Don't discount AOL/CBS rumors yet

A persistent rumor has been making the rounds that America Online Inc. wants to buy nothing less than the CBS Corp. No one in a position to know is saying anything on the matter -- at least publicly.

But a former top official at one of the nation's leading media conglomerates -- who is now a major investor in Internet companies -- told me last week that the rumors are indeed well-placed. He insisted that America Online, increasingly (and effectively) now led by its president and chief operating officer Robert W. Pittman, is in fact serious about a bid.

We will leave it to others to decide whether it would be in the long-term interests of the shareholders of either company to combine a (relatively) low overhead business in a cutting-edge medium (the Internet), with a labor-intensive, management top-heavy business in an imploding medium (broadcast TV).

Doubtless the rationales in favor of such a deal will come down to the argument that on the Internet as elsewhere in the world of infotainment, "content is king" -- meaning that the biggest audiences will inevitably flock to the programming with the strongest mass appeal and professional polish.

Whether that turns out to be the case or not, only time will tell. But we do not need to wait to find out in order to pass judgment on the idea from the narrower short-term perspective of what it would do to AOL's stock price. The answer? Send it through the roof.

With CBS comes prestige
To begin with, though CBS suffered greatly under ex-chairman Lawrence Tisch, who sold it to Westinghouse Corp. back in 1995 after basically picking the business clean, the company remains to this day the best-known -- as well as the last wholly independent -- broadcasting network in America. By contrast, NBC (joint-venture partner in MSNBC.com) is owned by General Electric Co., ABC by the Walt Disney Co., Fox by News Corp., UPN by Viacom, WB by Time Warner -- and basically that's about all there are.

Thus, from an image perspective alone, America Online would gain enormously in business-world prestige were it to merge with and acquire CBS. For America Online, such a deal would, in effect, amount to a coming of age -- enabling the company to shed once and for all its image as a business based on an essentially unreliable and jerry-rigged technology built around hooking up home computers to the phone in the den. This is the deal that would say in retort, "Yeah, well, we've got 60 Minutes and Howard Stern -- who have you got?"

More importantly, the deal would work financially as well -- at least if investors don't focus on the resulting goodwill charges to earnings. (More about that in a minute.)

Big fish, little fish
With 934 million shares outstanding, America Online boasts a market value on Wall Street that tops $135 billion, which is just about equal to the Walt Disney Co. and General Motors combined. Compare that $135 billion to the current market cap of CBS: $31 billion -- which is to say, nearly one-fifth that of AOL. In this case, big fish could eat little fish and barely burp.

It is the appreciated stock price that would enable America Online to do so. At a Thursday closing price of approximately $145 per share, AOL would have to issue no more than about 280 million shares to acquire CBS outright -- and that's even allowing for a generous 30 percent premium on CBS's current price of $43 a share.

In fact, because AOL's stock is so hot, the company could convincingly argue that it should not have to pay a premium at all -- reasoning, in effect, that the premium is built right into the AOL shares themselves and that any CBS stockholder would come out ahead strictly on an even-steven trade with no premium to the market price in the deal at all.

Even with a premium the deal would create an aggregate of no more than 1.2 billion total shares outstanding for the combined entity. Simply adding together Wall Street's 1999 earnings estimates for the two companies, you'd then end up with a likely 50 cents per fully diluted share for the combined operation -- versus 40 cents for CBS and 35 cents for AOL as stand-alone operations. In the lingo of these sorts of transactions, the deal would be "accretive" from day one.

At AOL's current multiple of 428 times year-ahead earnings, 50 cents per share in earnings would alone translate into a $214 price for the resulting stock. And in the current manic mood of investors, there seems no reason to apply a haircut to CBS's share of those earnings on the grounds that CBS is a slower growing business. Quite the contrary, if we are to assume that the bull market in general (and for Internet stocks in particular) is to continue (I personally have my doubts), one could argue that the combined entity would actually rate a premium for the CBS portion since CBS would now be in the Internet business!

A 'goodwill charge'
Nor would the problems of so-called "purchase accounting" be much of an obstacle. Purchase accounting treatment requires the acquiring company to charge off the acquired company's balance sheet goodwill against earnings -- which is why the Disney company is now taking a more than $400 million annual charge for having paid $19 billion for Cap Cities/ABC when more than $18 billion of the purchase price was goodwill.

If an AOL/CBS combination were subjected to the same treatment, it is possible that as much as 75 percent of the purchase price -- or $30 billion -- could be classified as goodwill. Spread over 40 years, that would result in $750 million a year in a goodwill charge to earnings, wiping out net income for the company for years to come.

But that is exactly what happened to Time Inc. in its 1989 merger with Warner Communications, and as the bull market rolled along, investors eventually grew comfortable with the fact that Time Warner had no earnings -- and thus began to focus, as the company had hoped, on its operating income and cash flow. In the process, the stock began a sustained climb that has seen it quadruple since 1996.

Meanwhile, Wall Street has increasingly begun to stress the importance of cash flow and operating income as alternatives to price-earnings measures of performance for many companies -- especially those in the Internet sector, which is now in the midst of an intensifying consolidation binge. And that in turn suggests that were AOL and CBS to merge, few investors would pay much attention at all to the mountain of goodwill likely to wind up on the balance sheet

Bottom line? So long as the bull market stays intact and rising stock prices keep investors happy, a merger of America Online and CBS would seem to be a cake walk. It was out of just such thinking that a fellow from Mississippi named Bernard Ebbers built his obscure WorldCom Inc. phone company into something mighty enough to devour MCI in little more than a decade. Perhaps now we'll get to see how the same type of approach plays out for America Online on 6th Avenue.

What are your thoughts on the AOL/CBS rumors? Let me know in the talkback below.