Time Warner (NYSE:TWX) could be sitting on a dramatically undervalued asset.
Earlier this month, analysts at UBS upgraded Netflix's (NASDAQ:NFLX) stock to buy, arguing that the streaming giant was well positioned to take the world by storm. But UBS also commented on Netflix's competitors -- in particular, the more established HBO.
"We believe HBO is meaningfully undervalued within Time Warner," UBS wrote.
While UBS believes Netflix will ultimately outmaneuver HBO in the long-run, it thinks HBO has some solid years ahead of it, and that investors may be underestimating Time Warner's premium network.
Netflix is now more valuable than HBO
HBO is one of three divisions within Time Warner, alongside Warner Bros. (its movie studio) and Turner (its collection of cable networks). Time Warner as a whole is worth roughly $70 billion, and UBS believes HBO accounts for $30 billion of that. That seems fair: HBO generates about one-third of Time Warner's operating income, and with its loyal subscriber base, it's a fairly stable business.
Trading around $560, Netflix is worth around $34 billion -- making it more valuable than HBO (assuming UBS is correct).
Is that justified, though? Including its sister network Cinemax, and its international subscriber base, HBO has almost twice as many subscribers as Netflix streaming -- about 116 million compared to 62 million -- and it makes a lot more money.
Last year, HBO generated an adjusted operating income of $1.8 billion on revenue of $5.4 billion. Including its DVD-by-mail business, Netflix generated slightly more revenue in 2014 -- $5.5 billion -- but nowhere near as much operating income: just $400 million. Excluding the DVD business (a market HBO does not compete in) makes it even worse, as DVDs brought in $368 million in profit last year.
But Netflix is growing much faster
Netflix is trading with a much higher multiple, about 145 times trailing earnings. Assuming HBO accounts for $30 billion of Time Warner's valuation, then it, in contrast, is trading with a much smaller multiple: around 16 times.
HBO is a more established business and is growing at a much slower pace than Netflix. Last year, HBO's revenue grew 10% on an annual basis -- Netflix's rose about 25%. HBO added 2.8 million domestic subscribers in 2014; Netflix added about 5.5 million.
Netflix might also have a much brighter future. UBS believes Netflix will have nearly 141 million subscribers by 2020, representing a compound growth rate of around 15.1%. When that happens, it believes Netflix will generate roughly $4.6 billion in EBITDA on $18.7 billion in annual revenue.
But UBS is also positive on HBO. It sees Time Warner's premium network having about 132 million subscribers in 2020, and generating about $3.6 billion in EBITDA on revenue of around $8.3 billion.
UBS believes Netflix has advantages over HBO, including its strategic goal of aiming for a larger addressable market. Once, HBO used to target children (it carried the animated series The Adventures of Tintin in the 1990s), but today, virtually all of its content is aimed at adults. In contrast, Netflix has a growing number of exclusive series aimed at viewers of all ages.
Netflix makes Time Warner a better investment
Of course, it's possible that Netflix is simply overvalued. HBO has a firmly established business model with a proven ability to consistently produce hit series. Netflix remains promising, but its business model is far less established, and while many of its hit series have drawn critical acclaim, it has yet to release anything on the level of Game of Thrones or The Sopranos.
An investment in Time Warner brings baggage far in excess of HBO -- its movie studio and its cable networks -- but if you like Netflix, you should like Time Warner. Netflix's CEO does.
I predict HBO will do the best creative work of their lives in the next 10 years. -- Reed Hastings.