America Online: No Longer An Internet Bellwether

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

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.

And how have investors done? Well, the book
value, which was $14.47 per share in 1989 managed to drop to $7.18 last
year. If you’d held the stock anytime in the last ten years except the
past two years you would have wished for a bank certificate of deposit — the stock seems to have only come alive post the Turner Broadcasting

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

nge: will
people, in the face of free access, choose to pay for AOL’s content?
Time Warner, the thinking goes, has what AOL needs: Access to people’s
homes via its cable TV franchises and a proven ability to charge for
content via its HBO and other premium offerings. TWX, on the other
hand, has been a miserable failure at providing, or should I say getting
paid for, content on the internet.

Both companies are looking to this
merger to solve a problem: Access for AOL, payment for content for
TWX. But the merger doesn’t solve the basic problem: Users won’t pay
for access in the future, and content will remain free as long as
advertising foots the bill. So AOL is trying to change its business
model into one that has failed.

In many ways this merger reminds me of the conglomerate days of the
1960’s, when moguls like Harold Geneen built far flung empires like ITT
only to discover that natural synergies are few and far between (more
recently, one might look at Cendant Corp.). No, I think the new century
will see more of the trend of the last one: in a increasingly complex
world, the true winners will be specialists within their fields.

AOL was an Internet company that has swallowed an entertainment/media
company. Unless investors believe Time Warner is the future of the
internet, AOL will assume a much smaller role as an internet
bellwether. As these two companies sort out what business they are in,
there will be lots of opportunities for specialists to build and
consolidate within their respective sectors. That’s where the real
action is.

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