January 13, 2000
StockHouse News Desk
By Jack J. Bensimon (jbensimon@stockhouse.com)
Nasdaq-100 Columnist
AOL Shareholders Poised To Win From Merger, AT & T Joint Venture
With the gradual convergence of Internet, media, and cable, the AOL-Time
Warner merger has set a pervasive industry trend of bundling services.
Analysts are scrambling to devise valuation models to account for this
hybrid merger. At the end of the day, AOL is buying real revenues, real
profits, real assets, and real subsidiaries that no other Internet company
has done. AOL shareholders are the clear long-term winners on that
account alone. They would benefit even more with an AT & T joint venture.
Toronto, ONT, January 13 /SHfn/ -- Many have questioned the synergies that America Online [AOL] and Time Warner [TWX]
are each bringing to the table. One of the biggest issues that analysts have not been able to reconcile is the issue of sector
valuation: Is the combined entity to be valued as an Internet play, Media/Communications play, or a hybrid of both? In addition,
industry experts have discussed the real possibility of the newly formed AOL Time Warner entering into a joint venture agreement
with AT & T, further complicating market valuations for AOL-Time Warner stock.
With much of the gains in the NASDAQ composite and the NDX-100 index coming from Internet and
telecom stocks in 1999, the P/E ratios of these high-tech indices provide little comfort to Time
Warner shareholders. For example, although the NDX-100 index returned over 100% over 1999, it
currently posts a forward index P/E multiple of 100 times. As if this isn't high enough, empirical
estimates indicate that the market capitalization of all US Internet companies is close to $12 trillion,
while the aggregate earnings for these same companies is a paltry $3 billion. That yields a forward
P/E Internet sector multiple of 4,000 times 2000 forecasted earnings. By linking up with this sector,
Time Warner shareholders, therefore, take on an additional risk premium not previously accorded to
media/communications companies.
At the end of the day, what matters to both AOL and Time Warner shareholders is which set of
stockholders will be better off and how clearly can the investment community perceive the synergies to be had. A close analysis of
both companies' inherent strengths and weaknesses indicate that despite valuation disparities, on balance, AOL shareholders are
better off in the long run. There are three factors that support this argument.
First, the merger, combined with the gradual convergence of the separate Internet, cable, and media spaces, exploits first mover
advantages, with AOL being a prime beneficiary.
Second, although valuation concerns are legitimate, over the long-term (not very long given the speed at which the convergence is
taking place), Time Warner provides unparalleled distribution for AOL with an exceptional brand name to boot.
Third, it makes more likely a joint venture with AT & T [T]. The bundling of Internet, cable, and media services into one package
makes leading US cable and long distance provider AT & T almost a natural joint venture partner for the AOL-Time Warner team.
Convergence of Internet, cable, and media make AOL a prime long-term beneficiary of the merger.
With the gradual convergence of Internet, cable, and media becoming a trend in the broad communications medium, the merger
signals a new company breed aimed at extending its customer reach to all levels. Before the announced merger, Time Warner was
increasingly viewed by Wall Street as a company that was not in sync with the New Economy -- investors were eager to pay more
for future AOL growth than future Time Warner growth, growth that was tapering quickly.
A simple look at the numbers tells a revealing story. If the merger is approved, Time Warner will
provide 82% of the revenue and 70% of the operating cash flow; however, Time Warner shareholders
are only receiving 45% of stock in the combined AOL-Time Warner. This is clearly not a merger of
equals. If it were, Time Warner shareholders would have wound up with more.
From a relative valuation perspective, is this merger of "non-equals" to be valued as two separate
companies, with its break-up value worth more than the sum of its combined parts? AOL's Steve
Case argues "the two companies are very similar, even though at first blush it's not evident." Time
Warner's Gerald Levin believes that both companies "are subscription-based, providing distribution
and brand building."
In addition, given Time Warner's steady stream of cash flow and lower credit risk, Time Warner
provides a form of safety net for AOL shareholders, a hedge against AOL's high earnings variability and lack of cash flow growth.
Therefore, this lowers the downside risk for AOL shareholders, when viewed on a long-term basis. Ken Novack, AOL's vice-chairman,
said that the AOL-Time Warner merger is "about a new paradigm, the creation of a totally new business". Although Novack is
correct in asserting it is a new business, Time Warner's history of consistent earnings and cash flow imply that AOL is not buying
castles in the air in the form of projected sales, phantom earnings, or market hysteria; instead, AOL is buying something that only a
handful of internet companies have-real revenues, real earnings, real subsidiaries, real assets, and a brand name that has been
around well before the concept of a website was known.
Time Warner provides unequalled distribution capabilities for AOL extending its reach.
In the ruthlessly competitive communications space, the players who develop strategies that capitalize on looking outside in by way
of creating alliances, acquisitions, joint ventures, partnerships, are more likely to win the game of competition. The AOL-Time
Warner deal is precisely that attempt. AOL and Time Warner are relying on universal convergence-communication services through
video on demand, Internet, local and long-distance calls. They are both counting on upgraded cable TV as being central conduits to
deliver services into US households. And AOL is not limiting their competitive marathon to the US-Europe is a major stopover.
Industry analysts have made a strong case that there is possibility of AOL and Germany's Bertelsmann looking to do an IPO for a
European joint venture to be called, 'AOL Europe.'
However, there have been serious concerns raised regarding the marrying of the two firms. Henry Blodgett, a leading Internet analyst
at Merrill Lynch [MER], believes his biggest concern is that "on more occasions than investors probably care to remember, the
high point of watershed [acquisitions] has often been the press conference-after that it's all in-fighting, politicking, culture clashing,
loss of cohesiveness, identity and competitiveness, value deflation, and ultimately, brain drain."
AT & T viewed as natural joint venture with AOL-Time Warner team, AOL net gainer.
Despite AOL and AT & T having several run-ins in their attempts to bully one another for gaining access to greater market share via
cable lines, there is a formidable case to be made that the AOL-Time Warner merger could very well provide the impetus required for
the joint venture. With Time Warner's cable customer base at 12 million and AT & Ts at 16 million, Time Warner provides AOL a
route to sell its high-speed version of its service (Time Warner provides a route to 20% of its households). With the expected closing
of the MediaOne [UMX] / AT & T deal this year, AT & T will have one-third of all US cable wires and will also inherit a 25% stake in
Time Warner's cable systems, further solidifying their relationship. Where would the AOL-Time Warner-AT & T synergies be?
AT & T needs a reason for people to buy its services-by offering the AOL service, this marketing strategy can only benefit AT & T in
enhancing the brand to prospective customers. Time Warner needs to buy wholesale phone services in order to retail it to its cable
customers. With AT & T securing 60% of the residential US long-distance market coupled with its marketing prowess, AT & T could
funnel an enormous amount of business to AOL Time Warner.
In addition, AT & T is positioned to make such a deal. "AT & T would be in an enviable position to strike a deal", notes Guy
Woodliet, Prudential Securities analyst. And the confidence level at both of these companies provides comfort of the potential for the
joint venture to materialize. AT & T's general counsel Jim Cicconi believes that "we should be able to put together a mutually
beneficial transaction."
Even in the absence of a future joint venture with AT & T, AOL is merging with a financially stronger company. The deal provides
relatively more upside for AOL over Time Warner shareholders. |
