On the Right Financial Track

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A year ago, Time Warner Inc. was a company in crisis. Still reeling from its failed and costly merger with America Online Inc., the loss of several top managers and the raised ire of investors, new chairman and CEO Richard Parsons vowed to get the company back on track. He set his sights on reducing debt, simplifying operations and taking a more cautious approach to acquisitions.

Because Time Warner has fared very well in achieving those strategic initiatives it is the recipient of Multichannel News’s 2004 Innovator Award for business strategy.

In January, Time Warner announced that it had paid down debt to under $20 billion from around $30 billion, a year earlier than expected. While that was mainly achieved through the sale of non-strategic assets like the music division, a CD and DVD manufacturing operation, a 50% interest in Comedy Central and professional basketball and hockey teams, it was also the result of a new focus on operational efficiency. By September, the debt had dropped to $16.8 billion.

CASH FLOW CONVERSION

Operationally, Time Warner executive vice president and chief financial officer Wayne Pace said the company has set a goal of converting 30% to 40% of its operating income before depreciation and amortization into free cash flow (cash flow after interest payments and capital expenditures are made), which can be used to pay down debt and to finance growth.

In the first nine months of 2004, Time Warner has generated about $3.1 billion in free cash flow, a 42 % adjusted OIBDA (operating income before depreciation and amortization) conversion rate.

On the mergers and acquisitions side, Parsons backed away from a $5 billion deal to purchase Metro-Goldwyn-Mayer Inc.’s studios, although MGM said Time Warner tried to rejoin the auction after the studio selected a group led by Sony Corp. — including Comcast Corp. — as the winning bidder.

Time Warner has said that it attempted to re-enter the auction at the request of partners in other ventures, but backed off when MGM would not give additional time for a new bid.

Fulcrum Global Partners media analysts Richard Greenfield said that Time Warner’s debt reduction success was welcomed by Wall Street, but added there are still more pressing issues facing the company.

“It was great that they fixed the debt,” Greenfield said. “But the big issues are proving that AOL really is a good business, or has value — something the market still doesn’t believe, although we believe that is starting to change — and showing that cable is a better business than people currently think.”

But when Time Warner’s debt was hovering around $30 billion, many analysts were wondering how they were going to pay it off. While there was never any danger of Time Warner being unable to meet its obligations, many analysts feared that such a heavy debt load would constrain the media giant.

Pace argued that the balance sheet was always strong — there was never any chance of default — but that the company was becoming concerned with its exposure to a few banks.

“At $30 billion we were among the largest corporate borrowers in the world,” Pace said. “Even though our balance sheet was very strong, we felt that the absolute level of debt was higher than what we were comfortable with. And while our banking relationships were also very strong — we had protected our strong investment-grade credit rating throughout — we felt we might be reaching maximum levels of exposure within one bank, even at the largest banks. We didn’t want to be in a position where we had borrowed all we could. We wanted more flexibility than that.”

Pace said that Time Warner’s rolling 12-month leverage ratio (from the third quarter of 2003 to the third quarter of 2004) is at about 1.7 times, less than where company leaders would like to be.

He also said Time Warner would prefer to be leveraged at around 2 times, but added that 2.75 times is the most it would tolerate.

'POTENTIAL ACQUISITIONS’

“The way we are managing this company is over the long term,” Pace said. “We will be looking at alternatives to give value back to our shareholders, increase our stock price and increase the return to our shareholders [through] a number of things: potential acquisitions, the possibility at some point in time of a stock buyback on an opportunistic basis, and the possibility at some point in time of paying a dividend,” Pace said.

As far as potential acquisitions go, Time Warner appears to be the leading candidate to scoop up Adelphia Communications Corp., and is expected to make a joint bid for the assets with Comcast.

Acquiring the Adelphia assets — which is not expected to occur until at least mid-January, when final bids are due — would give Time Warner a wider cable footprint and could possibly remove the last financial albatross from its neck, Comcast’s 21% interest in Time Warner Cable.

Time Warner is expected to launch an Adelphia bid by merging its cable assets into the smaller MSO, which is already publicly traded. Such a reverse merger could also satisfy Comcast’s interest in the cable company — allowing it to exchange its Time Warner Cable interest for systems.

COMCAST ALTERNATIVES

Even if an Adelphia deal does not materialize, Time Warner has given Comcast at least a partial out of that stake through an earlier restructuring of their joint interests in Texas Cable Partners and Kansas City Cable Partners, which have a total of about 1.5 million subscribers.

According to that deal, both partnerships were merged with each party owning a 50% interest. Time Warner will continue to manage both entities for at least two more years and either can trigger a split after 2006.

Comcast also has the right to lower its Time Warner Cable stake to 13% through two separate put options for 4% blocks.

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