SAN FRANCISCO – As Time Warner (TWX) Chairman Dick Parsons (search) faced angry investors last week, he confronted the inescapable fact that what may make sense in the long term often has negative short-term repercussions.
Besieged by billionaire investor Carl Icahn (search), who is demanding that the company's cable operations be tossed aside and that a recently announced stock buyback be quadrupled to $20 billion from $5 billion, Parsons isn't free to simply ignore such ideas.
Parsons felt obligated to meet with Icahn — who now seeks to nominate directors to the company's board — to assure investors that he cares about Time Warner's stock price.
Since his tenure began in 2002, Time Warner shares have been just about flat in the $18 range.
Parsons said Wednesday that the primary source of untapped revenue for Time Warner is America Online. He also reiterated his rationale for holding on to the company's cable unit — the second-largest in the U.S. after Comcast Communications (CMCSK) .
The rationale for holding on to cable is that it remains a strong business in the near term, Parsons said, thanks to the company's "triple-play bundle" of video, broadband and digital phone service.
In the second quarter of 2005, revenue at Time Warner Cable rose 11.4% to $2.36 billion, as demand increased for digital video, digital video recorder and subscription video-on-demand services. Average monthly revenue per basic cable subscriber rose 12%.
The unit is also seen as an important factor in making sure there is good enough distribution for Time Warner's array of cable networks, including CNN, the TBS Superstation, TNT, HBO, Cartoon Network and others.
"People have said to me, 'Well, no, Dick — your content is so compelling that people have to buy it,' " Parsons said at the Goldman Sachs Communacopia Conference. " 'Who's going to drop a CNN?' ... Believe me, there are enough competing and substitute offerings out here that all of those things can be at risk, and are at risk daily.
"And we need to be sitting on the other side, on the distribution side of the table, so we know that we can get our product to market, and people will have to react to that."
The cable network's revenue in the second quarter rose 4.7% from the year-earlier period to $2.49 billion, on higher rates and increased subscribers at Turner Broadcasting and HBO.
But investors who share Icahn's point of view are worried about the future. They see a landscape in which Verizon (VZ) and other phone companies, with money overflowing from their coffers, are able to undercut cable on price for voice service, video and broadband.
Cable skeptics look at eBay's recently announced acquisition of Skype, an Internet-based phone company, and the growing popularity of competing services offered by Google (GOOG) , Yahoo (YHOO) and others.
They see consumers getting increasingly accustomed to free digital phone calls — and cable companies being forced to react to that reality, bundle or no bundle.
Right now, companies like Time Warner and Comcast are able to command $35 or $40 a month for voice service.
'Spooked by Cable'
"Public investors who are spooked by cable," said Ted Henderson, a cable-industry analyst at Stifel, Nicolaus & Co. in Denver, "are worried about spiraling downward monthly prices across all product lines."
News from the small town of Keller, Texas, on Thursday didn't help that perception. Verizon announced the rollout of its FiOS TV bundle of video, broadband and phone service in Keller, including 330 channels of television programming. The company is also offering 600 on-demand titles, with 1,800 planned by the end of the year. The lineup includes more than 180 digital channels, 20 of them in high-definition.
Basic service is $12.95 a month, with expanded basic available at $39.95.
The announcement came a day after Verizon unveiled a wide-ranging video and broadband programming agreement with Walt Disney Co. (DIS) that includes ESPN and many other networks and services.
So it seems to many that cable, already trying to beat back the aggressive subscriber-acquisition tactics of its satellite rivals, is really in trouble.
"The fact that you have to mention Skype in the same sentence with a media company kind of shows you why Carl would like to have [cable] split off completely," said James McGlynn, manager of the Summit Everest Fund in Cincinnati, which owns Time Warner shares.
Gauging telecom's threat
Still, amid all of this concern, too many people are overestimating the extent of the threat phone companies really pose to cable, according to Craig Moffett, cable and satellite analyst at Sanford Bernstein & Co.
"By the end of this year, an optimistic view might be that one-half of 1% of Americans will have the option of getting telco TV," Moffett said. "In 10 years, that number might be as high as 40%. But if one assumes that the [phone companies] take 20% market share in all the homes they pass, you're still [only] talking about the Bells taking 8% of the video market in 10 years."
Moffett went on to say that the other major problem for the phone companies is that they'll be confronted with significantly higher costs than cable operators, who have the advantages of huge head starts in infrastructure and relationships with programmers and customers.
"They will have a 15% to 20% disadvantage in programming costs," he estimated, "and, in terms of labor, they have a 100% cost disadvantage," due to union-mandated wages, benefits and pension requirements.
Verizon maintains that its labor costs stem from its commitment to having its services installed by highly trained professionals.
"Our customers tell us that the quality of our technicians and customer service representatives is one of the key reasons they chose to do business with Verizon," said spokeswoman Sharon Cohen-Hagar, in an e-mail message. "What anyone needs to take away from this is that we think customer service is paramount."
As for programming costs, Verizon Chairman Ivan Seidenberg told investors last week that the company gets a break on certain deals because its fiber-optic system can carry more content than cable.
Because programmers are also interested in new wireless opportunities, Verizon gets "a little bit of an advantage" on those agreements, as well, Seidenberg added.
In any event, said Robert Rosenberg, president of Insight Research, the costs incurred by the Bells in their drive to offer video service "aren't really the issue."
Because the phone companies have been losing land-line business, their ability to offer a robust video service is "crucial," Rosenberg said, and can be fully justified as long as they "provide some rate of return to their investors."
Cable can't ignore the likelihood that everything, including video, will be routinely delivered over the Internet Protocol standard, which would theoretically make all programming available on an on-demand basis, Rosenberg added.
"So you don't need the cable companies' networks to get content, and you wouldn't need their ability to package, because you'd be able to go straight to the originator, whether it be the movie studio or what have you," he said.
What stands in the way of that scenario is that the studios don't want to cannibalize DVD and affiliate-fee revenue. "But what that all amounts to is digital rights management, and that will resolve itself," Rosenberg said, because the technology makes too much sense to be bypassed.
Stifel & Nicolaus' Henderson argued that the phone companies won't be able to compete on price effectively over the long run.
"The business model to build fiber does not work if it means they build the most expensive infrastructure and cut prices right and left to get market share," he said. "Once you cut prices it's very hard to raise prices again."
Henderson said the market isn't paying enough attention to the private equity investors and cable-company managements that opted to take Cox Communications private, and are doing the same with Insight Communications (ICCI) and Cablevision Systems (CVC) .
"Cable has a head start on an early portion of the market that's going to remain loyal for a long period to come, and that is what the private equity guys are seeing," he said. "They're saying, 'Hey, we'll take these guys private and harvest the cash flow that they're about to generate for the next 20 years.' "
The Icahn Agenda
Meanwhile, Parsons is already moving in the general direction Icahn wants.
Part of Time Warner Cable will soon be spun off to the public, following the closing of its buy, with Comcast (CMCSK) , of bankrupt cable operator Adelphia Communications (ADELQ) . As part of that transaction, Time Warner will buy out Comcast's stake in Time Warner Cable.
With an 84% stake in the new entity, Time Warner can still realize certain tax advantages.
"I don't have to make the call today as to whether cable [will remain] strategic or not," Parsons said Wednesday. "I know it is today, and I believe we're creating a structure that allows me to react in real time if my view changes."
However, McGlynn countered: "You don't get the highest multiple by having a hybrid."
Share Buyback, Portal Throwback
Having devoted a great deal of time and energy to paying down the company's debt, Parsons said the company is still evaluating what to do with the cash it has on hand, as further consolidation takes place in the online space and elsewhere.
McGlynn agreed with Icahn that the idea of boosting the magnitude of Time Warner's stock buyback makes sense. "I think shareholders would say, buy your stock back, and if your stock price is high enough, you can make your acquisitions."
One area where Parsons sees consolidation continuing is the online space, where the company has taken on the task of transforming AOL from a dial-up access service into a portal worthy of comparison to Google and Yahoo.
Time Warner relaunched AOL.com in July. It's counting on new products such as AOL Radio with XM Satellite, AOL Explorer, MyAOL, AIM Triton and a potpourri of streaming video content to make the portal an "audience destination," where it can get enough page views to spark a surge in online-advertising revenue.
Ad revenue at AOL rose 45% to $320 million in the second quarter.
"I can definitely understand why Parsons doesn't want to just punt AOL," McGlynn said. "If they get rid of it, they've got to turn right around and say, 'OK, what's our Internet strategy?' You've seen News Corp. buying these Web sites. Time Warner already has one; now can they get the most value out of it? We'll see."
News Corp. (NWS) recently identified the growth of online revenue as its top priority. It just acquired IGN, an operator of video-game Web sites.
When it comes to "old" media, Time Warner is dealing with many of the same issues that confront its peers.
So far this year, Warner Bros. ranks second in market share among movie studios, at 15%, according to data compiled by Boxofficemojo. The studio's films have grossed $954.1 million in 2005, trailing only Twentieth Century Fox's total of $1.13 billion.
The top grosser for Warner this year is "Batman Begins," which has racked up $204.6 million. Second is "Charlie and the Chocolate Factory," at $203.6 million. Meanwhile, "Wedding Crashers" has collected $203.6 million for sister unit New Line Cinema.
Filmed-entertainment revenue fell 14.7% to $2.64 billion in the second quarter, reflecting strong DVD sales of "The Lord of the Rings: Return of the King" in last year's June quarter.
Parsons remains sanguine about DVD demand, though there are signs that it is plateauing. "The place you're seeing the most slowing is library product," he told attendees at the Goldman conference.
Because of the continued surge in TV box sets, and opportunities overseas, Time Warner should still be able to generate revenue growth in DVD, he said.
By the Books
Publishing revenue in the second quarter rose 4% to $1.5 billion, as increased Time Warner Book Group revenue offset declining advertising at Time, Sports Illustrated and Fortune magazines, though publishing ad revenue overall rose 4% thanks to recent launches as well as strength at Southern Living, Real Simple and InStyle.
The decline in ad revenue at the company's core magazines has to be seen in the context of the broader decline in news consumption that has been seen at newspapers, said David Mindich, chair of the journalism department at Saint Michael's College in Colchester, Vt.
"This has extended to television, where the median age for news viewers is 60, and to magazines," Mindich said.
Mindich noted that Sports Illustrated has lost share to ESPN The Magazine, which is a telling development because ESPN has been able to effectively migrate viewers of the cable network back and forth between it, the magazine and the ESPN.com Web site.
"I notice that my students who consume ESPN really consume it across all platforms," he said.
Time Warner's attempt at an SI-branded sports cable network, CNNSI, was a failure, primarily because ESPN had too much of a head start.
"Once you become the market leader in a particular area, it serves as fodder for conversation among peers, and that's what you want to generate."
In another attempt to create some cross-platform synergy, CNN and Time Inc. said earlier this month that they would combine the business news Web sites CNNMoney.com, Fortune.com, FSB.com and Business2.com into a single financial-news site to be launched in January.
This combination makes sense because it can maintain a reasonably similar tone and audience across all of those outlets, Mindich said.
Conversely, on the cable network front, CNN Headline News may be hurting its brand by its recent decision to give outspoken ex-prosecutor Nancy Grace a primetime show, in Mindich's view. "What happens is that people feel they can no longer look to Headline News as a place where they can get serious news 24-7."
News Corp. is the parent company of the Fox News Channel, which operates FOXNews.com.