Time Warner Cable: Time to Tune In?
We expect Time Warner Cable's (TWC) pending structural separation from its parent company, Time Warner (TWX), to improve the strategic flexibility and simplify the ownership structure of the second-largest U.S. cable operator. After an initial public offering in early 2007, we also expect the pending transaction to substantially enhance the public float of the company's shares, probably increasing its nimbleness for a potential use of its stock as a currency for further acquisitions, amid a rapidly changing landscape.
TWC recently completed an integration of certain cable systems acquired in July, 2006, from Adelphia Communications, as well as certain swaps with Comcast (CMCSA). In the years ahead, we expect the company, with a much larger cable footprint, may derive sizable scale economies from the landscape-transforming transaction, as the key operating metrics of the recently acquired systems continue to converge with the comparatively healthier levels of TWC's legacy systems. This outlook is supported by the company's first-quarter results and management's full-year guidance, in our view.
One of the earliest cable operators to launch digital phone service, TWC's competitive strategy, amid an intensifying battle of the bundles, hinges on a continued rapid penetration of its triple-play service, which is now substantially available across its entire footprint. We believe its contiguous state-of-the-art systems have also allowed the company to become an industry leader in deploying advanced video and interactive digital services. In addition, over the longer term, we think TWC could also be poised to reap majaor benefits from a relatively untapped commercial market opportunity for small, midsize and large enterprises.
We view TWC's financial condition as generally sound, despite some near-term concerns with higher financial leverage on a sizable dividend payment related to the pending separation. Management expects TWC to regain relatively ample financial flexibility soon after the separation—thanks in part to a projected acceleration of its free cash flow. Furthermore, we believe the company's corporate governance structure, which we deem generally satisfactory, would be further enhanced by a single share class following the separation. We believe the shares, which recently traded at 30, offer attractive upside potential from their current levels, and our recommendation is 5 STARS (strong buy).
In May, 2008, parent company Time Warner set some details on previously announced plans for a complete structural separation of its 84% TWC stake in a tax-efficient transaction. We expect this transaction to provide TWC with much improved strategic flexibility in a rapidly changing cable landscape. In addition, the deal should simplify TWC's capital structure and enhance the public float of its shares. Subject to necessary FCC and franchise approvals, as well as an IRS tax ruling, the parties expect to complete this transaction by the 2008 fourth quarter.
Under an initial exchange and recapitalization pursuant to the separation, TWC's parent would exchange its 12% stake in TW NY Cable Holding for 80 million newly issued TWC Class A shares (resulting in a stake of 85.2%), and then convert its supervoting Class B shares into TWC common shares on a one-for-one basis. TWC would then pay a special dividend of $10.9 billion ($10.27 per share) just prior to the separation. Thereafter, the parent company would distribute all of its TWC stake to its shareholders, with the exact form of such stock distribution (e.g., a spin-off distribution, a split-off exchange, or a combination) to be determined based on prevailing market conditions.
Time Warner Cable is the second-largest cable operator in the U.S.—and a majority-owned subsidiary of Time Warner, one of the world's leading media conglomerates. After its July, 2006, acquisition of Adelphia Communications, TWC became a public company on Feb. 13, 2007—the effective date of Adelphia's reorganization plan. Its Class A shares began trading as of Mar. 1, 2007, while its parent company owns its nontrading supervoting Class B shares.
As of Mar. 31, 2008, TWC's cable systems passed about 26.6 million U.S. homes, nearly 85% of which were in New York, the Carolinas, Ohio, Southern California, and Texas. The company's subscriber count was more than 13.3 million for basic video (50.0% of homes passed); 8.3 million for digital video (62.2% of basic customers); 7.9 million for a residential high-speed data service such as Road Runner (29.8% of homes passed); and 3.2 million for digital phone (11.9% of homes passed). Nearly all of the homes passed in its legacy systems and about 94% in the acquired (Adelphia and Comcast) systems were served by a system with at least the industry's state-of-the-art 750 MHz of capacity. Also included are nearly 788,000 customers in Kansas City, Mo., upon a dissolution of a cable joint venture with Comcast in January, 2007.
Over the years, TWC has achieved its current scale through a combination of organic growth and acquisitions. Most notably, in July, 2006, the company acquired Adelphia Communications for about $8.9 billion in cash, plus 16% of its common stock. After some concurrent system swaps with Comcast, TWC effectively added a net total of 3.2 million subscribers from those transactions, which consolidated its position as the second-largest U.S. pay-TV provider.
Driven by the launch of digital phone service since 2004, TWC's triple-play bundle (also including video and high-speed data) has become a central element of its competitive strategy, by our analysis. As part of its Adelphia integration, management has also made a point to deploy its bundled offering across its acquired systems. We believe the company's relatively contiguous cable systems allow it to attain an improved time to market, enabling it to deploy new services and features in a more responsive and economically feasible manner than might otherwise be the case.
TWC remains an industry leader in digital services, reflecting a continued penetration of high-definition and DVR services—nearly 45% of digital subscribers as of May, 2008. It is also aggressively ramping up its HD programming, now counting up to 50 channels in several markets, and growing. TWC is on track to launch Switched Digital Video in its major markets by the end of 2008, in our view, and in another move to reclaim bandwidth for further HD rollout, the company is currently in the early stages of a multiyear migration to an all-digital platform (starting with New York).
Evolving Wireless Strategy
In the past few years, TWC and its peer group of leading cable operators have mulled various strategies aimed at adding a wireless service to a potential quadruple-play bundled offering—albeit with mixed results, in our view. In April, 2008, among a cable consortium including Comcast, Time Warner Cable, and Cox Communications, TWC discontinued its mobile-phone service under a joint venture with Sprint Nextel (branded Pivot) that was formed in November, 2005. Earlier, in November, 2006, TWC was also part of SpectrumCo, a joint venture between the aforementioned cable consortium and Sprint Nextel (S), which won 137 Advanced Wireless Spectrum (AWS) licenses for $2.4 billion from an FCC auction. SpectrumCo has yet to announce a deployment strategy for the acquired spectrum.
Meanwhile, TWC and its peers are actively pursuing other wireless initiatives which we believe could ultimately lead to potentially viable convergent services. In May, 2008, as one of five strategic investors (Comcast, Bright House Networks, Intel (INTC), and Google (GOOG)) that would provide a combined $3.2 billion in a mobile broadband venture led by Sprint Nextel and Clearwire (CLWR), the company agreed to invest $550 million in a nationwide WiMAX network. Upon an expected fourth-quarter closing, the new Clearwire mobile WiMAX service would be offered as a 4G service by TWC (and peers), which would also offer Sprint's wireless voice and data services (in their bundled packages) under 3G wholesale agreements.
Commercial Market Opportunities
While principally focused on residential customers, TWC and several other major cable operators have recently begun to deploy more financial and human capital to the commercial market. These efforts are aimed at what we see as an undertapped but potentially sizable market for small, midsize, and large enterprises across their cable footprints. We view the commercial business as a potentially viable longer-term growth platform for the entire cable industry.
We expect consolidated revenues to rise about 9% in each of the next two years, reaching about $19 billion in 2009, with full contributions from the acquired systems. A completed deployment of digital phone should drive penetration of bundled data and video services. Even with relatively modest basic subscriber losses, we see video revenues aided by annual rate increases, and higher average revenue per user (ARPU) on a continued penetration of advanced offerings. We also anticipate increasing (if relatively small) contributions from commercial customers (data and phone), as well as further gains in advertising revenues.
While 2008 margins may be constrained by higher marketing spending, we anticipate an improvement in 2009, helped by greater upside from the acquired systems, as well as further scale-related savings in programming costs, outweighing increased competitive pressures in legacy and acquired systems alike. We project consolidated EBITDA advancing about 9% and 11.5% in the respective years, to nearly $6.3 billion and $7.0 billion. It is noteworthy that TWC expects 2008 revenue growth of 9% (off a base of $15.955 billion), and EBITDA growth of 9% to 11% ($5.742 billion).
Despite near-term concerns with higher financial leverage on the pending separation, we view TWC's financial condition as generally sound. The company had long-term debt of about $13.3 billion (net of $226 million cash and equivalents) as of Mar. 31, 2008, and $4 billion of available borrowing capacity under a $6 billion unsecured five-year revolving credit facility. For 2008, TWC expects free cash flow to grow at least 40% (vs. $1.06 billion in 2007), benefiting from reduced cash taxes resulting from the economic stimulus package.
Pursuant to the separation, the company plans to finance its one-time dividend through a $9 billion bridge loan, plus a $1.9 billion drawdown of its revolving facility. In the unlikely event that TWC cannot fully refinance its bridge loan within two years, we note that Time Warner, its parent company, has also provided a supplemental loan commitment of up to $3.5 billion for a period of two years after separation. S&P Credit Market Services (an entity operating separately from S&P Equity Research) has placed the company's BBB+ credit rating on negative watch.
We believe TWC deserves a relative valuation premium to publicly traded peers, and to recent private market transactions, based on what we view as demographically attractive locations for the company's cable systems, an industry-leading penetration of its triple-play offering, a continued strong penetration of its advanced and interactive services, possible further upside from a successful integration of recently acquired cable systems, and a longer-term opportunity from the commercial market.
Using relative enterprise value per subscriber on our 2008 and 2009 estimates (pro forma for the pending separation), we derive a price of $35, reflecting the midpoint of our 2008 and 2009 estimates, suggesting an attractive upside from current levels. Our pro forma net debt balances are also consistent with the details of the separation, and management expectations to return to its steady-state leverage within a year thereafter.
Our price-to-free cash flow valuation model also generates a price of $35. We project the company to generate nearly $3.5 billion of combined free cash flow in 2008 and 2009 (after about $6.7 billion of total capital spending, vs. $3.4 billion in 2007), and we believe it is likely to accelerate thereafter. Our target price-to-free cash flow multiple also reflects a premium to the S&P 500.
We believe the company has a satisfactory corporate governance policy, which was first adopted in June, 2006, and became effective with the July, 2006, Adelphia acquisition. The board periodically refines its policy and reviews its practices against the requirements of the Sarbanes-Oxley Act of 2002, as well as the Securities & Exchange Commission and New York Stock Exchange rules, among other laws and regulations. As of Dec. 31, 2007, parent company Time Warner owned 82.7% of TWC's Class A shares, and 100% of its Class B shares. This equated to a total voting power of 90.6% held by the parent (or an 84.0% economic stake), making TWC a "controlled" company as defined by the NYSE.
Currently, the board has 10 members, including two Class A directors and eight Class B directors—who must be elected by holders of the respective share classes. There is a separation of the chairman and CEO positions. Directors generally have terms of one year. At least 50% of directors must be independent (as defined under NYSE rules), and the board currently deems six of its members as independent. There are three standing committees of the board—Audit, Compensation, and Nominating & Governance&with the latter also charged with CEO succession planning.
TWC's governance framework should be further enhanced upon the completion of its pending separation, in our opinion. Under an initial exchange and recapitalization plan, parent company Time Warner would convert its supervoting Class B shares (75 million) into TWC common shares on a one-for-one basis. This would be followed by the special dividend payment, after which Time Warner would effect a stock-for-stock distribution of its holdings to its shareholders. This plan effectively eliminates TWC's dual-class share structure, further streamlining its governance structure.
The primary risk to our recommendation and target price, in our view, is continued uncertainty relating to the potential impact of TWC's pending separation on its financial flexibility—given the relatively ample dividend payment pursuant to the plan. The proposed separation is also subject to certain approvals.
Separately, in a relatively saturated market for video, data, and voice services, we note intensifying competition among cable and satellite TV providers, and telcos. Combined with the current U.S. economic slowdown and weakness in the housing sector, we are wary of a dramatic slowdown in unit growth and potential margin compression.
Lastly, we see lingering uncertainties related to a number of regulatory issues, which could have negative near-term implications for TWC and the rest of the cable industry. Chief among these issues include net neutrality and a la carte programming, as well as digital multicasting and recent Federal Communications Commission bans on integrated set-top boxes and exclusive deals with multiple dwelling units.