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One of the Best Media Companies to Own Today

Matthew Coffina, CFA

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Morningstar StockInvestor editor Matt Coffina. We are going to talk a bit about his recent purchase of Time Warner (TWX) and why he thinks it's well positioned in a changing media landscape. Matt, thanks for joining me today.

Matt Coffina: Thanks for having me, Jeremy.

Glaser: So, you've talked in the past about how media is kind of undergoing this secular change right now, going through a lot of different changes. Can you just tell us a little bit about what some of those changes are?

Coffina: Sure. I definitely wouldn't downplay the changes that are going on in media, and I think this is really a once-in-a-generation shift driven by technology. We've already had, for a number of years, digital video recorders, which enable consumers to skip through advertisements, for example. Somewhat more recently, over-the-top services like Netflix (NFLX) that enable you to watch exactly what you want, when you want over the Internet. There's been an increasing trend toward on-demand watching, in general, where consumers are not necessarily sitting down to watch a show at any given time. They just want to record it or get it through an over-the-top service and watch it when they want.

This is going to have profound impacts, in my view, on the media industry. And I think there will be winners and losers. I bought Time Warner recently for our Hare portfolio because I think it's going to be among the winners. I think it has one of the strongest moats in media. It's right up there with companies like Disney (DIS) and, to a lesser extent, FOX (FOX) as having a relatively strong competitive position.

Glaser: Let's take a deeper dive on that. One of the threats is certainly the decline of traditional advertising. Why do you think Time Warner is better positioned here?

Coffina: I'm a big believer in the shift to digital advertising. It won't happen overnight. You're not going to lose all of the advertising that has been on TV and have it all go to digital; but we own, for example, Google (GOOG) and Baidu (BIDU) in the Hare portfolio, and that's a play on digital advertising, where we think, steadily over time, digital ads will gain share from traditional media and TV advertising, in particular--which has been largely untouched until now, I think, is going to start to gradually give way to more digital advertising.

The good thing about Time Warner, on this front, is that advertising is only about 16% of overall revenue. So, that's definitely at the low end relative to peers. You have other companies like Discovery Communications (DISCA) or Scripps Networks (SNI) that are much more highly dependent on advertising. It might be 50% of their revenue. Also, companies that own broadcast networks, in general, are much more dependent on advertising.

Time Warner, in contrast, gets more affiliate fees--HBO subscriptions, content licensing fees from Warner Brothers. Those revenue sources, I think, are much more insulated from this shift in advertising spending. So, for advertising, I don't have high hopes for growth; but even if advertising spending steadily loses a percentage point or two of share every year, the overall ad market is growing, so we might still be looking at stagnant ad revenue. It's not initially going to outright decline; it might just lose market share steadily to digital over the years. And then the fact that it's a small percentage of Time Warner's overall revenue is what really gives me confidence to say that it's a headwind that can be overcome.

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Glaser: We have seen an increasing number of clashes between distributors and the content producers. Do you think Time Warner has the upper hand here? Do people need their content?

Coffina: Yes, this is definitely another trend that we are seeing. Distributors consolidating within themselves. We are seeing Time Warner Cable potentially being acquired by Charter, for example. And then, just in general, I think consumers are getting increasingly frustrated with cable bills that go up every year by mid- or high-single-digit percentages. And so the distributors are finding it necessary to push back against the consistent rate increases of the content companies. And the best tool in their tool box for doing that is to exclude channels altogether. And so I think we are seeing rise of more narrow content bundles. We saw, for example, Dish's Sling TV. We saw Verizon trying to break down the bundle into smaller parcels and giving consumers more options to not pay for content that they don't want or that they are not watching.

So, Time Warner's advantage is really that they own what I would consider must-have content. We are talking, specifically, about the Turner segment. They own TBS and TNT, which are both top-five basic-cable networks; Cartoon Network, which includes Adult Swim, which is popular with the younger demographics; CNN, which is declining in ratings and struggling with some competition from MSNBC and FOX News but still a very solid franchise and very solid internationally, especially. Combine that with HBO and I think Time Warner has a very compelling package of content to offer to distributors. At the same time, they don't have a lot of these lesser-watched channels that they're trying to push through as well. So, they can focus more on these high-quality channels, and that makes [Time Warner] a must-have for distributors. In Sling TV, for example, we see that TBS and TNT are included in that package, as are Cartoon Network and CNN. I think, in general, that Time Warner's channels are going to be some of the last ones that you are going to try to exclude from a narrow content bundle. If consumers aren't willing to go without those channels, that really gives the bargaining power to Time Warner more so than for somebody with weaker channels that are more easily excluded from the bundle.

Glaser: Are you concerned about the risk of fragmentation in the media landscape, more generally, that maybe people don't want to watch shows on any network if they are going to get them elsewhere? Do you see that as a big long-term threat?

Coffina: There is definitely concern about the breaking of the bundle. Are people going to not need traditional cable bundles anymore and what does that do to the content companies? I think the overall demand for video content is actually only increasing over time. If you think about it, people are basically carrying around little TVs in their pockets nowadays in the form of smartphones, and they have their iPads around the house. They're able to watch TV anywhere, at any time. So, I think the demand for video content will always be there.

Don't forget, also, that the typical household in the U.S. watches some crazy amount of TV--something like five or six hours a day of TV per household. That's not easy to replicate with a service like Netflix. Certainly, there are some millennials who maybe are just watching Netflix and complementing it with Hulu or YouTube or things like that; but I think the vast majority of households are still going to want some kind of content bundle, regardless of how it's delivered--whether it's from a traditional cable company or whether it's an over-the-top service like Sling TV. I think the vast majority of households are still going to want some kind of bundle. We are seeing that overall pay-TV subscribership isn't growing anymore; it's even shrinking a little bit. But it's going to be a very gradual shift. And I think Time Warner--again, with the very strong channels--is going to be able to get those channels included in whatever bundles come about. It also has an opportunity through HBO to go direct to consumers in an over-the-top way. At the same time, Time Warner, with its relatively strong bargaining position, should be able to continue increasing its affiliate fees more so than somebody with weaker channels.

Glaser: You mentioned that standalone, HBO. Is that one of the primary potential growth drivers for the company?

Coffina: It's very hard to handicap what might happen with HBO, but I think HBO already has a great suite of content. They have exclusive rights to all the movies from the major studios, not just Warner Bros. but also 20th Century Fox and Universal, I think, as well. For a lot of the major studios, HBO gets their movies first after they're out of the theatres. And then on top of that, HBO, of course, has its very popular original content. Right now, it's Game of Thrones that everyone is talking about. Then, of course, they have their library of past content--The Sopranos and all of the hit shows of the past.

So, I think HBO has a very compelling offer for consumers, and it's very hard to handicap at this point how big that could be. But I think it certainly has the same kind of appeal as Netflix, and I don't think these services are mutually exclusive. The more you see people abandoning the traditional cable bundle, the more likely they are to pursue multiple over-the-top-services. So, maybe they will subscribe to Amazon Prime and Netflix and HBO, and that will be their bundle. And, again, I think Time Warner is better positioned than the vast majority of media companies to preserve its role and preserve the economics of its particular channels versus some weaker peers.

Glaser: So, if the company is in a good competitive position, what does that mean for valuation? Why are the shares trading at a discount right now?

Coffina: I think the shares are very reasonably valued. When we purchased Time Warner, it was trading at about 18 times earnings. Our analyst is forecasting mid-teens earning per share growth, and it's very hard to find a company with that kind of growth trading at that kind of multiple in the current market. So, we think they can get there through just mid-single-digit top-line growth--call it 4% to 5%. Again, that's mostly affiliate fee growth, HBO growth, Warner Bros., and so on--not so much from advertising. On top of that, they've consistently expanded margins in recent years, and they're continuing to find ways to do that. It's a very leverageable business model. Once you have quality content, you can just sell it over and over again and send it out through different channels.

A great example would be Friends, which went off the air over a decade ago. Besides rerunning the episodes on TBS and so on, Warner Bros. just relicensed Friends to Netflix. And then you still have I Love Lucy on TV 50 years later. So, in some cases, this content has a very long life, and once it's produced, it's just basically pure margin. So, I think they can continue to expand their operating margins over time, and then on top of that, it's a very cash-flow-rich business. They've been repurchasing 4%, 5%, or 6% of the shares every year. Maybe that will slow a little bit because they have a fair bit of financial leverage at this point, but I think that will continue. And then the shares also pay a decent dividend--little under 2%.

So, all of those things combined, I think, make for a very attractive total-return profile and a very attractive valuation. The best reason I can give you for why they would be trading at that valuation are these concerns about disruptions in media. We see a wide spectrum of valuations in media right now. You have, for example, Disney trading at more than 20 times earnings, and then you have Viacom (VIA) trading at barely 10 times earnings because its content is perceived as lower quality. Time Warner definitely sits somewhere between those extremes; but again, if you believe in the economic moat and you believe that it's a defensible business over the long run, I think it's a very attractive valuation.

Glaser: Matt, thanks for the update today.

Coffina: Thanks for having me, Jeremy.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.

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