Icahn's Case for Time Warner

Attention, Time Warner (NYSE:TWX) shareholders: Carl Icahn has issued an open letter critiquing your company's board of directors. He advocates new representation on the board because of various factors that have contributed to the stagnation of the company's stock price. The letter bears reading, as well as consideration. With your shares trading for less than one-fifth what they fetched in 1999, new blood on the board (oh, what a phrase that is!) just might be the right formula to get the stock aimed upward again.

Suggesting that he sees Time Warner's stock getting a strong price on Wall Street, Icahn made it clear in August that he would like to see "a separation of the cable business from the content businesses, combined with the immediate repurchase of at least $20 billion of common shares." A $20 billion stock repurchase could remove 20% or more of the company's float, thus reducing the divisor for future earnings-per-share calculations. The added $1.2 billion in interest payment (using a 6% interest rate), which would drive interest payments up to $3 billion a year, could be paid from operating cash flow levels reached in 2004. Bulking up on debt, though, is risky -- it expects future earnings growth that may or may not be there.

Let's test two of the premises Icahn makes in his letter. First, let's see whether the company is indeed underleveraged. Then we can determine whether the company should be selling assets to reduce debt.

In the company's last published business outlook, it "reaffirmed its expectation that it will convert between 30% to 40% of its 2005 adjusted operating income before depreciation and amortization into free cash flow."

According to Capital IQ, trailing-12-month EBITDA (earnings before interest, taxes, depreciation, and amortization) was $10.02 billion, And 30% of that amount is $3.01 billion -- the low end of the company's estimate of what free cash flow will equal. Time Warner also had $7.6 billion in cash. With total debt at $20.6 billion, the company is on solid footing. Realize, too, that the debt-to-equity ratio is a reasonable 32.8%, which shows that the company has plenty of opportunity to take on more leverage (debt).

So if the company is underleveraged, you realize why Icahn questions the sales of Warner Music and Comedy Central on the basis of needing to reduce debt. Then, when you consider that the assets may have been sold for less than market prices, you realize that he has a strong case for a change on the board of directors.

Investors should realize, though, that just because Icahn is around, that doesn't mean their shares will automatically go up. Just look at Blockbuster (NYSE:BBI) -- the stock set a multi-year low in late September even with Icahn lurking behind the scenes.

The outcome for Time Warner may be similar to what happened recently with McDonald's (NYSE:MCD). While some expected major changes in the company, an IPO of Chipotle is the only restructuring they got. For Time Warner, that could mean just a $5 billion stock buyback and a sale of 16% interest in the cable business.

In other words, the only changes you might get have already been announced. But as the letter proves, you as a shareholder have a voice. And Carl Icahn wants you to use it.

Time Warner is a Motley Fool Stock Advisor recommendation. If you're in the market for other great companies, let Motley Fool co-founders David and Tom Gardner find the next big winner for you. Take a free trial now.

Fool contributor W.D. Crotty owns shares of McDonald's. Click here to see The Motley Fool's disclosure policy.