We expect Time Warner Cable's (TWC) pending structural separation from its parent company, Time Warner (TWX), to improve the strategic flexibility and simplify the ownership structure of the second-largest U.S. cable operator. After an initial public offering in early 2007, we also expect the pending transaction to substantially enhance the public float of the company's shares, probably increasing its nimbleness for a potential use of its stock as a currency for further acquisitions, amid a rapidly changing landscape.
TWC recently completed an integration of certain cable systems acquired in July, 2006, from Adelphia Communications, as well as certain swaps with Comcast (CMCSA). In the years ahead, we expect the company, with a much larger cable footprint, may derive sizable scale economies from the landscape-transforming transaction, as the key operating metrics of the recently acquired systems continue to converge with the comparatively healthier levels of TWC's legacy systems. This outlook is supported by the company's first-quarter results and management's full-year guidance, in our view.
One of the earliest cable operators to launch digital phone service, TWC's competitive strategy, amid an intensifying battle of the bundles, hinges on a continued rapid penetration of its triple-play service, which is now substantially available across its entire footprint. We believe its contiguous state-of-the-art systems have also allowed the company to become an industry leader in deploying advanced video and interactive digital services. In addition, over the longer term, we think TWC could also be poised to reap majaor benefits from a relatively untapped commercial market opportunity for small, midsize and large enterprises.
We view TWC's financial condition as generally sound, despite some near-term concerns with higher financial leverage on a sizable dividend payment related to the pending separation. Management expects TWC to regain relatively ample financial flexibility soon after the separation—thanks in part to a projected acceleration of its free cash flow. Furthermore, we believe the company's corporate governance structure, which we deem generally satisfactory, would be further enhanced by a single share class following the separation. We believe the shares, which recently traded at 30, offer attractive upside potential from their current levels, and our recommendation is 5 STARS (strong buy).
THE SEPARATION
In May, 2008, parent company Time Warner set some details on previously announced plans for a complete structural separation of its 84% TWC stake in a tax-efficient transaction. We expect this transaction to provide TWC with much improved strategic flexibility in a rapidly changing cable landscape. In addition, the deal should simplify TWC's capital structure and enhance the public float of its shares. Subject to necessary FCC and franchise approvals, as well as an IRS tax ruling, the parties expect to complete this transaction by the 2008 fourth quarter.
Under an initial exchange and recapitalization pursuant to the separation, TWC's parent would exchange its 12% stake in TW NY Cable Holding for 80 million newly issued TWC Class A shares (resulting in a stake of 85.2%), and then convert its supervoting Class B shares into TWC common shares on a one-for-one basis. TWC would then pay a special dividend of $10.9 billion ($10.27 per share) just prior to the separation. Thereafter, the parent company would distribute all of its TWC stake to its shareholders, with the exact form of such stock distribution (e.g., a spin-off distribution, a split-off exchange, or a combination) to be determined based on prevailing market conditions.