Should we expect continued outperformance from Time Warner stock when compared with the broader market? I'm inclined to believe so. Here's why.
A reasonable valuation
When Twenty-First Century Fox (NASDAQ:FOXA) submitted an unsolicited $85-per-share bid for Time Warner, it was essentially declaring the stock at least 20% undervalued. That's not quite true anymore. (The stock is trading about 10% off Fox's bid.)
What about the story compelled Fox to value Time Warner stock at such a premium? Here's how President and COO Chase Carey responded when asked that very question during this month's earnings conference call:
In many ways, our businesses look pretty similar. I think it gave us confidence in the ability to manage and navigate it and really did enable us to create scale in almost every place, whether it's TV studio, film studio, entertainment networks, sports, kids, news, nonfiction, that they really were pretty good mirrors of each other and, therefore, really created scale -- advanced scale.
In other words, Time Warner is one of the industry's few multi-platform entertainment leaders. A company that -- like Fox -- has strong products for both television and film, including a diverse set of programming. Mix in budding franchises with long-term potential, and you've a formula for achieving outperformance.
The best pay TV has to offer ...
If new franchises are the catalyst -- I'm thinking mostly of DC Comics properties, both on television and in theaters -- then television is the core. Pay TV, in particular. HBO is a big contributor to Time Warner's profit picture thanks to original programming.
We've known this for years, of course. The Sopranos thrilled audiences for six seasons. Sex and the City grew into a cultural phenomenon during its six-season run, spawning two movies. Band of Brothers earned wide acclaim even as viewership suffered from unfortunate timing. (The first episode on the 11-hour miniseries aired two days before the Sept. 11, 2001, terror attacks.)
More recently, the first-season finale for the anthology series True Detective broke the Internet and Game of Thrones set a new viewership record. More than 19 million tuned in to Season 4 after counting all sources -- live, rebroadcasts, DVR, downloads, etc. -- the biggest-ever audience for a season of an HBO original series. Profits are soaring as a result.
HBO's operating income grew 22.7% year over year in the second quarter. Revenue grew 16.5% over the same period. Last year, HBO grew 8.5% and 4.4%, respectively. Signs point to accelerated gains in this part of Time Warner's business.
... And the best brands on broadcast TV
Warner Bros. also has experience producing tamer forms of entertainment. In fact, the studio produces quite a bit of it for other network operators. CBS is a regular customer, buying distribution rights to The Big Bang Theory and Person of Interest, among other shows. Each program reaches tens of millions of prime time viewers.
"Heading into the 2014 to '15 TV season, Warner's is, again, the No. 1 producer of shows for broadcast," Time Warner CEO Jeff Bewkes said during Warner's latest conference call with analysts. "That's a position we've held for 11 of the past 12 seasons. Starting this fall, Warner will have 31 shows on broadcast networks, including at least two primetime series on each network and 60 shows overall across broadcast and cable."
He's including a range of new DC Comics adaptations -- including Constantine on NBC, Gotham on Fox, and The Flash on TheCW -- in that list. Arrow is already TheCW's most-viewed program.
Finally, I'd be remiss if I didn't mention Turner Broadcasting. The network behind TBS and TNT produces a little more than half of Warner's operating profit -- capital that Bewkes and team use to reinvest in new projects across the rest of the business. They have a good record: Returns on capital are up in each of the past five years and over the trailing 12 months.
Of course, none of that would matter if Time Warner stock was too expensive to own at current levels. I don't think that's the case, and neither does Rupert Murdoch given his recent bid for the company. Mix in accelerating profit gains at HBO, a thriving broadcast TV business, and DC Comics adaptations, and Time Warner stock could go much higher in the years ahead.
Tim Beyers is a member of the Motley Fool Rule Breakers stock-picking team and the Motley Fool Supernova Odyssey I mission. He owned shares of Apple, Google (A and C class), Netflix, and Time Warner at the time of publication. Check out Tim's Web home and portfolio holdings, or connect with him on Google+, Tumblr, or Twitter, where he goes by @milehighfool. You can also get his insights delivered directly to your RSS reader.
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