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Profit From Cable TV's Bidding War With This Buyback Machine

Marshall Hargrave

There is perhaps no better investment opportunity than when a company comes out and says it's worth more after receiving a takeover offer. This is especially true when there are a number of suitors for that same company.

In these situations, the "belle of the ball" becomes sought after, and the bidding war begins. The highest bidder wins the prize -- and shareholders make off with a bunch of money and profits.

This could well be what plays out with Time Warner Cable (NYSE: TWC). Charter Communications (Nasdaq: CHTR), backed by billionaire John Malone's Liberty Media (Nasdaq: LMCA), has offered to buy Time Warner Cable for $132.50 a share.

If Time Warner Cable and Charter can swing a deal, the combined company would have cable systems stretching from Maine to California.

However, TWC rejected Charter's bid as too low; TWC is looking for $160 a share. The most interesting aspect of the Charter offer is that it's an opening bid, which is a bid that gets the two sides to the negotiating table. 

Another company that is interested in buying Time Warner Cable is Comcast Corp. (Nasdaq: CMCSA). Comcast is the largest cable provider in the world. It could buy all of Time Warner or select cable systems within Time Warner. Consolidation in the cable industry makes a lot of sense, because the larger a cable provider is, the more power they have in negotiating programming rights.

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Over the past several years, there have been a number of blackouts, whereby the cable operators removed channels from their systems because of a breakdown in negotiations. The most notable example of this came last year, when CBS wasn't available for Time Warner Cable customers for several days. By having more subscribers, the cable operators gain an edge at the negotiating table.

  Currently, about 4.5 million customers within Time Warner Cable's service area rely on DSL. Of these customers, about a third rely on Time Warner for their video packages. The goal is to convert 500,000 subscribers to Time Warner Cable broadband over the next 18 months.  

Charter's opening bid values TWC at 7 times EBITDA (earnings before interest, taxes, depreciation and amortization). In comparison, Comcast and Charter are trading at enterprise value/EBITDA multiple of 8.5 and 10.3, respectively.

Among its peers, Time Warner Cable boasts the lowest price-to-earnings (P/E) ratio (17.9), the highest operating margin (21.3%) and the best return on equity (27%).

At 1.5%, Time Warner Cable also has the highest dividend yield in the cable space -- and there's room to increase the dividend since the current payout is only 39% of earnings. The company will also be repurchasing $2.5 billion of its shares, or almost 7% of its market cap at today's prices.

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The dividend and buybacks help make TWC the best "Total Yield" play among the leading cable operators. My colleague Nathan Slaughter has been researching "Total Yield" recently, and he's found that companies that execute this strategy beat the market -- and regular dividend investing -- hands down.

There appears to be a large opportunity to create added value with Time Warner Cable's existing customer base. Currently, about 4.5 million customers within the company's service area rely on DSL. Of these customers, about a third rely on Time Warner for their video packages.

Time Warner is aggressively going after these customers to convert them to the company's 2-by-1 HSD tier for $14.95. The goal is to convert 500,000 subscribers to Time Warner Cable broadband over the next 18 months. The company can then upsell the customers to other packages.

Time Warner Cable has also been increasing the number of channels for its TV Everywhere collection. Just this month, the cable operator added A&E and the History and Lifetime channels as part of its programming package. These channels will be available on iOS and Android smartphones and tablets and on the Web to cable subscribers at no additional cost.

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The other growth area for Time Warner Cable is in business services. Businesses need reliable internet and phone services. Time Warner Cable is hoping to double the revenue from its business services division over the next four to five years, from $2.5 billion to $5 billion. Business services revenue increased by $100 million in the third quarter, marking the 14th consecutive quarter of 20%-plus growth.

Risks to Consider: If a buyout of TWC fails to materialize, shares could have a slight pullback. The other risk is that more customers choose to "cut the cord" and abandon their cable packages. More shows are becoming available online and consumers today have more viewing options, including competition from satellite companies, phone companies, and online content providers such as Hulu, Netflix (Nasdaq: NFLX) and Amazon.com (Nasdaq: AMZN).

Action to Take --> Buy Time Warner Cable with a price target of $150, which represents upside of 11% -- and doesn't include the possibility of a lucrative buyout.

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