic metrics performed well, with subscription revenue up 7% and advertising up 6%.

Publishing

Publishing, while tried and true, is not a growth industry and is probably holding down valuation analysis on Time Warner. Subscription revenue was flat with last year and advertising revenue was up 4%, thanks to an overall improvement in the advertising industry across the economy. Although Time Warner's brands are recognized everywhere (

People

,

Sports Illustrated

,

Fortune,

, etc.) it' not clear where the growth is and the companies that can be roughly called comps (perhaps

Gannett

(GCI) - Get Report

or the

New York Times

(NYT) - Get Report

) have been trading at single-digit multiples of EBITDA due to lackluster or slowing growth.

AOL

Ironically, AOL would perhaps be the area with the most value in a breakup. Subscription revenue is going down ($3.5 billion in the last six months compared with $3.8 billion in the year-ago period) but advertising revenue is up significantly ($631 million vs. $435 million in year-ago period). Net income for the division is up 25%, from $553 million in the six months ending June 30, 2004, to $692 million in June 30.

A dip in overall revenue while net income is going up shows the bottom-line influence of the ad-based model. While AOL is going to try to improve subscriber revenue with a little help from the cable division through some joint marketing (although no effect from this will be seen in 2005 due to the usual synergistic collapse that happens with every good intention), my guess is it will slowly cut membership costs to be competitive with other broadband solutions and scale up the promotion of its services in order to continue to boost advertising.

If AOL got even one-third the EBITDA multiple of

Yahoo!

(YHOO)

or heaven forbid, CNet, it would be accretive to shareholders in any breakup scenario.

Valuation Problem Is the Whole, Not the Parts

The basic problem with Time Warner is not any of its divisions, because all are performing well and represent best-of-breed branding in every area. The problem is that Time Warner has perpetually been difficult to value and often has engaged in very complex financial transactions that have left shareholders scratching their heads.

Parsons has done the best he can with unwinding some of the more complex Levin deals (What

was

up with the U.S. West/Toshiba/Cable stuff of the 1990s?) but from the beginning there's never been much synergy (in fact, it's been mostly internal animosity) between Warner and Time, let alone between Time Warner and Turner, or, of course, between Time Warner, Turner and AOL.

Perhaps the last merger Time Warner has done that exhibited true synergy was the 1973 merger with Temple Industries, one of the largest paper and pulp producers in the country. Controlling the source of the paper allowed Time significantly cut the costs involved in producing its magazines. Unable to handle such tight interaction, Time spun off its paper division into what is now

Temple-Inland

(TIN)

in 1984 at a split-adjusted $12 a share. Since then, TIN has slightly underperformed the

S&P 500

.

So that's the background. Now here's my prediction on what is going to happen:

I give Icahn credit for kick-starting the conversation. Time Warner stock has not moved in more than two years, while the rest of the market has gone up significantly, and earnings and revenue have improved in every division. Perhaps a breakup is best or perhaps Parsons is correct to not spend too much energy in financial engineering and to instead focus on bottom-line results. Either way, Icahn wins.

In scenario one, which is unlikely, Icahn enlists the help of Crawford, and a full-scale breakup occurs. Everything gets valued according to its comps and shareholders in the long-term benefit.

In scenario two, which also is unlikely, nothing happens, but thanks to Icahn, investors realize that there is untapped value here and the stock moves to the $20-$25 range instead of the $15-$20 range.

But I'm voting for scenario three, some of the above. Icahn will get some concessions from management and perhaps a complete spinoff of Cable, or at least a spinoff that is larger than the 15% currently being proposed. (My guess is there will not be a spinoff of Publishing.)

Meanwhile, if AOL can demonstrate continued bottom line improvements (it was the fastest-growing division on the bottom line last quarter) then Time Warner might see more of a 12 to 15 times multiple on EBITDA than the nine times it currently sports.

Additionally, Icahn will press for, and win, an announcement of an increased buyback. Time Warner has announced it will be buying back up to $5 billion of its shares. The company will increase that at some point to $10 billion or more. The cash flow supports it, if it's done over a several-year time period, and it will demonstrate the company is refocusing on shareholders instead of just debtholders.

In any of these scenarios, Icahn wins, and he's already done quite well from his

initial purchase, and Time Warner shareholders win. So life is good.

James Altucher is a managing partner at Formula Capital, an alternative asset management firm that runs several quantitative-based hedge funds as well as a fund of hedge funds. He is also the author of

Trade Like a Hedge Fund

and

Trade Like Warren Buffett. At the time of publication, neither Altucher nor his fund had a position in any of the securities mentioned in this column, although positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Altucher appreciates your feedback;

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