America Online: No Longer An Internet Bellwether
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OK, I'll admit it. I'm not part of Generation X. I've been around for a long time: I actually lived through the 1972 bear market. I remember the inflation of the late 1970s and early 1980s, the disinflation that started with Ronald Reagan's tax cuts. I was there when President Kennedy was shot. I remember when someone other than Alan Greenspan was chairman of the Federal Reserve System. I've seen investment fads come and go. Usually, I understand. But with AOL and TWX, I just don't get it.
I arrived a little late to the market to really participate in the growth stock mania of the 1960's, but I've experienced my share of investment cycles. In the 1970's, high inflation made asset rich companies valuable as the cost to replace far exceeded the book value of basic industrial stocks. Financial stocks took off in the early 1980's as inflation's peak spelled widening spreads. Retailers were the rage in the mid-1980's as the strong US dollar slashed costs. Real estate had its fling under attractive tax laws; crumbled after the Tax Simplification Act of 1988.
I've seen the rise of new industries like biotechnology and, now, the internet. I've had my share of winning and loosing stocks. I've learned a lot about stock valuation. With the possible exception of a depression, I've probably seen it all. There are a few fundamental things I've learned. One of them is that the world is becoming increasingly specialized. The other is that ultimately, only solid, well-managed companies survive.
And that's my problem with the America Online (AOL) /Time Warner deal. For my money, Time Warner is one of the worst managed companies in America. Over the last ten years, (TWX) has collected $97 billion in revenues on which it managed to loose a cumulative $562 million (it has only had three profitable years in the last decade!). Of course, some people argue this isn't an earnings story. OK, cash flow, net of capital expenditures has been $4 billion over the period.
Is AOL any better? It managed to net $206 million over the past decade on only $11.6 billion in revenues, though on a cash flow basis was only about break even. The merger, however, will fix that: by paying over $300 billion in excess of TWX's asset value, AOL's good will liability ensures that investors will never see conventional profits but will generate huge cash flows: an additional $11 billion / year, I'd guess.
But growth will weigh on the company's valuation. If, say, AOL is growing 40-50 percent a year and TWX at maybe 10-15 percent, the combined entity is unlikely to expand faster than 20-25 percent. Investors aren't likely to find this as attractive as many internet (and also money loosing) companies growing at 50 percent a year or more. So if investors were to pay a generous 30 times cash flow, the combined entity isn't worth more than about $80 per AOL share. So, from a stock point of view, the merger isn't occurring in the best of conditions.
Unless, of course, there truly are synergies that can accelerate the growth of both enterprises. My take on this merger is this: This isn't a merger built on the strengths of two companies; its goal is to shore up their weaknesses.
For all its trappings of content, AOL's revenues come from providing access to the internet. With free access making inroads, and high-speed access a reality from competitors, AOL faces a real challe