Illustration: David Plunkert
By Shawn Tully
March 21, 2013

When Time Warner announced in early March its plan to spin off the Time Inc. magazine unit by the end of 2013, financial analysts and the business press expressed broad agreement on the prospects for the two future entities. For the new Time Warner, the prevailing view was highly positive: The split is the next logical step in solidifying a pure-play television and motion picture colossus after the spinoffs of AOL and Time Warner Cable four years ago, and with CEO Jeff Bewkes shedding the drag of magazines and sharpening his focus on a stable of growing businesses, his record of enriching shareholders seems bound to keep rolling.

For a newly independent Time Inc., the 91-year-old publisher of Time, Sports Illustrated, People, and dozens of other titles, including Fortune, the general opinion was downbeat: Unlike Time Warner, which grew operating earnings in its nonpublishing businesses by 4.7% last year, the magazine business needs radical change. Put simply, revenues and profits for Time Inc. and the magazine industry as a whole are shrinking.

It’s unclear what strategy will reverse that decline. But industry experts and analysts agree that it might require daring bets — new digital platforms, alliances with tech-savvy partners, and even shrewd acquisitions. “Magazines could have a strong digital model, better than most media companies,” says Neil Begley, a fixed-income analyst at Moody’s Investors Service. “But for magazines to have a fighting chance, they will need financial flexibility, meaning the freedom to invest heavily to revive their businesses.”

To get a dispassionate view of our parent company’s prospects as a spinoff, we talked to Begley and other analysts, along with portfolio managers and investment bankers, for their views on how Time Warner should proceed. By and large, they endorsed Begley’s view that Time Inc. would perform best with low leverage and the ability to be financially agile. It is certainly in the interest of Time Warner for the new Time Inc. to find favor with investors. The parent company’s shareholders will receive stock in the new company — shares representing roughly 5%, or 1/20, of the value of a Time Warner share. Since Time Warner spun off AOL and Time Warner Cable in 2009, the stocks of those two companies have easily outperformed the broader market. And shares of Time Warner itself have nearly doubled.

For Time Inc., however, the path to revival could be blocked even before the spinoff happens. The crucial issue, analysts agree, is the amount of debt that Time Warner will place on Time Inc. If the magazine company is saddled with excessive leverage, it will lack what it needs to grow again: ample cash for big investments. It’s tough to be innovative when your main concern is paying down debt. Diverting too much cash flow to debt payment could also stifle Time Inc.’s ability to pay a dividend. Another factor is that Time Inc. must replace outgoing CEO Laura Lang. Attracting a star to the job will be a lot easier if the company isn’t overleveraged.

So how much debt is the new Time Inc. likely to carry? The most common measure for leverage is the ratio of debt to Ebitda, or earnings before interest, taxes, depreciation, and amortization — essentially the cache of profits available for making interest payments. Time Inc.’s Ebitda has been falling sharply since 2007. According to projections by Morgan Stanley, its Ebitda will reach $524 million by 2014, its first year as an independent company. That’s a 15% drop from 2012.

Time Warner hasn’t given a specific number yet for what the debt load will be. Nor has it said whether it will pitch Time Inc. as a stock that pays a dividend at the outset. (Analysts believe that asking the fledgling company to pay a dividend and service debt could stunt its prospects.) On Wall Street predictions range widely, from $500 million to $2 billion. But an individual familiar with Time Warner’s thinking told Fortune that the company “plans to put on a level of leverage consistent with the ratios followed at Time Warner.” Time Warner has a current debt-to-Ebitda ratio of 2.6, close to its stated goal of 2.5. Let’s assume that Bewkes plans to base the spinoff company’s ratio on Time Inc.’s 2013 Ebitda of close to $600 million. In that scenario Time Inc.’s debt would approach $1.5 billion.

The 2.5-times-Ebitda number may be right for Time Warner, but Begley and others think the ratio is excessive for Time Inc., which does not boast the same credit quality or diversified revenue sources as its parent. Consider that entertainment and publishing conglomerate News Corp. plans to shed its publishing assets this year — as the new News Corp. — with no debt.

Here’s how piling on excessive debt could choke off the new Time Inc.’s investment capital. Afoccording to Begley, Time Inc. cannot afford to let its interest costs absorb a bigger and bigger share of its cash flow. To reassure investors, it should hold constant the cents in interest that it pays on each dollar of Ebitda. Ebitda has been shrinking at over 7% a year for five years, and most analysts expect the trend to continue. So Time Inc., from 2014 to 2018, would need to pay down an average of $95 million in principal on its $1.5 billion in borrowings to hold its interest payments constant at 19ยข, or 19% of Ebitda.

The crucial number is what’s left over after Time Inc. pays its taxes and interest. That’s the free cash that it can lavish on digital publishing technology or acquisitions. From 2014 to 2019 it would be forced to spend over a third of its cash flow on debt repayments, lowering the amount available for investments to around $180 million a year. But a bigger number would generate higher earnings and also make the company far safer in the eyes of lenders and shareholders.

So let’s consider a second scenario: Time Warner structures the independent Time Inc. with a relatively light debt-to-Ebitda ratio of 1 to 1. That’s the amount of leverage that Begley recommends. Based on its 2013 Ebitda, Time Inc. would then carry about $600 million in debt. To be prudent, it would still pay down principal each year to keep debt service at a constant portion of its Ebitda. But since both its interest and principal payments would be lower, Time Inc. would generate more cash each year.

Layer on a second set of assumptions: Let’s forecast that Time Inc. spins off with a 1-to-1 ratio and invests aggressively, and that those investments are successful. As a result, cash flows keep dropping in 2014 and 2015, then embark on modest growth of 3% a year through 2019. From then on, they simply rise with inflation at around 2%. In this projection, the cash flow available for investment would average about $320 million, almost 80% higher than under the $1.5 billion debt load scenario. The rising cash flows would create a virtuous cycle of ever lower debt and stable earnings.

That kind of turnaround will prove a tough challenge. But if Time Inc. can generate any kind of growth — and again, low leverage is key — its stock could actually be quite attractive to investors. Most analysts predict that after the spinoff Time Inc. will have an enterprise value — debt plus equity, minus cash — of around $4 billion. If that proves true and that the company takes on the more manageable $600 million debt load, Time Inc. will have an equity value of $3.8 billion. If Time Inc. can indeed restore growth by 2016, it could potentially boast a market cap of $6.3 billion by the end of 2019 — meaning annual returns of 9% for five years starting in 2014. That would be more than enough to turn a struggling magazine company into an unexpected Wall Street success story.

This story is from the April 08, 2013 issue of Fortune.

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