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Why Time Warner Should Spin Off HBO

By Sam Mattera - Feb 19, 2016 at 12:54PM

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Protecting the cable bundle could limit the growth of the network behind "Game of Thrones."

HBO Now. Source: Time Warner

Time Warner (TWX) shareholders might be better off if the company were broken up. The firm's extensive assets, which include Home Box Office, Warner Bros., and Turner networks, appear to be in conflict.

Late last month, The Wall Street Journal reported that Time Warner was interested in acquiring a portion of subscription-based online streaming service Hulu. Buying a stake in Hulu would help Time Warner diversify its revenue, and hedge against fears of cord-cutting. As part of its investment, however, Time Warner is said to be seeking a major change in Hulu's strategy, making it move away from offering viewers network shows soon after they air on network TV.

The rumored proposal underscores Time Warner's commitment to the traditional cable bundle -- a business model that may limit the success of its other division, Home Box Office.

Getting rid of current seasons
Unlike rival Netflix (NFLX -1.36%), Hulu offers subscribers access to many shows shortly after they air. Hulu has a few original series, and a growing catalog of older programs (notably Seinfeld), but its single biggest selling point centers on its collection of in-season programming. Hit series including The BachelorNew Girl, and The Daily Show arrive on Hulu within a few days of their original broadcast.

Netflix offers access to many of the same shows, but only after they've aired months (or even years) earlier. Both Netflix and Hulu offer Family Guy, for example, but Netflix's catalog only contains the first 12 seasons. Hulu subscribers can watch episodes from all 14 seasons, including new episodes that first aired in February.

Time Warner is allegedly looking to put a stop to this practice. Making shows available to Hulu subscribers shortly after they air makes the prospect of cord-cutting more attractive, a trend Time Warner's management has been actively working to undermine in recent months. In November, Time Warner shares plunged after the company reported that subscribers to its Turner networks -- including TNT, TBS, CNN, and Cartoon Network -- came in lower than anticipated. In response, Time Warner's management has emphasized its commitment to making the traditional cable bundle more attractive.

Time Warner has reduced the number of commercials it broadcasts on certain channels, and pursued new content aimed at younger audiences. It plans to rethink its deals with streaming providers, perhaps extending the window between the original broadcast of its shows and their arrival on over-the-top services. Altering Hulu's business model would be another step toward shoring up the bundle. Last year, Hulu revealed that it had 9 million paying subscribers. Exactly how many of these subscribers choose Hulu instead of paid-TV is unclear, but the loss of in-season programming could drive some Hulu subscribers back to cable.

On the company's earnings call earlier this month, Time Warner's management was asked about The Wall Street Journal's report. CEO Jeff Bewkes refused to comment on it specifically, but didn't deny it outright.

HBO vs. Turner
It's clearly in Time Warner's best interests to keep the traditional cable bundle intact. Last quarter, its Turner business generated about 37% of Time Warner's total revenue and more than half of its adjusted operating income. Turner generates revenue through the licensing of its content to streaming video services, but still depends largely on paid-TV subscriptions and advertising. 

But Home Box Office could thrive in a world dominated by digital, over-the-top services. Last year, Time Warner launched HBO Now, making its flagship channel, HBO, available to consumers directly over the Internet. It was a major step for Time Warner's management, who had -- only a few years ago -- refused to consider HBO apart from the cable bundle.

Yet Time Warner may not be pushing HBO Now as aggressively as it could. Moreover, it's possible the market would give it a higher valuation if it were operating apart from Turner.

Earlier this month, Time Warner revealed that HBO Now had a mere 800,000 subscribers -- well short of analyst estimates. Time Warner has yet to bring HBO Now to many key platforms, most notably PlayStation and Xbox, and continues to push a price point that's far above its competition. Although consumers now have the digital option, for many, it's still cheaper to purchase HBO from a paid-TV provider. And HBO sister station Cinemax remains wed to the bundle. Last year, Time Warner added the first season of Cinemax's flagship program, The Knick, to HBO Now for a limited time. The move seemed aimed at encouraging HBO Now subscribers to come back to the bundle, as -- if they wanted to watch the second season -- they'd have no choice but to pick up a paid-TV subscription.

Time Warner's market cap, at around $52 billion, is only about $11 billion (around 27%) more than Netflix's, which is striking, given that Time Warner's Home Box Office business alone has more subscribers than Netflix and generates considerably more operating income. Of course, the gap in valuation is easily attributable to growth rates -- Netflix is growing rapidly; HBO not so much.

Netflix acknowledges its competition, but views the growth of rival streaming services -- somewhat paradoxically -- as beneficial to its business. In its long-term view, Netflix writes that "multiple firms can be successful ... Many people will subscribe to both HBO and Netflix since we have different exclusive content. The transition to Internet TV ... will mean growth for many Internet TV services." As consumers move away from the expensive paid-TV bundle, they may have more disposable income to put toward streaming services, including both Netflix and HBO Now.

Time Warner's management believes the company is best served operating as a single entity, but activist investors -- widely rumored to be circling the company -- may disagree.

Sam Mattera has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Netflix. The Motley Fool recommends Time Warner. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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