Saturday, February 18, 2006

Carl Icahn and Time Warner-Defeat or Victory?

I believe that Icahn and shareholders in general won a victory in the Time Warner (TWX) battle that has been fought over the last six months.

As you know, the two sides came to agreement last night with Icahn agreeing to back away from a proxy fight for representation on the board. The company agreed to the following:

  1. The company will increase its existing share repurchase program and extend the program’s ending date. Under the expanded program, management will be authorized to repurchase up to an aggregate of $20 billion of the corporation’s common stock during the period from July 29, 2005 through December 31, 2007. At existing price levels, the company intends to continue the current pace of purchases under its share repurchase program within its stated objective of maintaining a net debt-to-OIBDA ratio of around 3-to-1, and expects it will purchase approximately $15 billion of its common stock by the end of 2006, and the remainder in 2007.

  2. The Nominating and Governance Committee will recommend the election or appointment of two new independent directors to the board. The company will seek the advice and recommendations of its major shareholders, including Icahn Partners, in this process. This will be accomplished by no later than July 31, 2006.

  3. Time Warner has begun a comprehensive review of costs at each of its operating divisions and at its corporate parent with the objective of better aligning its costs with the long term needs of the business. This resulted in at least $500 million of cost reductions that are reflected in its current operating plan for 2006. The company will intensify these efforts with the objective of achieving commensurate reductions against planned expenses in 2007, for a total reduction of $1 billion over the period. These initiatives should improve the company’s operating margins and increase both free cash flow and earnings per share.

  4. The company will continue to review the Lazard Report and will continue its dialogue with Icahn Partners regarding the recommendations in the report. Management’s view continues to be that a different capital and corporate structure may be appropriate for Time Warner Cable in the future so long as it provides strategic flexibility with the company’s content businesses.

I think it is noteworthy to see how much has been accomplished by a corporate activist with merely a 3% position in the stock. Icahn et al filed their preliminary proxy in September of 2005. One of the major tenets that they cited was:

We believe that Time Warner’s most attractive acquisition opportunity right now is its own stock. The IRR generated by purchasing TWX stock at what we believe to be a 40% discount to its inherent value is superior to any other investment opportunity the company has today. The typical cash flow yield for acquisitions in the content/media space is in the sub 3% range, while the implied after−tax Free Cash Flow Yield on TWX stock is well in excess of this. Using low cost debt financing to repurchase TWX’s undervalued stock will reduce the share base and leverage Free Cash Flow per Share growth. With the steady growth profile of TWX’s remaining asset base, this action should garner a premium multiple.

In the last 5 years, TWX has generated operating cash flow of $24 billion, or which approximately $13.5 billion was free cash flow. Despite the huge dissipation of shareholder wealth in the purchase of AOL in 2000 (having spent $106.2 billion only to write off $54 billion two years later) since that time, the company has thrown off considerable free cash flow but little of it saw its way back to shareholders.

In fact, prior to the August 29th issuance of a 5 cent dividend, the company had never paid a dividend in this time period. Roughly $1.1 billion had been spent on share buybacks in early 2003 and through 2002. The buybacks hardly meet the test of effectiveness…the share count on a fully diluted basis has gone from 4.4 billion shares to 4.71 billion shares.

On August 3rd, the company announced its intent to buy back $5 billion in stock. By November 2nd, the company relenting to the pressure and influence of dissident shareholders increased its authorized buyback to $12.5 billion. Now, finally we have a $20 billion program with a $15 billion initial cut at it for 2006.

TWX will not only look to reducing its operating costs but will likely look for changes in capital structure to improve its capital efficiency. The company has a pathetic 3% return on invested capital. Buying back stock at a price below intrinsic value can only improve the financial performance.

By way of disclosure, I, my family, and my clients have a position in TWX. On behalf of all minority shareholders, we thank you Mr. Icahn for your influence on the management and board of TWX.

To Dick Parsons and the Board, I am glad that you could come to agreement. But,it is a shame that the obvious actions that were required of you could only be cajoled through outside shareholders. I note with considerable interest, that directors have sold $3.5 million in stock in the last six months, not to mention officers who have sold about $2.7 million. There are some terrific businesses in this conglomerate, HBO, TNT, TBS, Warner Brothers, cable businesses, Warner Brothers, etc, etc, etc. But surely, the return on capital is dismal for a business that contains so many leading franchises. For comparables, I suggest you look to the some of the peer group that you identify in your proxy and their returns on capital:

McGraw Hill 23%
Yahoo 20%
Disney 7%

I think all minority shareholders should carefully watch the progress that this company will make. Though activists are often portrayed in a very negative fashion, seeking publicity and short term gains, I believe that Mr. Icahn's influence has resulted in a return to shareholders of some $20 billion before any additional capital appreciation.


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