A Happy Ending for Time Warner?

WHEN TIME WARNER (TWX) CEO Jeffrey Bewkes took the reins of the media giant from Richard Parsons in January, Wall Street was crying for change. Six months later Bewkes, 56, has delivered, announcing the spinoff of the company's 84% stake in Time Warner Cable in a deal that will net Time Warner more than $9.25 billion in a cash dividend. Yet, instead of cheering, shareholders — who could end up pocketing some of that stash in the form of enhanced dividends themselves — have dumped the stock, hand over fist, leaving Time Warner at 14.69, down about 12% this year.

Like hedge-fund manager Carl Icahn, who agitated for a breakup of the company two years ago, today's critics have a laundry list of complaints, many now focused on Time Warner's struggling AOL unit. But the carping obscures the stock's stunningly cheap valuation, the promising outlook for the company's remaining media and entertainment units, and the opportune ways Time Warner can use its cash.

Strip out the value of the cable-transmission business — about $5 per share — and Time Warner trades closer to $10, or for a mere 10 times estimated 2008 earnings of 99 cents a share. At six times enterprise value (market capitalization plus net debt) to Ebitda, or earnings before interest, taxes, depreciation and amortization — a more popular entertainment-industry metric — the stock is similarly undervalued, relative both to its history and peers like Walt Disney (DIS) and Viacom (VIA). Doug Mitchelson, an analyst at Deutsche Bank Equity Research, thinks the shares could be worth as much as 26 in a year, based on the company's "terrific assets and reasonable growth prospects."

After years of empire-building through mergers and acquisitions, and divestitures including cable, Time Warner will be left with four business units: filmed entertainment, cable-television networks, publishing and AOL. Together these operations could generate more than $31 billion in revenue this year, and $7.5 billion in Ebitda. Benjamin Swinburne, an analyst at Morgan Stanley and a Time Warner fan, forecasts Ebitda of nearly $8 billion next year, and thinks earnings per share could edge up to $1.04. Time Warner earned $1.17 a share last year; Time Warner Cable (TWC) contributes more than 40% of Ebitda.

Swinburne figures the company's assets, excluding cable transmission, are worth around $16 a share, based on a sum-of-the-parts analysis. He ascribes a value of almost $77 billion to the various units, valuing both AOL's advertising business and the HBO cable group at nearly 14 times 2008 estimated Ebitda; the Turner cable networks at 13.2 times Ebitda; Warner Brothers, the movie studio, at 8.2 times; Time Warner's publishing properties at 6.4 times and the shrinking AOL subscription service at a lowly 3.5 times.

Adding in $12.9 billion of cash and subtracting the company's $22.6 billion of debt excluding cable, as well as Google's (GOOG) $629 million minority interest in AOL, Swinburne arrives at a total value of $66.6 billion. He then divides by Time Warner's 3.6 million shares, and applies a 15% conglomerate discount.

Time Warner's most immediate opportunity to enhance shareholder value could come later this year, if Bewkes and his management team, including Chief Financial Officer John K. Martin, could separate, spin off or sell the subscription arm of AOL. America Online was considered a jewel when it merged with Time Warner in 2001 in an ill-fated, $180 billion deal. The subscription business could have become the premier social network, outdoing Facebook and MySpace, given its early presence online and the enormous popularity of AOL Instant Messenger. Instead, a lack of investment and missed opportunities have turned AOL into a declining annuity. The business lost two-thirds of its subscribers from 2002 to just 8.7 million at the end of the first quarter.

Excising the subscription business also would expose the profitability of AOL's digital advertising platform, which Time Warner has been bulking up through acquisitions. With the recent $850 million purchase of Bebo, a social-networking site operating in the U.K. and Australia, the company hopes to develop new ways to connect and advertise to its AOL customers.

Some have criticized the deal as pricey, but Martin defends it. "Social networking is not a fad," he tells Barron's. "It is fundamentally changing the way consumers are using the Internet, and...we were losing a considerable amount of our [AOL] community to social-networking traffic."

That is apparent in AOL's revenue, which sank 33% last year to $5.2 billion, or 11% of Time Warner's total. The unit's operating profits edged up, however, to $2 billion, or 22% of the total. Even with its problems, AOL enjoys 35% profit margins, about three times those of the filmed-entertainment business. "The biggest key is unlocking AOL," says Tuna Amobi, a media analyst at Standard & Poor's who has a Hold rating on the stock. "We could be more constructive [on the stock] if AOL shows signs of finally turning around."

If AOL holds the biggest opportunity for Time Warner, the film division may prove the biggest challenge. The unit produced revenue of $11.7 billion last year, and $845 million of operating profits. It will account for the biggest chunk of total revenue — 37% — after cable departs, but remains the least profitable part of the company, with operating margins of just 10.4%, reflecting the high cost of making movies.

This year, in a bid to cut costs, Time Warner consolidated its New Line Cinema unit into Warner Brothers, and shuttered Picturehouse and Warner Independent Pictures, whose art films, such as La Vie en Rose, about French singer Edith Piaf, have generated critical acclaim but limited box-office sales. Like all studios, Warner Brothers needs to keep churning out hits like its Harry Potter movies. But it will have fewer opportunities this year to grab viewers' attention because it is likely to cut production by as much as 50%. Last year saw a glut of releases throughout the industry, and other studies are curbing their output, as well. Warner is banking this summer on its Batman film The Dark Knight.

Bewkes, a 29-year Time Warner veteran who rose through the ranks at HBO before overseeing filmed entertainment and networks, knows the big screen well.

One way to boost profits in the movie business is greater electronic distribution of films both in the U.S. and abroad. Another is more on-demand movies available earlier in the release schedule. Global growth is an opportunity, too. The company is exploring opportunities in Eastern Europe, Russia, Latin America and India, Martin says. About 40% of Warner Brothers' revenue is derived outside the U.S., he adds.

You can thank time warner's HBO cable network for making Sex and the City's Carrie, Charlotte, Miranda and Samantha household names at home and abroad in recent years. This and other television endeavors, from properties such as Turner Broadcasting System's TNT, CNN and a joint venture with CBS, helped network profits jump 11% last year to $3 billion, even though revenue expanded by just 2%.