One Era Ends, Another Begins

Time Warner Cable started 2007 with high hopes: The integration of Adelphia Communications was moving forward; it was coming off a strong 2006, where, like the rest of the cable industry, it had enjoyed healthy increases in basic subscribers; and it was looking forward to being split off as a separate publicly traded company from parent, media giant Time Warner Inc.

While all of that did happen, the country’s second-largest cable company also encountered a few unexpected turns — including integration problems at the former Adelphia systems — and managed to not only weather the setbacks but reverse them before the year was out. That resilience, coupled with strong performance in the first half of this year, is why Time Warner Cable was selected as the 2008 Multichannel News Operator of the Year.

Time Warner Cable split from Time Warner Inc. (which still maintained an 84% ownership stake in the cable operator) in March 2007. The stock opened at $38.75 per share on March 1, closing that day up 18 cents to $38.93 each. That wasn’t bad, given that just two days earlier, the market was reeling from a 416-point drop in the Dow Jones Industrial Average.

Time Warner Cable’s first quarter as a separate stock was encouraging, with revenue up 10%, operating income before depreciation and amortization (OIBDA) up 12% and a gain of 46,000 basic video subscribers. New services also showed strong growth: digital cable added 278,000 customers; high-speed Internet additions were up 45% from the prior year to 356,000; and digital phone customers increased by 236,000 subscribers in the period.

Then there was the second quarter. And everything changed.

What looked like a smooth integration of two top markets acquired in the joint purchase of Adelphia with Comcast in July 2006 — Los Angeles and Dallas — appeared to unravel. In the second quarter, while revenue and OIBDA each rose by 9%, TWC reported a loss of 57,000 basic customers — 38,000 in the acquired systems. That was followed by a loss of 83,000 basic customers in the third quarter (72,000 in the acquired systems).

Time Warner was not the only cable company that was bleeding customers. Basic-subscriber losses were the mainstay for most of the industry — even Cablevision Systems, which had the strongest basic-customer growth in the industry for the past several years, lost a total of 4,000 basic customers in 2007.

The trouble for Time Warner appeared to be focused in the Los Angeles and Dallas markets, two areas that were being pummeled by competition from satellite and telco providers.

Los Angeles, which had a history of poor customer service from its last two cable providers, and Dallas, which already had the highest satellite TV penetration at about 38% of homes, was especially ripe for the picking by competitors.

Exacerbating the problem were service interruptions throughout both markets tied to upgrading the networks to provide high-speed Internet and phone service. (See separate story, page 24.)

While TWC had expected basic-subscriber losses as the integration process moved forward, what seemed to catch Wall Street off guard was a perceived acceleration of problems in the acquired markets. TWC lost about 83,000 basic customers (66,000 in the acquired systems) in the third quarter of 2006 — the first after the deal closed in July — and about 23,000 in the fourth quarter of that year.

While losses in the acquired systems were about 52,000 in the fourth quarter 2006 (offset in part by a gain of 29,000 in legacy systems), they declined substantially in the first quarter of 2007 to 20,000 losses.

TWC chief operating officer Landel Hobbs said the company approached the Los Angeles and Dallas markets like it does with all new markets — with a three-pronged approach. The first step, Hobbs said, was to rebuild the plant, followed by launching new services and repairing the service reputation of the markets.

“Step 1 is done; Step 2 is done; Step 3 is ongoing,” Hobbs said.

In addition to literally ripping up the streets for the rebuild, upgrading the plant also included smaller yet highly disruptive aspects such as changing channel lineups.

“It’s not easy, it takes time and it’s disruptive,” Hobbs said of those early stages.

TWC was also facing a somewhat unusual situation in that the competition knew it was coming for more than a year. Couple that with the fact that Adelphia was already in bankruptcy, and TWC had to fight off erroneous public perceptions and the tactics of some less-than-truthful competitors.

“We had a little misstep. We corrected it,” Hobbs said. “Of course, investors wanted us to move faster. But we wanted it to fit the basics of the business. We’re seeing that happen.”

And for all intents and purposes, Los Angeles and Dallas appear to have turned the corner.

In the first quarter of this year, TWC reported a gain of 55,000 basic subscribers. In the second quarter — typically weak as snowbirds and college students disconnect service as they return to their summer residences — the company shed 9,000 basic customers, far below the 58,000 it lost in the second quarter of 2007.

What’s more, Los Angeles and Dallas appear to be contributing to the basic customer rolls. While TWC would not give specifics, Hobbs said that Dallas has its best revenue generating unit quarter since the acquisition.

“In terms of category growth, yes [L.A. is growing],” Hobbs said. “We’re seeing an operational turnaround. Building the reputation, that’s going to take a little longer. But we will build that with reliably great products.”

Miller Tabak media analyst David Joyce said a compounding of outside events had an impact on TWC during 2007: the nationwide housing slump which impacted new customers, initial inroads made by telco video providers, as well as the integration problems with Adelphia.

But the analyst said that initial integration pain — and Time Warner’s reaction to it — is paying off in Los Angeles this year.

“They’ve been able to shift from integration mode into marketing and customer service mode,” Joyce said. “While they had to fix some of the integration and customer service, they’ve been able to leverage off of that. They’ve been really knocking the cover off the ball with RGUs.”

With Los Angeles and Dallas on the mend, TWC doesn’t have any time to rest on its laurels. Because one of the most aggressive telephone companies in the video space — Verizon Communications — is launching its FiOS TV product in New York City, attacking TWC’s second-largest market — Manhattan — later this year. (See story, page 38.)

Hobbs said the strategy for Manhattan is the same approach as with any market that may come under siege from a new competitor: lock in customers to longer-term deals (with discounts) as necessary; focus on new products and services (TWC is rolling out its popular Start Over feature in the area and can beef up HDTV channels when necessary); and deliver strong customer service (the MSO is guaranteeing a 2-hour window for service calls in New York).

“We have competed with Verizon in other markets, obviously other cable operators have competed against them,” Time Warner Cable CEO Glenn Britt said. “The business part of it isn’t any different here [Manhattan] than it was for Bright House in Tampa, Fla., or it’s been for us in other markets or Cablevision in Long Island. What we’ve seen across the country is that cable competes very well.”

Britt added that he expects the cable operations will lose some subscribers to competition, but that will be more than made up for in gains in high-speed data customers and phone customers.

As if that weren’t enough, the operator also is in the midst of a full separation from parent Time Warner Inc.

In May, Time Warner Inc. announced that it would divest its 84% interest in the cable company, converting all of its Class B super-voting shares into Class A common stock and converting its 12.5% interest in a cable subsidiary TW NY Cable Holding into 80 million newly issued shares of Time Warner Cable.

TWC will issue a special $10.9 billion one-time dividend to shareholders as a result of the split, of which Time Warner Inc. will receive $9.25 billion in cash. Time Warner, which will have control of about 900 million TWC shares as a result of the two transactions, will distribute those shares to its shareholders.

The exact form of distribution will be determined shortly before the closing of the transaction, expected by the end of the year.

After the divestiture, TWC will be a pure-play cable operator stock. And with its own currency — unencumbered by a corporate parent — TWC is expected to have greater financial and operational flexibility.

“I think that our lives won’t change a tremendous amount — we’re already public and we have been wholly owned for 20 years, so that’s created a certain separateness all along,” Britt said. “Day-to-day operations really won’t change at all. I see it more as an evolution. We’re evolving from being solely a television company to being a broader-based company. That makes the separation natural.”

TWC chief financial officer Rob Marcus said that for the most part, the heavy lifting for the spin-off is over. Now the company is basically waiting for a favorable tax ruling on the separation from the Internal Revenue Service and clearance from the Federal Communications Commission — expected sometime before the end of the year. The next step would be a shareholder vote and then the actual separation.

While Time Warner Cable has been trading as a separate stock from Time Warner Inc. since March 2007, some believed that the parent’s 84% ownership stake was a drag on the stock. Cable has also been a top performer for Time Warner Inc. — the systems operations accounted for more than 40% of the parent’s total OIBDA and more than 30% of its revenue in 2007.

In the end, the decision to split was made by Time Warner Inc. CEO Jeff Bewkes, who saw the idea of transforming TWI into a pure-play content provider — consisting of cable networks and the Warner Bros. movie studio — as the way to go.

Marcus said that while the concept of a separation has been kicked around the hallways of the company for years, Bewkes is the man who decided to pull the trigger. And the split had its roots in the 2006 joint purchase of Adelphia for $17.6 billion.

As part of that deal, Adelphia’s bondholders agreed to receive the bulk of their value from the transaction in the form of Time Warner Cable stock. And when TWC became a publicly traded company on March 1, 2007, that’s exactly what happened — 84% of the shares went to Time Warner inc. and 16% went to Adelphia bondholders.

“Doing the Adelphia transaction, cleaning up the cable structure and issuing a separate cable equity is a natural precursor to doing a spin off,” Marcus said. Often, companies will do a public offering for “a small slice of their equity in anticipation of doing a separation. People say it’s called 'seasoning the stock.’ We happen to have done it via this acquisition transaction.”

That structure was one that many believed couldn’t last for long — analysts and investors have complained in the past that the structure left TWC with an abnormally small float (the only shares traded were those that were sold by former Adelphia bondholders) and artificially limited the shares. Marcus agreed.

“Coming out of the blocks we were owned by unnatural holders, distressed debt guys that owned Adelphia via the bankruptcy.” Marcus said. “That has changed significantly over time. The stock started trading in March 2007, since then there has been significant turnover in shareholders, there is a much more natural shareholder base now.”

But Marcus admits that the stock’s current float is small, which has prohibited some investors from buying shares. And that is expected to change dramatically once the separation is completed.

“Some guys like to take bigger positions [in TWC] but don’t because there is not stock available,” Marcus said. “One of the real benefits of the separation for Time Warner is that we’ll have plenty of float. I don’t want to be presumptuous, but it’s highly likely we will be included in the S&P 500 Index, so we’ll get the benefit of having the index players in there. There is a whole bunch of investors attracted to the stock or [who will] be incented to take bigger positions in the stock.”

One of the incentives to own the stock will be the pure-play nature of the new Time Warner Cable. It won’t own content like Comcast (which owns E!, the Golf Channel and Versus, to name a few) and Cablevision (which owns Rainbow Media) and it won’t have a dominant owner like those two MSOs and the remaining two publicly traded cable companies Charter Communications (controlled by chairman Paul Allen) and Mediacom Communications (controlled by chairman Rocco Commisso).

“When you lay out the history of cable, almost every cable company has either been integrated with a broad-based media player or owned by a family with high-vote/ low-vote shares,” Marcus said. “We are going to be absolutely pure in every way — we’re essentially cable-only, we will have one class of stock, we will have no significant owners, certainly no family owners, and no management owners. I think that is a pretty attractive proposition for investors who really want to play in cable and want to play in a well managed cable company.”

The split will also give TWC more financial flexibility, which some take as meaning that the company, armed with a freshly unencumbered deal currency, will embark on an acquisition spree. That is something that Britt said is highly unlikely.

And Marcus, who before joining TWC in January as CFO was the parent company’s top deal-maker, agrees.

“It’s easy to envision consolidation deals that people think are inevitable like a Cablevision, like a Charter,” Marcus said. “I do feel strongly that those deals, while they may seem inevitable or seem to be Time Warner Cable’s manifest destiny, are not necessarily going to happen. They’re only going to happen if they can happen on terms that enable us to capture value for our shareholders. There is nothing inherently good or necessary about our owning Cablevision or Charter or even getting bigger. It has to be done on the right terms or else there is no value in it for us.”

Marcus said that some areas the company may look for acquisitions include those that expand an existing business or that allow the company to enter businesses adjacent to its existing operations.

“As we get into the commercial [phone] business, I’ve thought that it’s possible we may utilize M&A as a way to supplement our capability in that area,” Marcus said. Other possible targets are regional sports networks (it already owns a piece of SportsNet NY) and other local programming.

The separation will also mark the end of an era — it will uncouple the last of the vertically integrated major MSOs, a concept that Time Warner Inc. practically invented with the merger of Time Inc. and Warner Communications in 1989.

Britt, who was with Time Inc. during that historic merger, said that at the time, pairing content and distribution made sense. Today, with so many different distribution avenues — cable, satellite, telco and to an extent, the Internet — that benefit isn’t so clear anymore.

Britt said that vertical integration in the early days of cable made sense in that it provided programmers with the financing they needed to create content and gave cable operators the networks they needed to fill the growing number of channels on each system.

“As things have evolved, I guess there are still ideas for new networks, but it’s not the formative stage that it was in the ’70s and early ’80s,” Britt said. “The big categories have certainly been covered. And most of the big networks have full distribution and there is competition in distribution. There’s a lot less rationale to be vertically integrated than there was before. You don’t need to own distribution to get distribution.”