Time Warner Deal Implies Company Throwing in the Towel

22 October 2016 | by Sean Stannard-Stockton, CFA

Multiple news sources are reporting that Time Warner is on the verge of agreeing to be purchased by AT&T for about $86 billion or a total enterprise value of $108 billion. Time Warner’s willingness to sell at this price suggests that the management team has lost confidence in their ability to navigate the changes being wrought by streaming technologies. Yet, the deal also supports the idea that the market is materially undervaluing content companies.

A little over two years ago, the company rejected an offer from 21st Century Fox to buy the company for about $80 billion* (enterprise value of $97 billion). At the time, Time Warner said that the Fox offer significantly undervalued the company. It was reported that Fox was willing to offer as much as $89 billion (enterprise value of $106 billion, essentially the same amount under discussion in the AT&T transaction), but people close to the deal said that Time Warner wanted “well over” $93 billion (enterprise value of $110 billion).

The acceptance of the AT&T deal at essentially the same value as what Fox was said to be willing to pay over two years ago — despite Time Warner generating almost $7 billion in free cash flow since rejecting the deal — strongly suggests that management has a significantly degraded outlook for the future of their business. It is a well-accepted fact that the rise of streaming video content is disrupting the media industry. At the same time, content owners like Time Warner are seeing the value of their content increase as a new group of bidders (Netflix, Google, Apple, Amazon, etc) correctly recognize that whether it is delivered via internet enabled streaming or traditional television infrastructure, consumers want to watch quality content. The challenge for content companies like Time Warner is making sure that they retain or even enhance the monetization of their content assets as the means of distribution evolve.

The decision to sell to AT&T implies that Time Warner management believes they are simply not up to the task of managing their valuable assets through the transitions roiling the industry. Yet the deal also suggests that investors have been significantly underestimating the value of Time Warner’s content and likely are similarly underestimating the value of other content focused media companies. Just prior to rumors of the deal coming out on Friday, Time Warner was being valued by the market at just $63 billion (enterprise value of $86 billion), a large discount to the AT&T deal price. Even so, this price was close to a 52-week high as the market had valued Time Warner at an average price over the last year of just $59 billion and as low as $51 billion back in February.

What is curious about Time Warner throwing in the towel on their ability to navigate the transition to streaming on a standalone basis is the fact that the company owns HBO, which has the potential to become a significant player in global, direct to consumer distribution through HBO NOW. This potential was recognized by Netflix, the leader in the move to streaming video back in 2013, when on the eve of launching House of Cards, the first Netflix Original show, their head of content Ted Sarandos stated bluntly “the goal is to become HBO faster than HBO can become us.”

While Time Warner has put resources behind HBO NOW and it has had some success in building a direct distribution business, the management team has seemed to believe that it is more important to protect their legacy business and their $1.3 billion annual dividend rather than invest aggressively in preparing their business for the transition to streaming.

By selling to AT&T, Time Warner is waving the white flag and admitting that Netflix has become HBO before the company could become Netflix. Therefore, their best option is to sell to a distributor like AT&T, which itself needs content to compete effectively against Netflix and other streaming platforms.

While Time Warner may have failed in their attempt to deliver on  their plan to “create significantly more value for the Company and its stockholders” after rejecting the Fox takeover, the AT&T acquisition highlights the critical value of content. While many players have been late to fully act on the imperative to adapt to the changes brought on by streaming, at least some executives recognize the that there is huge opportunity in addition to the risks. Chief among those forward thinkers is John Malone, the billionaire famous for his role in developing the cable TV industry from its infancy, whose current collection of media assets have outperformed Warren Buffett’s Berkshire Hathaway over the past decade even as the disruptive threat from streaming has coursed through the industry.

For some time now, Malone has been making the case that streaming technology increases the value of content because suddenly that content can be monetized on a global scale rather than via local, legacy TV distribution systems. At the same time, distribution systems need quality content because streaming destroys the local monopolies that distributors have had in the past and so consumers will select those distribution offerings that deliver the best value for high-quality content.

Of course, not all content travels globally. While Seinfeld reruns might still command high value in the US, this content is unlikely to travel well to India, Korea or Italy. So when it comes to the value of content, it will be all about high quality, globally relevant content. This is one reason why a media company like Discovery Communications (controlled by Malone) is so well-positioned for the shift to the global stage, where the company already gets half of its revenue, more than any other publicly traded US content company. Discovery focuses on non-fiction content, such as nature documentaries, which are inexpensive to produce and are relevant to consumers around the world.

The sale of Time Warner will be seen over time as one of the seminal moments of the shift to a global, streaming-enabled media industry. What we know now is that Time Warner simply wasn’t prepared to make this shift on their own, although just two years ago when they rejected Fox’s offer, they had not yet recognized this reality. Going forward, we believe that Netflix’s success in becoming HBO before HBO could become Netflix establishes it no longer as a disruptor but as the leading player in the global, streaming-enabled media industry. As other players race to catch up, we expect that consolidation will continue as the players come to terms with the fact that they must be part of a global distribution platform of high-quality content in order to thrive. Indeed, with an enterprise value of $56 billion or half the price AT&T is paying for Time Warner, it seems quite likely that Netflix may see intense interest from potential acquirers such as Apple, which itself discussed buying Time Warner, Amazon, Google or even a content owner such as Disney.

You can learn more about Ensemble Capital’s view on the media industry in Part I and Part II of our series Of Media & Moats.

*Attentive readers will note that the $107.50 price reported to be offered for Time Warner shares seems to be a large premium to the $85 offer Fox made. But Time Warner has spent a lot of money buying back shares in the last two years so the $107.50 price equates to market cap only 7.5% higher than the Fox bid and a 3% discount to the price Fox was said to be willing to pay. But Time Warner has also taken on more debt since then (which the buyer will take on the responsibility of paying off), so when taking the debt into consideration, the AT&T offer is a 2% superior offer to the amount Fox was said to be willing to pay.

Ensemble Capital’s clients own shares of Netflix (NFLX), Discovery Communications (DISCA), Alphabet (GOOGL) and Time Warner (TWX).

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