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Ready, Set, Stop

4/12/2008 2:00 AM Eastern

In the next two weeks, Time Warner Cable could well be on the path to becoming a fully independent cable operator, free of Time Warner Inc. and able to chart its own course in a world where hundreds of channels are delivered over telephone lines and via satellite, and Internet distributors provide a seemingly limitless array of entertainment and communications.

And though full independence could open new doors for the cable operator — for one, it could free it to use its stock to acquire other multiple-system operators — the near future for the No. 2 U.S. cable company may best be summed up in three words: “Ready, Set, Whoa!”

While most analysts believe TWC will eventually become a consolidator in the cable space — its CEO, Glenn Britt, had said as much prior to the Feb. 6 announcement that the parent was considering a split — it may take a while before the cable giant begins making moves.

In the meantime, New York-based TWC must first focus on completing the integration of its former Adelphia Communications assets, fight back challenges from its telco and satellite competitors and find a way to bolster its sagging stock price.

The perennial expectation? That Time Warner Cable will try to complete its hold on the New York metropolitan area by buying out Bethpage, N.Y.-based Cablevision Systems and its 3.3 million subscribers. But Pali Research analyst Richard Greenfield noted that Cablevision is not for sale.

Beyond the Big Apple, he added, pieces of other operators — like Charter Communications’ Los Angeles, South Carolina and New England systems and Cox Communications’ properties in San Diego and New England — could fit nicely with TWC’s existing clusters. But neither Charter nor Cox have given any indication they plan to sell systems.

“Long term, yes. Near term, what is there to buy?” Greenfield said of acquisitions. “It doesn’t sound like acquisitions are their core short-term focus. I’m sure that longer term it certainly is. One of the reasons of separating is certainly to have a more liquid currency that they could use for deals. But nothing sounds imminent.”

Miller Tabak media analyst David Joyce believes consolidation may come a bit quicker, but conceded that market conditions — cable stocks are trading at near historically low multiples — and the paucity of systems available could hold back acquisitions. Still, Joyce added that TWC was a bidder for Insight Communications’ 650,000 customers in Ohio, Indiana and Kentucky last year, although the systems were pulled off the market because of low initial bids. This means TWC could re-enter the hunt quickly.

“They are in no rush,” Joyce said. “But they are in position.”

System Subscribers Notable Cities
SOURCE: Multichannel News research compiled from company data
Los Angeles 1.7 million Los Angeles, San Bernadino
New York 1.4 million New York City, Bergen County, N.J.
Northern Ohio 947,000 Cleveland, Akron
E. Carolina 727,000 Raleigh, Wilmington
SE Wisconsin 577,000 Milwaukee, Green Bay
Southwest Texas 518,000 El Paso, Corpus Christi
Charlotte 431,000 Charlotte, N.C.
San Diego 423,000 San Diego


DISSECTING THE SPLIT

First, however, will come the split. Time Warner Inc.’s newly minted CEO, Jeff Bewkes, set the stage in February when he said the media giant was in talks with Time Warner Cable’s board of directors concerning altering its ownership stake.

Time Warner has owned 84% of TWC since it spun part of the company off in July 2006 as part of its acquisition with Comcast of Adelphia Communications. Bewkes said a final decision on the fate of TWC would be made by the company’s next quarterly earnings call, which was later set for April 30.

The April date has another point of significance — that’s when restrictions that would increase the taxes on the sale of the TWC stake would expire. Those restrictions, which originated with the restructuring of its Time Warner Entertainment partnership with Comcast five years ago, expire when April ends.

While Time Warner has not given any formal indication on what it plans to do with TWC, according to several analysts that follow both companies, the media conglomerate has three options:

Spinning off its full 84% interest to its shareholders in a tax-free exchange.

Selling all or part of the 84% interest to a third party.

Purchasing the 16% of TWC that it doesn’t own and waiting until a later date (when the market for cable stocks improves) to sell or spin off the company.

Executives of Time Warner and Time Warner Cable declined to comment.

Still, “I think it’s pretty clear they are blowing out of cable,” Greenfield said. “They fundamentally believe these two companies don’t have synergies and there is no reason not to separate them.”

At the Bear Stearns Media Conference in March, Bewkes hinted that a split of the cable operations was “likely.”

Separation would make Time Warner Inc. — which would include its cable networks, such as HBO and TBS, the Warner Bros. studio, Time Inc. magazine-publishing business and AOL online unit — more of a pure-play media stock. And speculation has been for months that the company could eventually spin off those two latter arms.

A split would also allow both companies to have separate capital structures, something that Wall Street looks on with favor.

Because of relatively stable cash flows — from subscription revenue, as opposed to advertising sales — and a need to compete on services delivered by high-bandwidth networks, cable companies are generally more leveraged and require more substantial capital outlays. For example, in 2007, Time Warner Cable’s capital expenditures were $3.4 billion, or about 20% of revenue. According to Bear Stearns media analyst Spencer Wang, capital spending for the cable networks amounted to just 3.4% of revenue, while filmed entertainment capital spending was about 1.4% of revenue.

DEBT VALLEY

Despite that capital intensity, Time Warner Cable is considered to be underleveraged compared to its peers. With about $13.6 billion in debt, TWC’s debt is about 2.4 times its cash flow. Other operators have ratios in the three-times range.

While Time Warner executives have insisted that the possibility of a split does not signal that corporate has lost its taste for cable distribution, the simple fact is that TWC, although it contributes about one-third of Time Warner’s total revenue and more than 40% of its total cash flow, has been a bit of a drag on the parent company.

That drag has been more perceptional than performance related. Media investors, fearful of growing competition from telephone companies and satellite-TV providers, have taken it out on Time Warner. That’s evident in the stock prices — Time Warner Inc. shares were down 25% in 2007 and have fallen 9.8% so far this year, while TWC shares fell 29% in 2007 and are down 2% in 2008.

“It [TWC] has been the reason Time Warner stock [has fallen] down so much,” Joyce said.

The market worth of cable stocks have dropped to about six times their annual cash flow, in the past few years. Before the Internet bubble burst in 2000-2001, the multiples were in the high teens. TWC’s multiple is currently about 6 times, while Time Warner has a multiple of about 7.2 times. That still lags behind its pure-play content peers like The Walt Disney Co. (7.3 times), Viacom (9.1 times) and News Corp. (7.5 times), according to Wang’s estimates.

Joyce said splitting off TWC isn’t going to mean an immediate rise in Time Warner’s stock price — the media giant has other issues regarding AOL’s competitive strength in the online ad business and declining ad revenue in its publishing unit. Last week, AOL was reported to be talking with similarly challenged Web portal Yahoo about merging operations. But Joyce said that a split could serve both companies well — TWC would get the flexibility to add more debt to its balance sheet and Time Warner would be able to focus more on its core network and film businesses.

Just how that split will occur is still open to question. And while there are several options open to Time Warner, most analysts believe that a split will occur through some form of distribution to shareholders.

TWC 4Q 2007 Time Warner 4Q 07
SOURCE: Company reports
Revenue: $4.1 billion Revenue: $12.6 billion
OIBDA: $1.6 billion OIBDA: $3.5 billion
Operating Income: $795 million Operating Income: $2.3 billion
Percent of Whole: 34.6% Percent of Whole: $100%
TWC FY 2007 Time Warner FY 2007
Revenue: $16 billion Revenue: $46.5 billion
OIBDA: $5.7 billion OIBDA: $12.9 billion
Operating Income: $2.8 billion Operating Income: $8.9 billion
Percent of Whole: 31.4% Percent of Whole: 100%


GROWTH, UNTETHERED

Wang believes that Time Warner won’t just distribute shares in TWC to its shareholders. That would provide some soft benefits like the removal of the discounting of its stock as part of a larger holding company and added flexibility to take on debt, when needed for acquisition or expansion, but wouldn’t provide quantifiable benefits to shareholders, he wrote. Instead, Wang predicted that Time Warner would execute a split similar to one its content counterpart Viacom did in 2004 with its Blockbuster subsidiary.

According to Wang’s report, TWC could pay a one-time special cash dividend of as much as $3.86 per share to all of its shareholders — including Time Warner Inc. and public TWC investors. Time Warner Inc. could then split off its 84% stake in TWC to some of Time Warner’s shareholders in exchange for their shares in the parent company. That scenario provides two benefits — TWC shareholders would get cash and Time Warner would in effect be using its TWC stake to buy back its own stock.

Wang estimated that TWC could finance the dividend by borrowing about $3.8 billion, which would raise its leverage ratio to about 3 times cash flow. About $3.25 billion of that dividend would accrue to Time Warner Inc, Wang wrote.

“This cash could then be redeployed by Time Warner to reinvest in its core businesses, fund its recurring dividend and/or buy back more stock,” Wang wrote.

Wang added that with this structure, Time Warner could reduce its total share count by as much as 40%, which could help boost the stock price.

Time Warner without the cable systems will be a materially different and smaller operation. In 2007, TWC accounted for $16 billion of Time Warner’s total revenue of $46.5 billion and 44% ($5.7 billion) of its $12.9 billion in operating income before depreciation and amortization (OIBDA), a measure of cash flow.

While Bewkes said at a Bear Stearns conference in March that he doesn’t mind being smaller if the return on investment is stronger, other analysts wonder how that will be accomplished.

“The question for Time Warner is how much growth is there going to be ex-TWC?” Greenfield asked. “That’s the issue that everybody is struggling with right now.”

Joyce said that while Time Warner may miss the revenue and cash flow from the cable systems, it would be more than offset by lower capital expenses and the removal of the cable competition discount that has weighed on the stock.

Joyce pointed to other content-only companies — Disney and Viacom — which have fared well without a distribution arm.

TURNING CORNERS

After a tricky integration period with the former Adelphia system in Los Angeles and a former Comcast system in Dallas (also acquired through the Adelphia deal), TWC appeared to turn the corner in the fourth quarter.

Revenue in the period rose 12% to $4.1 billion and OIBDA increased 19% to $1.6 billion at TWC in the fourth quarter. For the full year, revenue and OIBDA were up 36% each (to $16 billion and $5.7 billion, respectively).

In the fourth quarter, customer losses in Los Angeles and Dallas were reduced by about 69% — roughly 21,000 of TWC’s 50,000 basic subscriber losses were attributable to those two cities. In addition, Los Angeles led the company in net additions for high-speed Internet, phone and the triple-play bundle.

Another measure of the successful turnaround, Wang said, is that complaints in Los Angeles have fallen below pre-acquisition levels.

Citing City of Los Angeles Information Technology Agency data, Wang said that average monthly customer complaints fell to 117 between June and September — down from 266 between August 2006 and May 2007 and below the pre-merger level of 125 per month between August 2005 and July 2006.

With the Los Angeles and Dallas integrations moving ahead smoothly, Joyce said that TWC could consider further acquisitions to increase its scale. It won’t necessarily happen immediately, though, he added.

Time Warner also has made some operational moves to prepare itself for a split. Earlier this month, it made several regional executive changes, creating a new western division led by Stephen Pagano and moving former New York cable honcho Barry Rosenblum to head its Texas division. Rosenblum’s move could be a sign that TWC is increasing its focus on the Dallas turnaround.

“They’re gearing up for more action as a standalone company,” Joyce said.

But a standalone company that does not appear, just yet, to be planning to make any big waves.

September