Time Warner Cable: Time to Tune In?

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Using relative enterprise value per subscriber on our 2008 and 2009 estimates (pro forma for the pending separation), we derive a price of $35, reflecting the midpoint of our 2008 and 2009 estimates, suggesting an attractive upside from current levels. Our pro forma net debt balances are also consistent with the details of the separation, and management expectations to return to its steady-state leverage within a year thereafter.

Our price-to-free cash flow valuation model also generates a price of $35. We project the company to generate nearly $3.5 billion of combined free cash flow in 2008 and 2009 (after about $6.7 billion of total capital spending, vs. $3.4 billion in 2007), and we believe it is likely to accelerate thereafter. Our target price-to-free cash flow multiple also reflects a premium to the S&P 500.

CORPORATE GOVERNANCE

We believe the company has a satisfactory corporate governance policy, which was first adopted in June, 2006, and became effective with the July, 2006, Adelphia acquisition. The board periodically refines its policy and reviews its practices against the requirements of the Sarbanes-Oxley Act of 2002, as well as the Securities & Exchange Commission and New York Stock Exchange rules, among other laws and regulations. As of Dec. 31, 2007, parent company Time Warner owned 82.7% of TWC's Class A shares, and 100% of its Class B shares. This equated to a total voting power of 90.6% held by the parent (or an 84.0% economic stake), making TWC a "controlled" company as defined by the NYSE.

Currently, the board has 10 members, including two Class A directors and eight Class B directors—who must be elected by holders of the respective share classes. There is a separation of the chairman and CEO positions. Directors generally have terms of one year. At least 50% of directors must be independent (as defined under NYSE rules), and the board currently deems six of its members as independent. There are three standing committees of the board—Audit, Compensation, and Nominating & Governance&with the latter also charged with CEO succession planning.

TWC's governance framework should be further enhanced upon the completion of its pending separation, in our opinion. Under an initial exchange and recapitalization plan, parent company Time Warner would convert its supervoting Class B shares (75 million) into TWC common shares on a one-for-one basis. This would be followed by the special dividend payment, after which Time Warner would effect a stock-for-stock distribution of its holdings to its shareholders. This plan effectively eliminates TWC's dual-class share structure, further streamlining its governance structure.

INVESTMENT RISKS

The primary risk to our recommendation and target price, in our view, is continued uncertainty relating to the potential impact of TWC's pending separation on its financial flexibility—given the relatively ample dividend payment pursuant to the plan. The proposed separation is also subject to certain approvals.

Separately, in a relatively saturated market for video, data, and voice services, we note intensifying competition among cable and satellite TV providers, and telcos. Combined with the current U.S. economic slowdown and weakness in the housing sector, we are wary of a dramatic slowdown in unit growth and potential margin compression.

Lastly, we see lingering uncertainties related to a number of regulatory issues, which could have negative near-term implications for TWC and the rest of the cable industry. Chief among these issues include net neutrality and a la carte programming, as well as digital multicasting and recent Federal Communications Commission bans on integrated set-top boxes and exclusive deals with multiple dwelling units.

Amobi follows media stocks for S&P Equity Research.