One More Stab At AOL – Time Warner Heading Lower

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Time Warner (TWX) shares fell for the 7th straight day yesterday, no doubt continuing the negative reaction since word spread that AOL might switch strategies again. The stock has dropped 5.1% in total, erasing about $3 billion in market value.
As I noted in a post last week, the shift away from a subscription model could have an immediate EBITDA hit of $200 million. Since investors were probably not valuing AOL at 15 times EBITDA, I think the reaction is reality settling in that AOL is worth a lot less than previously assumed and might not be salvageable.
Reading analyst research about the AOL situation, I was intrigued by a comment from Jessica Reif about AOL’s declining page views. Remember that the idea behind giving free access to all the features at AOL.com to any user with a broadband connection is to keep subscribers that are deserting the dial-up business on the AOL site and maybe even attract some new users. The goal, of course, is to turn AOL.com into Yahoo and build an advertiser driven business that more than makes up the EBITDA loss from the dying dial-up subscription model.
Personally, I think it is a hopeless case because AOL is a weak and stale brand. To justify my harsh view, I asked Jessica for data on AOL’s page views and unique visitors. I know that internet stock investors are probably very aware of this data but what I found was pathetic…..

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Disney’s Pirates Brings Big Profits

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Consumers and investors tend to focus on box office and forget profits when looking at domestic box office numbers. Several analyst reports out today are looking at the profitsfor Pirates and the news is good for Disney (DIS). Analysts must have been playing it safe because several bumped their estimates by a nickel or more for FY07 which is where the profits on the film will reside due to the requirement that marketing and production costs be expensed upfront. Film profits usually come from windows like DVD and sale of TV rights that come six to 18 months after the domestic theatrical opening.
For Pirates, analysts are estimating that production costs were anywhere from $200 million to $250 million. Film advertising and print cost estimates range from $75 million to $150 million. This creates a cost basis ranging from $275 million to $400 million before additional costs related to participations for talent and any financing partners. Consequently, on the assumption that DIS will collect revenues equal to 50% of the global box office, the total worldwide take must be $550 million to $800 million for the film to reach breakeven during the theatrical run which will correlate with DIS’ 3Q and 4Q06. The first film did worldwide box office of $653 million ($305 million domestic, $348 million international). Analyst are estimating the new film to do at least as well as the first film, thus, breakeven is on the horizon. That would be good news as most films are not profitable on their theatrical run.
Analysts project that over the next 18 months, the film will produce profits for DIS form $250 million to $400 million across all windows and including merchandising. Down the road, there is also an immeasurable benefit to the theme parks. This film is the perfect example of how DIS can benefit across its divisions from successful family-oriented films. With Chicken Little, Narnia, Cars, and Pirates all having been successful since the 2005 holiday season, there is a lot of cushion in the DIS numbers over the next 4-6 quarters.

A Look at Records Set By Pirates of the Caribbean

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The numbers for Pirates of the Caribbean: Dead Man’s Chest (POTC) are truly enormous even in an era when studios, theatres, and moviegoers have become used to huge opening weekends. Over at The Hot Blog, David Poland has referred to these big opening weekends and lesser legs as “front loading.” All the comparisons below are against other films that have been impacted by front loading.
• POTC had the largest opening weekend ever with $132 million, beating the four year old record of Spiderman by $18 million.
• POTC had the largest 3-day opening ever beating last May’s release of the final Star Wars film, Revenge of the Sith, by $8 million. Sith opened on a Thursday.
• POTC earned $100 million in just two days, the first film ever to reach that level.
• Friday’s one day haul of $55 million was the largest ever single day, beating the opening of Sith which pulled in $50 million. POTC also had the 5th biggest single day ever on Saturday and the 27th biggest single day on Sunday.
• POTC is just the 6th film to bring in over $100 million in its first three days. The others are Sith, Spiderman, Matrix Reloaded, Harry Potter and the Goblet of Fire, and this summer’s X-Men: The Last Stand. Interestingly, four of those movies were released in May (the Potter film opened in November). Compared to other movies opening in the true summer months of June, July, and August, POTC just crushed anything. The largest ever June opening is the third Harry Potter movie, Prisoner of Azkaban with $93 million. The largest ever July opening prior to POTC was Spiderman 2 with $88 million. The largest opening in August belongs to Rush Hour 2 with $67 million. At first I was surprised that May was so dominant for opening weekends, but upon reflection the fact that kids are still in school forces ticket sales to weekends. Also, there are fewer entertainment alternatives in May and less folks on vacation.
Other records on the horizon for POTC could include the 4-day and 10-day records of $158 million and $236 million both held by Sith. Also, keep an eye on the one week record of $192 million held by Spiderman 2. The fastest film ever to $200 million is Spiderman 2 in just 8 days. Sith is the fastest ever to $300 million in 17 days. Six films have made it to $400 million with the record for getting there fastest belonging to Shrek 2 in 43 days.
How high could POTC go? The first film released last summer opened at $46 million but showed amazing legs to stay in the top ten for ten weeks and earn $305 million. There is precedent for sequels outperforming their originals, most notably Shrek 2, which earned $441 million versus $267 million for the original. I think the latest POTC and Shrek 2 have some similarities in that both franchises became much more popular due to the success of their DVDs. Both also have very brad popularity across all key movie going demographics.
Of the five previous films to open to $100 million or more, their total domestic gross ranged from $235 million (X-Men) to $404 million (Spiderman). These five films grossed anywhere from 2.3 to 3.5 times their opening weekend. For POTC, that would lead to a box office of $300 million to $462 million.

Pirates Provides Big Boost To Box Office

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Pirates of the Caribbean: Dead Man’s Chest (POTC) blew away even the most optimistic estimates and broke all opening weekend records pulling in $132 million in just three days.
All by itself, POTC would have made for a successful weekend for the movie business, but not be overlooked is that the other films in the top ten also performed well. Second place Superman Returns fell 57% vs. its opening weekend but that is really not that bad considering the huge numbers for POTC. All the other films in the top ten fell between 40% and 50% except for Cars which fell just 30% and continues to show good legs. Overall, the weekend box office rose 42% according to estimates supplied by BoxOfficeMojo.com. The year-to-date box office is now up over 6%, which means that attendance has rebounded to positive growth despite all those home theatres, downloads, and alternative entertainment options.
I stand by my thesis that the death of theatrical movies is an invalid assumption. This creates investment opportunities for studios that are having successful years and movie exhibitors. Disney (DIS) is the best play among studios as the company looks like it will get the top two spots at the summer box office with POTC and Cars (yes- the “disappointing” Cars seems headed for over $235 million and second spot). POTC, also a DIS film, is sure to finish #1. And don’t forget last winter’s success for Chicken Little and The Chronicles of Narnia. Profits from these four films will flow to DIS over the next year.
Among exhibitors, I remain happily long Regal Entertainment (RGC), which should benefit from the recovering box office through good financial performance and expanding valuation. A 6% current yield and a history of special dividends is nice support while I wait for the shares to move up to my target of $23-24.
The coast is clear for DIS and RGC but comparisons do toughen this coming weekend when Charlie and the Chocolate Factory and Wedding Crashers opened very strongly a year ago. DIS reports August 8th and obviously is dependent on far more than the success of its movie studio.

Wall Street Journal Confirms AOL Rumors

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Yesterday’s Wall Street Journal carried an article confirming the rumors I have been writing about concerning major changes at AOL. The most important takeaway is that AOL wouldn’t be considering such drastic action unless the deterioration in fundamentals was accelerating. That means dial-up subscribers are still leaving at a fast clip, broadband subscribers under the company’s latest offer are falling short of expectations, and traffic and advertising at AOL.com is failing to hold market share. Regardless of how management spins the numbers when the strategy shift is formally announced, AOL is in big trouble and worth a huge discount to the $20 billion implied value from Google’s acquisition of a 5% stake…..

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July Model Signals

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Northlake’s Market Cap model completed its transition for July by flashing a large cap signal for the first time since June 2005. As a result, I sold all remaining mid cap exposure dedicated to the ETF rotation strategy, swapping it dollar for dollar to large caps. Specifically, at the open on Monday, I sold the S&P 400 Mid Cap (MDY) and bought the S&P 500 (SPY). There was no change at all in the signal from style model which continues to flash value as it has since February 2006.
Current positions within the ETF rotation strategy are now entirely large cap, equally split between SPY and the Russell 1000 Large Cap Value (IWD). As recently as two months ago, clients had 25% in small cap value and 50% in mid cap, so a shift to 100% large cap is a significant change.
The market cap model has picked up on several trends that favor large cap outperformance including….

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Prada, Not Superman, Keeps The Box Office Growing

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July 4, 2006 was a pretty good weekend for the domestic box office, making it seven straight up weekends against the easy 2005 comparisons. With the most anticipated movie of the summer, Pirates of the Caribbean: Dead Man’s Chest, hitting theatres on Friday, my bullish thesis built on a strong 2006 summer box office remains in place. There is no change to my two long positions that play the thesis: Disney (DIS) and Regal Entertainment (RGC). Both could get a short-term trading boost ahead of the release of Pirates, which is a Disney film.
Looking at just the three-day weekend, the box office rose a little over 5%. The up weekend occurred despite a softer-than-expected opening for Superman Returns. The film has brought in over $100 million since its release a week ago, but that figure trails last summer’s July 4 holiday blockbuster, War of the Worlds. Fortunately, The Devil Wears Prada about doubled expectations, bringing in $27 million over the three-day weekend. Prada actually earned more than the combined gross of the No. 2 and No. 3 films of the holiday weekend a year ago. In fact, this year’s No. 3 movie, Click would have been No. 2 a year ago with its $20 million gross. Cars also contributed to the up weekend, showing good legs with its box office poised to cross $200 million by early next week. (DIS longs will be happy to know that some observers thought $200 million might be a stretch after the weaker-than-expected opening weekend — $230 million-$250 million is definitely within reach.)….

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Apple Implicated in Stock Options Scandal

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Analysts are predictably defending Apple Computer (AAPL) on last week’s news that the company is caught up in an options backdating scandal. Merrill Lynch did a good analysis showing that options granted very close to the annual low in the share price were only 5% of total options. None of these suspect options were granted to Steve Jobs. Excluding Jobs, a larger 15% were granted within 5% of the annual lows.
According to Apple’s press release, Jobs did receive one huge grant of 20 million options in 2000 which was apparently cancelled and provided him no financial benefit. However, the New York Times noted that in 2003 when Jobs options were cancelled they were worthless. Further, the options were replaced by a stock grant worth $75 million dollars that had a three year vesting period.
10 million shares of the Jobs grant were announced on January 19th, 2000 in a press release issued by Apple. The press release said that the exercise price was about $87 as of the date of the grant which was January 12th. On January 19th, Apple already was trading at $106, giving Jobs a $190 million paper profit. The gist of the options scandal is that company’s were granting options after the fact and backdating them to the lowest prices of the past year providng no risk profits to managers while diluting shareholders. It is not clear if Apple did any backdating in this case. An internal investigation will be conducted to determine if any impropreity occurred.
Analysts are focused on whether the investigation undercuts shareholder support for Steve Jobs and Tim Cook. Assuming management is left in place, analysts seem unconcerned. Apple longs are lucky that the company is something like the 50th to be implicated rather than the 1st.

Mac Sales Looking Good For Apple

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News broke last week that Microsoft (MSFT) won’t have a fresh operating system or a fresh update to Office for the Christmas selling season. On the other hand, all indications are that the new consumer laptops from Apple (AAPL) are selling above initial analyst estimates (which were probably conservative).
APPL shares are trading near their 2006 low. The stock’s weakness has been mainly related to fears about iPod sales. While I would prefer to see stronger iPod sales, I stand by my bullish thesis built on accelerating Mac sales. One million iPods are worth $200 million in revenue to Apple. With an ASP of $1300, or over six times an iPod, it takes only an incremental 150,000 Mac sales above expectations to make up any revenue shortfall from iPods. And Macs have higher margins.
I’ve been wrong on Apple this year but I think the setup is good heading into the company’s seasonal strong period driven by back-to-school and holiday sales. Most analysts have reduced iPod shipment and earnings estiamtes. The expectations bar has been lowered so that a decent earnings report and in line guidance should support the shares. Positive news about better than expected Mac sales and/or a refresh of the iPod line could boost the shares.
I am sticking with AAPL but expect lots of volatility surrounding the company’s June quarter earnngs report.

Major Layoffs Coming at AOL? If So, It Is Bad News For Time Warner

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I read a post on Henry Blodgett’s blog about two weeks ago alluding to the major layoffs at America Online (AOL). I do not know the writer, but I have found the discussion at Henry’s blog to be quite good. SInce then, more outlets are reporting rumors of large layoffs and weak advertising growth. There is no confirmation yet from management of AOL’s owner, TIme Warner (TWX), but I think major layoffs at AOL are a big negative for TWX shares.
Major layoffs at this point are a sign of weakness given that some key new strategies for saving AOL have been in place for almost a year. Layoffs indicate that the broadband rollout is either not getting enough subscribers or not producing enough profits or both, and/or that dial-up subscriber losses remain elevated. Any of those outcomes is menas that advertising growth at AOL.com, the key to AOL’s turnaround strategy, is falling short of expectations.
I think there is a risk that implied valuations in TWX shares of up to $20 billion for AOL may implode. This has serious downside implications for TWX, since any meaningful downgrade of AOL’s value across TWX’s 4 billion-share base is significant relative to a $17 stock….

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