Content Digs a Wide Moat at Time Warner

We lowered our fair value estimate for

Foreign exchange continued to hurt the top and bottom lines in the quarter. However, management did raise its earnings per share guidance for 2016 to $5.30-$5.40 from $5.25. Revenue at Turner increased 2% to $2.7 billion as ad revenue improved 5%, offsetting flat quarters for the other segments. Advertising revenue was driven by additional MLB playoff games and improved ratings at CNN due to the primaries. However, this growth was more than offset by higher programming costs including the MLB rights. HBO growth of 6% was driven by a 20% increase in content revenue due to international library licensing. Warner Bros. revenue declined 15% as the division suffered from tough theatrical comps with The Hobbit and Interstellar in theaters a year ago. Adjusted operating margin fell 160 basis points to 19.6% as the decline at WB offset selling, general, and administrative expense improvements from last year's restructuring plan.

Management released the first subscriber numbers for HBO Now, its stand-alone subscription video on demand offering. The reported level of 800,000 subscribers appears weak despite the service only being on the market for 10 months. The slow rollout for supporting platforms appears to have limited the potential market, and HBO Now is still not available on Xbox One or PS4, two major streaming platforms. HBO plans to increase the number of hours of original programming by 50% to enhance the attractiveness of the service. We expect the next season of Game of Thrones to help improve new sub adds as the service launched with the premiere of the last season.

Barriers to Entry for New Cable Networks With the spinout of Time, Time Warner completed its transformation into a pure-play entertainment content company. Its entrenched cable networks and successful content studio create barriers to entry and are the reason for our wide economic moat rating.

Time Warner's portfolio of basic cable networks, which includes CNN, TNT, and TBS, generates about 50% of consolidated EBITDA. Creating a new basic cable network with 100% carriage, high-quality content, and attractive affiliate fees requires not only a large up-front monetary investment but also deep industry relationships. Most television distributors worldwide believe their channel offerings are deep enough and see no need to expand. A new channel could overcome this reluctance by paying for carriage, but the risk inherent in this tactic precludes small firms from employing it. Because its networks are among the most widely watched and create a steady stream of affiliate fees and advertising dollars, Time Warner can use its existing channels as leverage to gain distribution for new channels.

HBO, the leading premium cable channel (25% of EBITDA), remains the prestige platform for scripted television as the network generally earns the most Emmy nominations in major categories annually. We believe HBO will continue to prosper as the outlet of choice for creators of original programming, supplemented by its exclusive deals with several major movie studios. As Internet video gains acceptance worldwide, the HBO Go streaming service will increase in importance for attracting and retaining subscribers. HBO Now will broaden the channel's global reach and maintain its place with younger cord-cutters.

The film and TV entertainment studio, Warner Bros., is one of six major film studios and one of the largest producers of television content. The film library contains classic films, recent hits, and movie franchises. Television production holds a deep library that includes current hits such as The Big Bang Theory. We believe demand for quality content from the broadcast and cable networks along with OTT providers will only intensify, ensuring steady cash generation from both new and old programming.

Value of Video Continues to Increase We assign Time Warner a wide moat rating. Our guiding premise in media is that the value of video content continues to increase even as distribution markets mutate. Despite the changes in distribution, pay-TV penetration remains at around 90% of households in the United States. Even without a pay-TV subscription, most cord-cutters still consume video content. While OTT offerings such as Netflix and Amazon Prime have begun to create their own content, both services require deep libraries to gain and retain subscribers. Given the ongoing demand for content, we believe content creation for cable networks is not a zero-sum game, as quality content will always find an outlet.

A new entrant will encounter two major hurdles to launching a new cable channel with widespread distribution in the U.S. or abroad. First, the cost to create new quality content is very high. Turner Networks and HBO spend more than $3.5 billion combined annually on original and sport programming while Warner Bros. spends $5.5 billion on film and television production. Second, gaining distribution without paying for carriage in many markets for a new company may be nearly impossible, as cable operators have no need for new channels, which only add potential costs down the road. However, Time Warner can leverage its existing channels such as TNT or CNN with carriage to force an operator in the U.S. or around the world to carry a new offering.

Time Warner is vertically integrated with domestic and international channels, with most of the original content on these networks owned by the company. Time Warner owns a deep library of old and new content in both television and filmed entertainment. The company monetizes this content either on its own channels or by licensing it to other networks while retaining the rights to the programs. The strong performance of its shows offers a virtuous cycle in which the creators of the network's hit shows have an incentive to launch new shows with the network, and the performance attracts other creators to the platform. The company also owns HBO, which provides a premium platform with a history of creating and launching edgier content.

While there are a number of bidders for original programming, including NBC Universal and USA (Comcast), CBS (CBS), Fox and FX (Twenty-First Century Fox), and ABC (Disney), the revenue and profits for all of these players have increased over the past decade. The driver of growth remains the demand for content, as the average adult spends over five and half hours a day watching TV, according to Nielsen. As the largest producer of television content, Time Warner holds a very strong position, in our opinion.

Adapting to Changes Is Key Time Warner's results could suffer if the company cannot adapt to the changing media landscape. Basic television service rates have continued to increase, which could cause consumers to cancel their video subscriptions or reduce their level of service. The retail cost of HBO for U.S. subscribers is $15 per month on top of the cost of a basic video package. Viewership of its programs could fall below expectations, and advertisers could pull back on their spending, both of which could drag on advertising sales growth. Advertising is also cyclical, so another slowdown or recession would hurt revenue. Licensing historical content to providers like Netflix could have long-term negative subscriber implications for HBO.

While some observers believe the recent rejection of the Fox takeover from the company is a sign of an entrenched management team, we would point to shareholder-friendly moves, including the spinouts taken by the same team over the past several years, which reinforce our view that the board and current management believe independence is the best way forward. Many observers, including us, believe that Fox will rebid for Time Warner if the stock slips under $80 for a prolonged period. We believe that management has been and will stay focused on creating long-term value, but we will remain vigilant for any attempts to prop up the share price for shorter-term purposes.