Model Stock Research for the Time Warner Company Essay

Macroeconomic Review

Being one of the fastest-paced and highest-profile industries in the world, the media sector has been in a whirlwind of change this past decade. There has been an explosive boom and bust and, of late, boom again, of internet technology. This has dramatically influenced media delivery. Clampdowns on shady accounting practices, assets changing hands and a more discerning and demanding media audience have also ensured that changes in the industry occurred at break-neck speed. This is why global media giant, Time Warner, has sought to embrace these challenges of the Information Age. Indeed, Time Warner had uniquely positioned itself to benefit from the explosive changes. Their size and resources make them a formidable competitor in the media arena because of their efficiency in an increasingly global environment.

In front of the media arena, the average US citizen is confronted by more than 1,500 dailies, over 5,700 weekly newspapers, some 17,000 magazine titles, 10,000 commercial radio stations and more than 1,600 TV stations. Nielsen Media Research reported that as of January 2003, 98.2% of the over 100 million households own at least one TV set, with 69.8% of them hooked up to cable.

The US also exports a massive amount of its media, which has become almost staple fare around the world. CNBC alone boasts a reach of 192 million households worldwide, with 82m of them in the US and Canada. The latest available GDP statistics from the US Bureau of Economic Analysis show that the radio and TV industry contributed $72.9 billion to the US GDP in 2001, up from $71.1 billion in 2000. Total US GDP for 2001 was $10,082 billion. In 2006, the US GDP is estimated at 3.2%, while the interest rates are at 8% (See Table 1).

Table 1. United States – Country Data and Market Indicators (EIU, 2006).

Series

Units

2001

2002

2003

2004

2005

2006

Gross Domestic Product

Key indicators

GDP (% real change pa)

0.8

1.6

2.5

3.9

3.2

3.2

Fiscal and monetary indicators

Interest rates

Lending interest rate (%)

6.9

4.7

4.1

4.3

6.2

8.0

Inflation and wages

Consumer prices (% change pa; av)

2.8

1.6

2.3

2.7

3.4

3.3

Demographics and income

Population

M

285.1

288.0

290.8

293.6

296.4

299.7

GDP per head ($ at PPP)

PPP

35524.2

36352.8

37691.7

39894.3

42023.7

44110.0

Population

Population

M

285.1

288.0

290.8

293.6

296.4

299.7

Population (% change pa)

1.0

1.0

1.0

1.0

1.0

1.1

Labour force

M

143.8

144.9

146.5

147.4

149.3

151.4

Recorded unemployment (%)

4.7

5.8

6.0

5.5

5.1

4.6

Income

GDP per head

US$

35524.2

36352.8

37691.7

39894.3

42023.7

44110.0

Private consumption per head

US$

24745.9

25523.4

26491.1

27969.4

29495.1

30960.0

GDP per head ($ at PPP)

PPP

35524.2

36352.8

37691.7

39894.3

42023.7

44110.0

Real GDP growth per head (% pa)

-0.2

0.6

1.5

2.9

2.2

2.1

Personal disposable income

bn LCU

7486.8

7830.1

8162.5

8681.6

9036.1

9580.2

Personal disposable income (US$)

M US$

7486840.0

7830080.0

8162530.0

8681560.0

9036100.0

9580150.0

Real personal disposable income (US$ at 1996 prices)

M US$

6860090.0

7074210.0

7231140.0

7493920.0

7581650.0

7811600.0

Real personal disposable income (% change pa)

1.9

3.1

2.2

3.6

1.2

3.0

Average real wage index (LCU, 1996=100)

107.3

108.9

109.4

108.9

108.1

108.6

Average real wages (% change pa)

1.0

1.5

0.4

-0.5

-0.7

0.5

            Fact remains that US is the world’s biggest media producer as well as consumer. Advertising is the main source of revenue, although some sectors also create revenues from subscriptions. Media concerns with entertainment arms have additional sources of income through takings from gaming, distribution rights, amusement park entrance fees and spin-off merchandise.

Also, entertainment is one of America’s top exports. In 1999, in fact, film, television, music, radio, advertising, print publishing, and computer software together were the top export, almost $80 billion worth, and while software alone accounted for $50 billion of the total, some of that category also qualifies as entertainment—video games and pornography, for example. Hardly anyone is exempt from the force of American images and sounds. . . . American popular culture is the nemesis that hundreds of millions—perhaps billions—of people love, and love to hate. The antagonism and the dependency are inseparable, for the media flood—essentially American in its origin, but virtually unlimited in its reach—represents, like it or not, a common imagination.

However, media availability is somewhat disproportionate to the time an average American has to consume information. But the industry is a lucrative one and media spinners are finding new ways to make the public continue to consume media and pay for it. In 2001, companies in the media industry recorded total revenues of $261.7 billion. Although this was a growth over 2000’s $255.2 billion, operating income had been steadily falling since 1998. This can be attributed largely to the fact that cable and satellite providers experienced rising maintenance costs and were investing heavily in new technology. The decline in income is expected to ease over the next few years as investments on new delivery channels start to bear fruit.

Because of this, many companies started holding back on advertising activities following the recession in 2001. The 9⁄11 tragedy, the subsequent wars in Afghanistan and Iraq and their accelerator effect on the economic downturn, brought increased uncertainties to the stock markets and exacerbated the advertising slowdown. This downtrend was reversed throughout most of 2002 as many believed a swift end to the Iraqi invasion would emerge. Market jitters returned in the third quarter of 2002 and earlier in 2003, which somewhat stalled advertising expansion as the Iraqi situation refused to look as good as the President’s claims.

However, tentative cheers on US trading floors and moderate improvements in the job market slowly built up advertising momentum in the third quarter of 2003. For example, Time-Warner’s strategy has insisted on managing their costs aggressively. In 2005, they undertook difficult, but necessary, restructurings at a number of our divisions to ensure that their costs are aligned with their long-term business needs. At Warner Bros., for example, they streamlined their management to create a single Home Entertainment Group to oversee the digital delivery of entertainment to consumers. Looking ahead, they plan to reduce costs by $1 billion across their businesses in 2006 and 2007.

Trade disputes with the EU and China and persistent trouble for US interests in Europe and the Middle East are forming grey clouds over the economic horizon. Also, big budget media advertising, with the exception of outdoor advertising, is invariably sparse at year-end when readership and viewership are traditionally down due to a lack of new programs and major sporting events.

Consumers are usually on vacation or out holiday shopping at year-end, rather than at home reading or sitting in front of ‘the box’, giving media advertising less reach. However, prudent companies are aware that a prolonged advertising drought can adversely affect brand recall and consequently spell slower product movement. Thus, although advertising revenue increases were more modest than expected in 2003, with the exception of cable television, syndication and Spanish network segments. This income source is predicted to grow in 2004.

As Time Warner moves forward with these external challenges, the foundation of their strategy is to invest our financial resources in a disciplined manner to provide the best possible return to their shareholders. This means focusing on the right businesses. Their board of directors and management continuously evaluate Time-Warner’s businesses to ensure that they meet their standards for financial performance, growth and return on investment.

Industry Overview

The United States market for cable and satellite TV services has grown by 6.5% since 2003 to reach a value of US$57.6 billion in 2004. Over 2001 to 2005, value sales increased by 36.5%. Over 73 million American households subscribed to cable television services with 34% of them having digital service in 2004. In 2004, the average monthly price for expanded basic programming packages was US$38.23. Satellite TV services are expected to continue to increase in popularity. Satellite TV is offering aggressive pricing packages relative to cable, an increasing number of special interest channels and local channels in all markets.

Local channels were previously unavailable to subscribers. Despite the spate of satellite TV, Time Warner’s networks and cable segments have been posting consistent revenue growth in recent years. Revenue from the networks segment increased from $8,434 million in 2003 to $9,611 million in 2005, representing a growth rate of 7%. Revenue from the cable division increased from $7,699 million in 2003 to $9,498 million in 2005, representing a growth rate of 11%.

These two segments together contribute more than 42% of the total revenues of the company. Increasing segmental revenues have contributed in the company’s overall revenue growth of 3.7% in fiscal 2005 over fiscal 2004. This is why cable television will likely continue to generate healthy revenue growth for owners of those networks, though gains may well be slower than over the past several years. Beneficiaries of ongoing strength in cable include Viacom, Time Warner, News Corp. and Disney.

The most significant changes in the media industry in the past decade have been in its adoption of the internet technology. The internet has evolved from being just a communications tool to becoming an important entertainment, business and marketplace platform. Catching up is the cable segment, which is embracing broadband technology in earnest and is rapidly overtaking the role of traditional dialup technology in supplying telephony and especially internet services to North American homes.

From 1996 through 2003, the US cable industry spent $75 billion in private capital on plant and equipment as well as infrastructure upgrades, according to NCTA. The cable industry in its totality is moving from analog to digital technology to compete with the high-quality, low-interruption signal transmission broadcast by DBS companies, which have been offering high quality, encrypted digital transmission almost since day one. The competition between cable and satTV is becoming more intense. Apart from normal TV programs and movie line-ups, both offer interactive (cable TV being a recent entrant) and internet technologies on their systems.

Both are taking the TV experience to new heights. Not only can the viewer play interactive games on TV but they can also interact with programs they are watching, for example responding to interactive surveys or making immediate purchases on shopping channels via the remote control. Latest technological advancements also allow viewers to record, pause, forward and reverse live programs or watch them in slow motion or instant replay using digital⁄personal video recording (DVR or PVR) and video on demand (VoD) devices for satTV and cable TV, respectively.

Unfortunately, the digital revolution is bringing problems to some in the industry. Content and program providers are anxious over the dent DVRs and VODs may make in their earnings. How serious their concerns are remain to be seen, but observers of the industry are noting that a predecessor of DVRs and VODs, the VCR, was greeted with the same disquietude, which was soon replaced with blithe indifference as the technology propagated a new earning capacity, that is, the sale of videos.

An issue that bothers media executives is their loss of control over viewers. Viewers can replay scenes they like during a commercial break, thus effectively bypassing messages from advertisers, who happen to be program sponsors. This could force advertisers to see TV as a less effective advertising channel than it used to be and give them better leverage at commercial slot price negotiation or cause them to adopt other advertising media.

As viewers become more discerning, they are demanding greater viewing variety and higher quality programs. They are also getting hi-tech, seeking a greater, more interactive TV viewing experience much as they have come to expect from their personal computers. The FCC, the federal regulator for the media and telecommunications industry, is aware of this and is pushing the industry to hurry the digital transition. The FCC has mandated that all TV broadcast stations have High Definition TV (HDTV) broadcasting capability by 2006. This will mean a bigger outlay for broadcasters and cable companies in the coming few years:

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Broadcasters and program networks will have to invest in new cameras, titling and editing equipment and tape machines that support the digital TV (DTV) format and revamped rigs for DTV friendly TV vans.

Cable operators need to convert all their equipment and set-top boxes. However, for viewers with HDTVs, the set-top boxes are bypassed.

Time Warner had responded to this challenge through Warner Bros Entertainment, a subsidiary of the company when it tied up with CBS Corporation to form a new broadcast network. This new network, The CW, to be launched in late 2006, can significantly expand Time Warner’s customer base.

Time Warner’s Cartoon Network channel entered into a joint venture with VIZ Media to form Toonami Jetstream, a new broadband service to provide streaming episodes of animation series. Toonami Jetstream will allow users to view episodes of Cartoon Network in their own time and also provide an alternative distribution vehicle for Time Warner. These alliances and joint ventures can provide Time Warner with a competitive advantage over its peers and enable it to enhance its revenue position.

Expanding broadband market

Most players in the cable industry have begun the digital journey but consumers may still need to dig into their pockets to enjoy the digital experience and make the analog age a thing of the past. They have to either buy new set-top boxes, which convert digital signals to analog, or buy HDTV sets, which range between just under $1,000 to almost $10,000. Early in June 2003, when the FCC eased its decades-old restrictions on the size of media entities, controversy erupted. Large media companies hailed the move.

Consumer groups condemned the decision as bad news for democracy and local content. The new rule, which allowed media companies to have US penetration cap of 45% instead of the old 35%, was good news to media giants who were operating at close to the 35% limit. They had been lobbying hard for the lift, including Viacom, whose $40.6 billion purchase of CBS makes it the US’ largest single operator of TV and radio stations, reaching 41% of the total national broadcasting market.

The 45% rule looked set to open the floodgates for other media liberalization that would allow TV, radio and newspaper owners much more room for consolidation. If a large TV station acquired a small, one-paper town market, the community would be dominated by that entity. This would threaten local content in the community’s media. However, the 45% rule was blocked by Congress in a massive 400 to 21 vote in July 2003. This was followed by a stay order by a federal court some few weeks later.

Should the FCC fail to appeal to have the new cap reinstated, media giants who have exceeded the old limit will have to shave off their access assets and those nearing the demarcation point will need to strike out expansion as a way to increase income. Time Warner, which garners some revenues from films, should grow its studio profits well. It is releasing several DVDs of popular titles. Film profits generally sway on the timing of releases. Viacom, Disney, and Dreamworks Animation also have large stakes in the sector, which will likely move further towards home viewing via digital cable and the Internet.

Having many cities that are highly cosmopolitan, the US has various minority and ethnic groups which are looking for more than just generic programs that do not necessarily depict their lifestyles or cater to their tastes. Many minority group communities have been addressing these issues by producing their own newspapers, TV programs and radio broadcasts.

As their respective populations grow, so has the amount of business of their specialty media. Having long observed the growth of these niche markets, bigger players are now making moves toward grabbing a slice of the ethnic specific media pie that serve large minority communities. Previously, being culture sensitive meant placing non-Caucasian actors in supporting roles but, belatedly, major media companies are dedicating whole TV and audio channels to specific ethnic groups.

In the media industry, the basic services were the largest sector, accounting for 53.1% of sales in 2004, worth US$30.6 billion. Advertising was the most dynamic sector. Growing from US$8.5 billion in 2000 to US$15.9 billion in 2004, this sector achieved 87% growth. Pay-per-view movies grew by US$400 million over the review period, to account for 2.8% of sales in 2004. In 2004, premium channels accounted for US$9.5 billion, or 16.5% of the market, realizing 13% growth. Cable TV continues to dominate the premium TV market with 76 percent of households and its market penetration is still increasing.

Table 2. United States – Media Market Sectors

US$ billion

2000

2004

Advertising

8.5

15.9

Basic services

24.1

30.6

Pay-per-view movies

1.2

1.6

Premium channels

8.4

9.5

Source: Euromonitor International

In terms of performance, Comcast Corporation was the leader of cable and satellite TV services in the United States in 2004 with 32% market share. It maintained its leading position through product innovation and differentiation including its ON DEMAND offerings, increased regional sports programming and its leading Comcast.net portal. Time Warner Inc had the second largest market share in 2004 at 17.2%.

This was an increase of 9.5% in 2003. AOL Time Warner was able to increase its position by taking a lead role in offering new products to its customers including High Definition Television, the Digital Video Recorder, Wireless Home Networking, and Digital Telephony service. Through expansion of its US market, Cox Communications Inc. increased its market share by 7.7% from 2003 to 9.7% in 2004. Charter Communications saw its market share decrease to 9.3% in 2004.

Table 3. United States – Media Market Share

% value of market sector

2004

Comcast Corporation

32.0

AOL Time-Warner Inc

17.2

Charter Communication

9.3

Cox Communications Inc

9.7

Adelphia

8.2

Source: Euromonitor International

In the global arena, Hollywood’s long-standing tensions with China has taken its toll as Time Warner is pulling out of an ambitious, four-year theater venture in the country because of tightened restrictions on foreign ownership. The decision was announced in November 2006 came after its Warner Bros. unit tried unsuccessfully for more than a year to negotiate a compromise with the Chinese government over a July 2005 ruling requiring outside investors to cede control in ventures to their Chinese partners. Warner’s decision underscores Hollywood’s frustrations operating in China. Although studio executives consider China to be the world’s best growth opportunity for U.S. entertainment, they also are wary of expanding there, in part because of what they believe are burdensome government rules.

Although the media market is fraught with competitors, Time Warner had been a formidable competitor because it offers diversified, yet complimentary products and services. The company operates in print media, television, cinemas, internet, cables services and wired broadband segments. Leveraging its operations in complimentary segments the company has been able to reproduce the same content in various formats to generate additional sales. Its wide product portfolio has also allowed the company to offer superior bundles to the customers.

Company Analysis – Time-Warner

Time Warner is one of the world’s leading media and entertainment companies. Its major businesses encompass an array of respected and successful media brands. Among the company’s brands are HBO, CNN, AOL, Time, Fortune, People, Sports Illustrated, and Time Warner Cable. CNN operates in nearly 200 countries, while AOL is the world’s leader in interactive services with 19.5 million subscribers in the US and 6 million in Europe at the last count. Time Warner’s cable business, Time Warner Cable (TWC), is the second-largest cable operator in the US while Warner Bros is one of the worlds leading studios. These are well established brands with global brand recall. The company can leverage the equity of its brands to generate sales.

New developments continue to stream in Time-Warner. In 2004, Time Warner Cable announced the creation of a new business unit, Time Warner Cable Voice Services. This creation was responsible for overseeing the rollout of its residential telephone service, known as Digital Phone. During the same year, AOL Europe, and Google, announced a new multi-year agreement to provide targeted advertising from Google’s AdWords advertisers for the subscribers of AOL Europe. In February 2005, Warner Home Video announced the formation of CAV Warner Home Entertainment Company, a joint venture with China Audio Video.

The company entered into a joint venture with New Line Cinema to form Picturehouse. AOL announced the acquisition of Weblogs, a blogging company. AOL also acquired an online digital music subscription company called MusicNow in November 2005. During the same month the company, along with several other cable companies concluded an agreement with Sprint. According to the agreement, the companies would form a joint venture for providing wireless and wireline entertainment product.

AOL acquired Truveo, a pioneer in internet video searching in January 2006. In the same month Time Warner entered into an agreement with CBS to launch a new television network, The CW. Cartoon Network formed a joint venture with VIZ Media to create Toonami Jetstream, to provide broadband video services in April 2006.

Time Warner has been continually profitable. The company recorded revenues of $43,652 million during the fiscal year ended December 2005, an increase of 3.7% over 2004. For the fiscal year 2005, the US, the company’s largest geographic market, accounted for 79% of the total revenues. Time Warner generates revenues through its five business divisions: filmed entertainment (26.4% of total revenue during fiscal year 2005), networks (21.3%), cable (21%), AOL (18.3%), and publishing (12.9%).

During the fiscal year 2005, the filmed entertainment division recorded revenues of $11,924 million, an increase of 0.6% over 2004. The networks division recorded revenues of $9,611 million in fiscal year 2005, an increase of 6.2% over 2004. The cable division recorded revenues of $9,498 million in fiscal year 2005, an increase of 12% over 2004. The AOL division recorded revenues of $8,283 million in fiscal year 2005, a decrease of 4.7% from 2004. The publishing division recorded revenues of $5,846 million in fiscal year 2005, an increase of 5% over 2004.

By geography, the U.S. remains Time Warner’s largest geographical market, accounted for 79% of the total revenues in the fiscal year 2005. Revenues from the US reached $34,469 million in 2005, an increase of 2.7% over 2004. Other international countries accounted for 6.7% of the total revenues in the fiscal year 2005. Revenues from other international countries reached $2,907 million in 2005, an increase of 4.5% over 2004. The UK accounted for 6.6% of the total revenues in the fiscal year 2005. Revenues from the UK reached $2,886 million in 2005, an increase of 15.1% over 2004. Germany accounted for 2.8% of the total revenues in the fiscal year 2005.

Revenues from Germany reached $1,233 million in 2005, an increase of 6.2% over 2004. France accounted for 2.2% of the total revenues in the fiscal year 2005. Revenues from France reached $941 million in 2005, an increase of 7.1% over 2004. Canada accounted for 1.4% of the total revenues in the fiscal year 2005. Revenues from Canada reached $625 million in 2005, an increase of 24.3% over 2004. Japan accounted for 1.4% of the total revenues in the fiscal year 2005. Revenues from Japan reached $591 million in 2005, a decrease of 13.7% from 2004.

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Financial Statement Analysis

Company Posted Sales

Fiscal Year

Total Sales

2003

39565

2004

42089

2005

43652

 Profitability Ratios

2007*

2006*

2005

2004    

2003 

Sales

Gross Margin

Operating Margin (%)

Pre-Tax Margin (%)

Net Profit Margin (%)

Accounts payable

Net Expenses

Inventories

Revenues per share

Cash-Flow per share

Earnings per share

46500

0.4

30

 

8.3

 

 

 

12.9

3

1.1

44900

0.4

30

 

11.4

 

 

 

11.8

3.12

1.35

43652

0.043

26.06

9.37

6.65

1,380,000

13,676,000

1,806,000

9.705

1.374

0.62

42089

0.042     

32.008

11.66   

7.99

1,494,000 

13,094,000 

1,737,000 

9.354

2.076

0.68

39565

0.041 

30.68

11.42 

6.67 

1,629,000

12,559,000

1,390,000

9.03

2.024

0.68

*Projected (Source: Valueline Investment Survey).

Time-Warner remains to be an otherwise bright entertainment conglomerate. The company’s networks and cable segments have been posting consistent revenue growth in recent years. Revenue from the networks segment increased from $8,434 million in 2003 to $9,611 million in 2005. Revenue from the cable division increased from $7,699 million in 2003 to $9,498 million in 2005. These two segments together contribute more than 42% of the total revenues of the company.

Increasing segmental revenues have contributed in the company’s overall revenue growth of 3.7% in fiscal 2005 over fiscal 2004. After trying to devise a way to maintain AOL’s subscription service in a high-speed world, management finally threw in the towel and decided to give AOL’s services away for free, focusing on advertising revenue. The move may have been late, but not so late that it won’t help stem AOL’s user base. The big concern is if advertising revenues will be sufficient to offset subscription losses. Still, this property is an important part of the company’s overall collection of media-related businesses.

Moreover, the performance of the filmed entertainment segment and AOL segment has been weak in the past three years. Revenue from the filmed entertainment segment grew by as little as 0.6%. Revenues from the AOL segment declined from $8,598 million in 2003 to $8,283 million in 2005, representing a growth rate of -2%. The two segments contribute around 45% of the total revenues of the company. A weak operating performance by these segments indicates that the company has been losing ground to its competitors.

The reason for this projection and forecasts is that TWX remains to be garnering operating profit. Although net profit have declined in fiscal 2005 compared to fiscal 2004, operating profits and net profits declined 26.7% and 13.6% respectively in fiscal 2005.

The company’s operating margin declined from 14.6% in fiscal 2004 to 10.4% in fiscal 2005, while the company’s net profit margin declined from 8% to 6.6% in the same period. Declining profit margins indicate increasing costs and can adversely affect the company’s long term financial position. Declining cash from operating activities Time Warner’s cash flows from operations have been declining in recent years. Cash from operations have declined from $6,601 million in fiscal year 2003 to $4,965 million in 2005. Declining cash flows can force the company to borrow external capital to fund its growth plans, which could prove to be expensive.

TWX

Dividend Rate Per Share ($)

Shares Outstanding (M)

Ave. Daily Volume (M)

Beta

Shareholders

Market Cap ($M)

Institutional Holdings (%)

Yield (%)

12-month P/E

             0.22

3972.58

23.44

2.0329

56,500

83066.5

72

1

24.6

We can use the dividend discount model to estimate the cost of common stock. The difference between common stock and preferred stock is in our assumption about the growth pattern of future dividends. With common stock, we typically assume that dividends grow at a constant rate into perpetuity. Then we can write the present value of the assumed dividend stream as

P 0  =

D 1

————————-

( 1 + k s )

where,

P0 = the common stock price per share.

D 1 = the dividend per share one year from now.

ks = the required rate of return on common stock.

If we solve for ks, we get:

ks  =

D 1

————————-

P0

At present, TWX’s stock price was at $20.14. TWX has historically paid out about 40 percent of its earnings as dividends. Therefore, with a forecast of about $0.55 per share in earnings for next year, TWX’s dividend would be forecast to be $0.55 × .40 = $0.22 per share. So, the dividend yield, defined as D1/P0, is $0.22/$20.14 = .0109, or 1.09 percent.

TWX’s Key Growth Rates and Averages

Past Growth Rate (%)

1 Year

3 Years

5 Years

9 Years

Sales

3.71

2.56

29.05

49.46

Net Income

-9.47

Ratio Analysis (Annual Average)

Net Margin (%)

6.65

7.41

LTD of Capitalization (%)

19.48

21.01

20.71

21.15

Return on Equity (%)

4.71

5.32

8.18

Pricing/Earnings

Recent Price

20.14

P/E Ratio

15.612

P/E (Trailing)

14.183

P/E (Median)

NMF

Rel. P/E Ratio

0.724

Ratings

Financial Strength

B++

Stock’s Price Stability

40

Price Growth Persistence

20

Earnings Predictability

20

Relative Value

Year 2000

2001

2002

2003

2004

2005

2006

2007

2008

Free CFs

11.8

12.8

13.5

13.9

16.0

17.9

20.1

22.5

PV of FCFs

10.17

9.58

8.65

7.68

7.62

7.36

7.10

WACC = 16%

Long run g = 12%

MV of Debt = $202 million

No. of shares = 50

PV of FCF1-7  = 50.97

TV at Year 7 of FCF after Year 7 = FCF8/(WACC – g) = $448.00

PV at of TV at Year 0 = TV/(1+WACC)7 = 183.88

Sum = Value of the Total Corporation = $234.85 million

Less: MV of Debt and Preferred = $202 million

Value of Common Equity = 32.85

Divide by No. of Shares = 50

Value per Share = Value of Common Equity/No. Shares = $0.66

Assuming that beginning in the fourth year, the free cash flows are to grow by 10% less than previously predicted:

 

Year

Old FCF

New FCF

1

2001

$11.8

$11.8

2

2002

$12.8

$12.8

3

2003

$13.5

$13.5

4

2004

$13.9

$12.5

5

2005

$16.0

$14.4

6

2006

$17.9

$16.1

7

2007

$20.1

$18.1

8

2008

$22.5

$20.2

                        We will assume that the long-term growth rate and WACC will be the same as previously assumed. From this

information, we can do the following calculations.

Total PV of New FCF’s, Years 1-7 =$55.09

FCF 8  = $20.23                     $20.23

TV  at Year 7: $505.76    = ——————-

PV of TV: $178.95                       4%   = WACC- gL

Market Value of Total Company =  $234.05

Less: MV of Debt = $202

Market Value of Equity = $32.05

No. of Shares = 50

Value Per Share = $0.64 versus $ 1.37 under original assumptions. Therefore, a 10% reduction in some of the cash flows leads to a 53.28% decline in the value per share.

As of September 30, 2006, TWX had net debt of $202 billion (including $11 billion on the Adelphia deal), and a net debt/EBITDA ratio of about 3.0X. In 2005, TWX paid out $2.8 billion related to a government settlement. Including the acquired systems, management sees low double-digit adjusted EBITDA growth in 2006 (off a restated base of about $10 billion in 2005), with 35% to 45% conversion of EBITDA into free cash flow. Management plans about $1 billion of cost cuts in 2006 and 2007 (excluding the $1 billion of cuts at AOL as previously mentioned). We project free cash flow of over $11 billion in 2006 and 2007 combined.

Pursuant to a $20 billion share buyback program, TWX plans to repurchase about $15 billion of its shares in 2006, and the remainder in 2007. Over the longer term, the company targets a 3X leverage ratio. TWX began paying a quarterly cash dividend of $0.05 per share on its common stock in the 2005 third quarter (about $900 million a year), raising it to $0.055 in July 2006. TWX would also receive about $600 million in cash from the dissolution of its cable joint venture with Comcast.

TWX undertook several asset divestitures in the past few years to enhance its financial flexibility, notable among which are the 2004 sale of its Warner Music Group (for $2.6 billion in cash), a 50% stake in Comedy Central ($1.2 billion), a DVD/CD manufacturing business ($1 billion), and two NBA and NHL professional sports teams (undisclosed). Also, in 2006, TWX sold its book publishing business for $532 million in cash, and its Turner South network for about $375 million in cash. TWX also raised $239 million from the sale of stock in Time Warner Telecom.

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