No Signs of Cannibalization

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1 Tony Wible, CFA Media and Entertainment Price: $84.98 Fair Value Estimate: $ Week Range: $ $88.25 Market Cap (MM): $70,075 Shr.O/S-Diluted (mm): Average Daily Volume: 4,213,799 Dividend: 1.27 Yield: 1.5% Cash/Share: $4.26 FCF Yield: 4.4% Debt/Cap: 48% FYE: Dec 2014A 2015E 2016E EPS: $3.84A $4.65E $5.51E Prior EPS: $4.59 $5.36 Consensus NM P/E Ratio: 22.1x 18.3x 15.4x Quarterly EPS: Q1 $0.91A $1.19A $1.38E Q2 $0.98A $1.09E $1.32E Q3 $0.97A $1.13E $1.34E Q4 $0.98A $1.24E $1.47E Quarterly Revenue (M): Q1 $7,545A $7,127A $7,564E Q2 $6,788A $7,095E $7,143E Q3 $6,243A $6,710E $7,264E Q4 $7,525A $7,646E $8,249E Year: $28,101A $28,577E $30,221E Quarterly Adjusted EBITDA ($M): Q1 1,855.0A 2,074.0A 2,266.0E Q2 1,838.0A 1,901.0E 2,135.0E Q3 1,847.0A 1,941.0E 2,148.0E Q4 1,823.0A 2,064.0E 2,280.0E Year: 7,363.0A 7,980.0E 8,829.0E April 29, 2015 Time Warner, Inc. No Signs of Cannibalization PORTFOLIO MANAGER BRIEF (TWX) - BUY TWX posted upside to 1Q15 with revenue and earnings on stronger ad revenue, ratings improvements, cost benefits, and HBO momentum that more than offset rising content costs, erosion of basic cable subs, weak DVD sales, and HBO reinvestments. Although there are reports of technical issues at launch, HBO Now is clearly popular and more importantly not disrupting the traditional ecosystem. We maintain our Buy rating and $100 FV. ANALYST NOTES Positives - Ad Revenues, Ratings, HBO, Overhead, Games - Ad sales were up 4% on stronger ratings/demand despite FX and other headwinds. The strength is expected to carry into 2Q15 and ideally positions TWX ahead of the current upfront. HBO grew subs in 1Q15 while its HBO Now launch is seeing strong initial demand while avoiding cannibalization. This continues to be one of the biggest catalysts for TWX. Turner SGA was down 18%, while HBO SGA was down 3% (on a normalized basis) reflecting recent restructuring. The game business is thriving and facing a strong 2015 with Mortal Combat X (April), Batman (June), and Lego (Sept). Negatives Subs, Programming Costs, FX. Ad revenue and affiliate fee increases were offset by decline in MVPD subs. This issue will likely persist and counters arguments that OTT is not hurting basic cable net business. Management believes sub losses will eventually hit inflection with new MVPD technology catalyzing subs recovery. HBO margins under pressure with 9% YOY increase in program cost and costs launching HBO Now. Reinvestment in platform limits near term EBITDA upside, while uncertainty around AMZN deal could hurt 2Q15 revenue. FX had $130M drag on operating income ($0.14/share) and is expected to erode 2Q15 subscription revenue by 350bps. HBO Now We believe any Turner cannibalization associated with HBO s new OTT platform will be offset by incremental HBO revenue. Our study showed this in 47/48 scenarios. There is favorable risk/reward tradeoff; however, HBO is not experiencing cannibalization (as of yet). This creates an ideal scenario for the product, which is already benefiting from its new programming zenith. Under Appreciated Games TWX s game business ended 1Q15 with record US market share in double digits, which should get better with the strong launch of Mortal Combat X (4/14) that sold $130Mn in the first week alone. We believe the 2Q15 benefit from Batman will be more substantial as it may be one of the best selling games of the year. PAGE 1 OF 5

2 CHANGES TO OUR MODEL 1Q15 1Q15 First FY15 FY15 First FY16 FY16 First Updated Prior Call Updated Prior Call Updated Prior Call Revenue $7,127 $6,869 $6,992 $28,577 $28,575 $28,442 $30,221 $31,081 $30,414 Y/Y Growth 4.4% 2.2% 1.7% 5.1% 5.7% 4.4% Operating Income $1,814 $1,686 $7,060 $7,169 $7,870 $7,863 Y/Y Growth 17.9% 9.6% 10.1% 11.8% 11.5% 9.7% Operating Margin 25.5% 24.5% 24.7% 25.1% 26.0% 26.4% Adjusted EBITDA $2,074 $1,918 $1,902 $7,980 $8,110 $7,925 $8,829 $8,856 $9,082 Y/Y Growth 11.8% 3.4% 8.4% 10.1% 10.6% 9.2% EBITDA Margin 29.1% 27.9% 27.9% 28.4% 29.2% 29.7% Diluted EPS $1.19 $1.05 $1.09 $4.65 $4.59 $4.65 $5.51 $5.36 $5.77 Y/Y Growth 30.8% 15.0% 21.1% 19.7% 18.5% 16.7% Segment Performance: Turner $2,710 $2,673 $2,656 $10,893 $10,934 $10,731 $11,705 $11,686 $11,676 Y/Y Growth 4.5% 3.1% 2.4% 4.8% 5.2% 7.4% 6.9% Operating Income $1,128 $976 $983 $4,326 $4,220 $4,777 $4,639 Operating Margins 41.6% 36.5% 37.0% 39.7% 38.6% 40.8% 39.7% HBO $1,398 $1,397 $1,429 $5,717 $5,716 $5,713 $6,166 $6,167 $6,140 Y/Y Growth 4.4% 4.3% 6.7% 5.9% 5.9% 7.9% 7.9% Operating Income $458 $510 $522 $1,837 $1,988 $2,098 $2,261 Operating Margins 32.8% 36.5% 36.5% 32.1% 34.8% 34.0% 36.7% Filmed Entertainment $3,199 $3,085 $3,120 $12,975 $13,116 $12,935 $13,414 $13,228 $13,544 Y/Y Growth 4.3% 0.6% 1.8% 3.6% 4.7% 3.4% 0.9% Operating Income $330 $309 $338 $1,306 $1,377 $1,409 $1,399 Operating Margins 10.3% 10.0% 10.8% 10.1% 10.5% 10.5% 10.6% Intersegment Elim. $180 $286 $208 $1,008 $1,191 $1,013 $1,064 $1,243 $1,101 PAGE 2 OF 5

3 INVESTMENT THESIS TWX is poised to unlock value through new affiliate agreements, a reinvestment in programming, cost efficiency, and a large opportunity (starting in 2015) to improve HBO monetization through OTT service. Furthermore, the studio side of the business is now poised for above average growth with the rising demand for content, incremental improvement in the home entertainment market, international ventures, successful video game properties, new consumer product revenues, and the development of new franchise around DC, Harry Potter, and LEGO. Although there are near term issues affecting the TV market (e.g. programming costs and weak ad sales), TWX is minimizing its exposure and may see downside support given its strategic value in the current M&A landscape. ISSUES TO CONSIDER Key Issue Our Position Timing Impact Consolidation HBO OTT TV Ad Market Uncertainty Programming Costs Industry consolidation may put more pressure on affiliate fee growth and could act as a catalyst for large content companies to consider acquisitions. TWX has already been targeted, which may lead investors to value TWX based on its strategic benefits rather than near term fundamentals. The pay network will launch a new service to target online viewers. This has the potential to generate incremental revenue through new subs and possible greater retention of consumer ARPU. However, there are incremental costs and risk of MVPD retaliation that may offset some of the upside. Industry ad revenue growth is decelerating and leads investors to question whether the headwinds are secular or more circumstantial. This will suppress Turner s growth but will be partly offset by expense management and growth in non-ad business Ratings erosion and secular pressures in the TV ecosystem are increasing the demand for original/sports content and driving up costs. Warner benefits from higher demand while the Turner and HBO nets have to cope with the headwind. PAGE 3 OF 5

4 Company Description Time Warner Inc., a global leader in media and entertainment with businesses in television networks and film and TV entertainment, uses its industry-leading operating scale and brands to create, package and deliver high-quality content worldwide on a multi-platform basis. Among the Company s brands are TNT, TBS, CNN, HBO, Cinemax, Warner Bros., and New Line Cinema. IMPORTANT DISCLOSURES Research Analyst Certification I, Tony Wible, the Primarily Responsible Analyst for this research report, hereby certify that all of the views expressed in this research report accurately reflect my personal views about any and all of the subject securities or issuers. No part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views I expressed in this research report. Janney Montgomery Scott LLC ("Janney") Equity Research Disclosure Legend Janney Montgomery Scott LLC currently acts as a market-maker in the securities of Time Warner, Inc.. Janney Montgomery Scott LLC intends to seek or expects to receive compensation for investment banking services from Time Warner, Inc. in the next three. The research analyst is compensated based on, in part, Janney Montgomery Scott's profitability, which includes its investment banking revenues. Definition of Ratings BUY: Janney expects that the subject company will appreciate in value. Additionally, we expect that the subject company will outperform comparable companies within its sector. NEUTRAL: Janney believes that the subject company is fairly valued and will perform in line with comparable companies within its sector. Investors may add to current positions on short-term weakness and sell on strength as the valuations or fundamentals become more or less attractive. SELL: Janney expects that the subject company will likely decline in value and will underperform comparable companies within its sector. Price Charts Janney Montgomery Scott Ratings Distribution as of 3/31/15 IB Serv./Past 12 Mos. Rating Count Percent Count Percent BUY [B] NEUTRAL [N] SELL [S] PAGE 4 OF 5

5 *Percentages of each rating category where Janney has performed Investment Banking services over the past 12. Other Disclosures Janney Montgomery Scott LLC, is a U.S. broker-dealer registered with the U.S. Securities and Exchange Commission and a member of the New York Stock Exchange, the Financial Industry Regulatory Authority and the Securities Investor Protection Corp. This report is for your information only and is not an offer to sell or a solicitation of an offer to buy the securities or instruments named or described in this report. Interested parties are advised to contact the entity with which they deal or the entity that provided this report to them, should they desire further information. The information in this report has been obtained or derived from sources believed by Janney Montgomery Scott LLC, to be reliable. Janney Montgomery Scott LLC, however, does not represent that this information is accurate or complete. Any opinions or estimates contained in this report represent the judgment of Janney Montgomery Scott LLC at this time and are subject to change without notice. Investment opinions are based on each stock's 6-12 month return potential. Our ratings are not based on formal price targets, however, our analysts will discuss fair value and/or target price ranges in research reports. Decisions to buy or sell a stock should be based on the investor's investment objectives and risk tolerance and should not rely solely on the rating. Investors should read carefully the entire research report, which provides a more complete discussion of the analyst's views. Supporting information related to the recommendation, if any, made in the research report is available upon request. PAGE 5 OF 5