A Case Study: Is Time Right For AOL?

Forgive Steve Case for his euphoria on the day he announced the unexpected and stunning acquisition of Time Warner by his still-upstart America Online, which is one-fifth Time Warner's size. "I don't think it's too much to say that this really is a historic moment, a time when we transform the landscape of media and communications," the AOL chairman said.

Forgive Steve Case for his euphoria on the day he announced the unexpected and stunning acquisition of Time Warner by his still-upstart America Online, which is one-fifth Time Warner's size. "I don't think it's too much to say that this really is a historic moment, a time when we transform the landscape of media and communications," the AOL chairman said.

Indeed, with 100 million subscribers for its publications and interactive services combined, it's almost a given that AOL Time Warner will make history. The $156 billion merger will create the world's fourth most valuable company and forever change the way offline and online media interact.

But soon it will be time for Case to come down to earth. He is faced with the task of successfully forging the world's largest mating of any two corporations of any type. And after the high-fives are over, he must bring these two companies face-to-face with unparalleled risks. AOL Time Warner's success in divining, defining and creating a world where all kinds of media are available at all times ultimately may be judged on factors that are outside the control of even the new Goliath of convergence.

> Will a fickle Wall Street continue to value the combined company at the lofty multiples long enjoyed by the fast-growing AOL?

> Does the deal unleash competitive forces at Microsoft and Yahoo! that will someday allow those rivals to surpass AOL Time Warner in scope and influence within the media industry?

> Has AOL underestimated the task of absorbing and transforming the slow-of-foot, majestic Time Warner empire?

> Will AOL's engine of growth — subscriber revenue — dry up and bring the entire AOL Time Warner empire into distress if new rivals offering free Net access take root?

> Can the combined company truly deliver on the promise of broadband — or will it stultify broadband's development by trying to con- trol it?

Such questions about AOL Time Warner's prospects cannot be overshadowed by the audacity and entrepreneurial brilliance of bringing about a merger that will give AOL a 55 percent stake in — and control of — a company that operates everything from the best-known weekly newsmagazine in North America to the outfit that first allowed home viewers to see uninterrupted movies in their living rooms.

Nor can the potential pitfalls be skirted by the fact that a takeover by AOL is Time Warner's lifeline to the future and a neat, sudden escape for a company that has repeatedly botched attempts to capitalize on the delivery of electronic media, from its rudimentary teletext venture at the onset of the '80s to interactive television and Internet services in the '90s.

AOL is Time Warner's missing link. It bridges the gap between Time Warner's heritage in consumer media — with revered franchises ranging from Time magazine to Looney Tunes cartoons — and its sizable stake in cable systems capable of carrying a new breed of digital content to 20 million homes nationwide.

"We in the new media business were always convinced that this kind of convergence was going to come someday," said Mark Stevens, vice president of business development at Excite@Home. "What is surprising is how quickly this all has happened."

But ratifying that convergence — completing the deal — may be the easy part.

AOL: The little engine that could?

Even Wall Street was thrown for a loop initially by the audacity of Case's move. Despite a track record for frowning on mergers that linked new media companies with slower-growing traditional media firms, investors at first pushed AOL (www.aol.com) stock higher in the hours immediately after the Time Warner (www.pathfinder.com/corp) merger was announced.

Through the course of the week, however, the reality of the proposed transaction began to set in with Wall Street. While AOL shares dropped only slightly on the first day after the announcement, the stock tumbled more than 10 percent on the second day, and by Jan. 13 had closed at 11.5 percent lower than its $72.68 price when the deal was unveiled. As was the case last year when Wall Street perceptions helped scotch the proposed merger of Barry Diller's USA Networks' interactive unit with the Lycos navigation hub, investors showed they were leery of hitching the fast-paced growth of an Internet firm to an established real-world company and its slower growth rate — and pace of operation.

The basic truth behind this merger is that AOL will have to work much harder to achieve the kind of growth to which it has become accustomed.

The interactive company accounts for only 20 percent of the total cash flow of the combined AOL Time Warner. That means the online side of AOL Time Warner would have to more than double its 54 percent revenue growth rate of fiscal 1999 to avoid being flattened by the weight of Time Warner's large and relatively stable lines of business.

Many analysts say it can't be done. Investment firm BancBoston Robertson Stephens (www.rsco. com) projects a growth rate of 15 percent to 20 percent for the combined company, compared with the 30 percent growth it had expected in coming years from an independent AOL.

The challenge facing executives at both AOL and Time Warner is to convince Wall Street that the combined company has prospects for greater overall growth than would be possible if the companies stayed separate.

Gerald Levin, Time Warner's chief executive who will be CEO of the merged company, is pitching Wall Street analysts on the proposition that both companies have invested in establishing long-term relationships with subscribers. Combined, they will be able to develop consumer-branded digital services that can be sold to their customer bases.

"It's a statement by me that the value creation in the Internet space is very real," Levin said of his decision to pursue the merger. "Accelerated cash flow streams are meaningful, are real, can be calculated and can be realized — particularly by this company."

As a merged entity, AOL Time Warner can generate $40 billion in sales annually, with $10 billion in earnings before taxes, depreci ation and amortization, Levin projected. By joining forces, the company is betting it can layer on an additional $1 billion in pretax earnings through new revenue opportunities and cost savings.

But skeptics aren't convinced AOL Time Warner — subscribers or not — can achieve the lofty objectives it sets out. "There are no examples of large, traditional media companies that have taken their content and ported it to the Web profitably," said J.B. Haller, an analyst at research firm Current Analysis (www.currentanalysis.com). "And I'm not so sure AOL and Time Warner can do it either."

Microsoft unfettered

A lot is riding on AOL Time Warner's ability to keep its growth engine chugging and its stock price high. That's because, simply by completing this deal, AOL may let the Microsoft genie out of the bottle. Even as the U.S. Justice Department readies plans to request the software giant's breakup, Microsoft, in the wake of the merger, can argue more forcefully than before that real competition exists, that it should remain intact and that it should even have the freedom to pursue major mergers of its own to keep pace with the market.

Microsoft (www.microsoft.com) has already shown an eagerness to invest billions in cable companies such as AT&T and Comcast. Outright acquisitions of telephone companies and media conglomerates are not out of the question.

As was the case when AOL announced plans in 1998 to acquire Netscape Communications, Microsoft cited the latest AOL deal as an example of how quickly competitive forces can reshape market power in the technology sector.

"The AOL-Time Warner deal is the latest and best example of how competitive the marketplace really is and how competition comes from a wide number of areas within the high-tech industry," Microsoft spokesman Jim Cullinan said.

While the government's case against Microsoft centers mostly on market abuses related to its PC operating system monopoly, Microsoft will contend that the digital market now spans an array of devices beyond the PC, and Microsoft is only one of a string of competitors. And with a projected market cap of $350 billion, AOL Time Warner would represent significant competition, Microsoft will argue.

"[This deal] has to do with their AOL Everywhere strategy, which competes with the PC on many fronts," Cullinan said. "The reality is that AOL's business model is focused on making Microsoft and the operating system obsolete and irrelevant."

It's still too early to judge what reaction court officials will have to the AOL-Time Warner deal, but no one can deny the landscape has changed significantly in the past week, said Gary Arlen, president of consulting firm Arlen Communications (www. arlencommunications.com). "Microsoft hasn't made a move in the media space primarily because they've had the judge looking over their shoulder," he said. "Now, it might have the option to go and buy something there."

The Yahoo! factor

While Microsoft sits at the top of the heap and waits to unleash its $17 billion cash horde, navigation hub Yahoo! looms ominously in AOL's rearview mirror. With a market cap near $100 billion, speculation last week immediately turned to Yahoo! and the kinds of traditional media acquisitions it could engineer.

Don't hold your breath waiting for a comparable old-media merger from Yahoo! (www.yahoo.com), though. Tim Koogle, the seemingly unflappable CEO of the high-profile navigation hub, is keeping his company on the Web trail.

Rather than pursue media mergers, Yahoo! is focusing on building infrastructure for delivering Web content, communications and commerce services. Most interesting to the company, Yahoo! executives said, are acquisitions of firms building "transaction-oriented relationships" with consumers.

"Our goal is to go deeper

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