It's 20% easier to make a positive argument for AOL Time Warner (NYSE: AOL) now that the stock has fallen 20% since its July 18 earnings announcement. But what the heck made the stock plummet 20%?
Well, sales only grew 3% in the second quarter, to $9.2 billion. Not great. For the year, the company is expected to grow sales 9% to 12%. Yet, for the first six months, sales have only grown 6% to $18.2 billion. The first six months are usually much slower than the second, but how slow they were has some concerned.
The company must also improve its cash flow. Second-quarter EBITDA -- earnings before interest, taxes, depreciation, and amortization -- rose 20% to $2.5 billion. Yup, 20%. Not bad. Except that management told everyone in January to expect about 30% EBITDA growth this year, to $11 billion. EBITDA is up 20% so far in 2001, to $4.7 billion, leaving plenty to go.
But, dear investor, then there is free cash flow. Free cash flow -- net operating cash flow minus capital expenditures -- is up 162% so far this year, to $1.2 billion (excluding one-time and special charges, as all these numbers exclude). Free cash flow was hoped to at least double to $1.84 billion this year. It's already on track to do much better than that.
That's very good news because free cash flow growth is much more important than sales growth and -- ha! -- don't even compare free cash flow to EBITDA. EBITDA is a piddly, scrawny joke compared to the importance of free cash flow, which is a company's lifeblood. So, where it mattered most, AOL Time Warner shined even during the slow half of the year.
Concerns about advertising
Investors fled from the stock like cockroaches from light, however, because they're concerned that sales will continue to be soft due to weaker advertising revenue. The irony is that the AOL online service grew advertising sales 26% in the last quarter, and Time Warner Cable grew advertising sales 19%. It was the traditional media channels -- magazine publishing and television networks -- that had the slower advertising that really hurt the numbers.
AOL Time Warner's total ad revenue grew just 1% to $2.3 billion last quarter. I would sob, but advertising is a cyclical business, so there's no need. It will turn around. Meanwhile, AOL Time Warner isn't even doing badly in this steep downturn. It is, instead, holding up. (And just ask Yahoo! (Nasdaq: YHOO) how steep the downturn was.)
The big picture and the second half
When you step back and look at the company as a whole -- and remember that it just officially merged in January -- it appears to be growing well across the board. Four of the company's six business divisions grew pro forma sales impressively in the second quarter, while only music and print publishing saw slightly shrinking sales (which isn't unusual at times for either industry). EBITDA, which we use to estimate each division's free cash flow, grew even more impressively than sales at the four leading divisions -- AOL, Cable, Networks, and Film -- and grew nicely in the Music division as well, even with lower sales.
Now, in the second half of the year, this company's business traditionally (when you consider the separate pasts of each company) takes a steep upturn, especially in the last quarter. The fourth quarter can often represent more than 35% of the year's income.
In part due to this, management said on July 18 that it should still make its 2001 goals. It appears that it should. The company has $18.2 billion in sales toward its $40 billion goal, so it's nearly halfway there; it has $4.7 billion in EBITDA toward its $11 billion goal, so it's a whole 42% there going into the strong half of the year; and finally, free cash flow is already 66% to the $1.8 billion goal, so the company will likely blow past that goal. Achieving these goals is important because the stock is, of course, valued on these results.
The price tag: an attractive risk-to-reward
At its recent $43 price, AOL Time Warner is -- ahem -- can we call it a good value? Can we? I will. I'll put my neck out. At $43, the stock trades at approximately 20 times its estimated EBITDA for 2001. Given how the company is expected to grow EBITDA 20% to 25% this year and close to that rate next year, and given the similar multiples granted to peers that aren't as strongly positioned, AOL Time Warner's stock appears attractively priced.
The stock ain't cheap on a price-to-free-cash-flow basis, but free cash flow is growing rapidly, so it'll catch up. Media giants are typically valued on EBITDA anyway, so we can construct a simple but valid valuation argument given just AOL Time Warner's estimated EBITDA growth. Take a look:
Estimated Stock Price
Year Est. EBITDA at 20x 25x 30x
2001 $11.0 bil $44 $55 $66
2002 $14.3 bil $57 $72 $86
2003 $17.8 bil $71 $89 $107
2004 $21.7 bil $87 $109 $130
If AOL Time Warner can grow EBITDA at around 20% annually the next few years, or to the numbers that are generally expected and shown above, then depending on the stock market's mood, it should trade at 20 to 30 times EBITDA, or at the share prices listed in the table. That means that by 2004 (not that far away anymore!) the stock could more than double to at least $87 if business generally performs as hoped. And at any rate, the risk-to-reward scenario now, at $43, is quite favorable.
Add it all up, and it's a bull's story
AOL Time Warner is the strongest, most successfully diversified (not sloppily diversified) media company in the world. Its cable network has excellent long-term potential, as does its various content media, as broadband networks take flight the next several years. Perhaps best of all, the company remains aggressive. Last week it was announced that AOL might pay PC makers for premium spots on computer desktops, a first in the industry. I like that moxie. The company needs it to battle Microsoft (Nasdaq: MSFT).
Market leadership, great brands, strong free cash flow, an admirable growth clip even in a poor economy, and a share price that has considerably more room for long-term reward than for punishment. Add all that together and at these prices, AOL Time Warner is a bull's story, not a bear's story. But, oh, look out, here comes a bear....
Jeff Fischer doesn't own AOL Time Warner. His stock holdings can be viewed online, as can the Fool's disclosure policy.
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