From Alan Abelson in this week's Barron's:
This last manifestation of normality leads us to Doug Kass. Although by no means exclusively a short-seller, Doug is one of the ablest practitioners extant of that much maligned art. As a relatively frequent visitor to these columns, you may recall that he runs a hedge fund called Seabreeze Partners and that he had spectacular returns in both 1999 and 2000 and is comfortably ahead this year as well. Another sign that we're getting back to normal is that Doug is shorting AOL-Time Warner again.
Back at the end of May, with the stock in the low 50s, he staked out a short a position in it (he had covered at a neat profit an early short holding in AOL some months before). Well, the stock cratered to below 30 and he made another pot of dough. Now, he's short for the...frankly, we've lost track just how many times.
Doug's concerns on AOL-Time Warner are both near and long term (we failed to ask him, but we're reasonably sure he has mid-term concerns, too). To begin with, one of the worst- kept secrets in America is that the ad business stinks and probably will take its time getting better. Every significant facet of this company is vulnerable to the slowdown in advertising, whatever management's protestations to the contrary.
Sooner or later, of course, the spare rations of advertising to which media outfits have been consigned will give way to more abundant fare (we sure hope so, anyway). But in some ways, Doug is convinced, the paucity of advertising, painful as it is proving, is the least of AOL's worries. Of much greater moment, he believes, is the long-term threat of increasing saturation of the PC market and the likely declining growth in the number of AOL's subscribers.
On the first score, he notes that around 58% of U.S. households now have at least one computer, up from 20% a decade ago. There's an evident link between growth in computer penetration and growth in online subscriptions.
What's more, AOL has already taken so big a bite of the online subscription market that more than modest future growth here seems quite problematic. Doug reckons that the company will add 3.4 million net new subscribers this year and 2.8 million next. If he's right, it would mean three years in a row that growth in subscribers, after adjusting for cancellations, has slowed.
The more measured growth in the subscription business, contends Doug, means simply that Wall Street has way overestimated the company's potential long-term growth rate. The conventional wisdom among followers of AOL is that earnings per share are destined to average 25% annual gains. Doug thinks that's more than a little optimistic: Something between 10 and 15%, he's convinced, will be nearer the mark.
On this score, the crowd anticipates earnings of $1.27 a share this year and $1.57 next. By contrast, Doug is looking for $1.18 in 2001, $1.32 in 2002, and he concedes, generous to a fault, he may be too high.
In any inventory of bearish items, one can't overlook (although virtually everyone seems to) AOL Europe. This unit has not been a booming success, to date, anyway. It trails by sizable margin the subscriber base of rivals like T-OnLine, Tiscali and Wanadoo. According to Doug, AOL Europe will post revenues this year of somewhere round $700 million, on which he figures it will lose a cool $300 million or so.
AOL owns 50.5% of the European operation. Bertlesman owns the rest. And therein, conceivably, lies a horror story, Doug feels. For at the height of the Internet lunacy, back around the turn of the century, with AOL shares trading near their all-time high of 95, AOL and Bertlesman cut a deal. More specifically, the two companies entered into a put/call agreement that valued AOL Europe at between $13.5 billion and $16.5 billion. That compares with an unofficial value of perhaps $2 billion today.
The put belongs to Bertlesman. It gives Bertlesman the right, starting December 15 of this year and through January 31 of next year, to sell 80% of its 49.5% interest in AOL Europe to AOL-Time Warner for $5.3 billion. Then, in June, Bertlesman can sell the remaining 20% in AOL Europe to AOL-Time Warner for $1.45 billion.
In sum, if Bertlesman exercises its put -- and it's hard to imagine it not doing so -- AOL will be forced to fork over a nice little bundle worth some $6.8 billion in the first half of next year, with the major chunk -- $5.3 billion -- due January 31. AOL has an option of paying Bertlesman in stock, cash or a combination of the two. According to Doug, the agreement requires at least $2 billion of the purchase price be paid in cash.
Last he looked, cash items on AOL's balance sheet amounted to $1.3 billion. So if -- or should we say when? -- Bertlesman exercises its option to sell out its interest in the European unit, AOL-Time Warner will obviously have to borrow big-time and/or issue a wad of stock, which translates into appreciable dilution.
It's the kind of choice that Ulysses had, you remember, trying to decide between Charybdis and Scylia. And obviously exercise of the put has the potential to depress AOL's stock, all the more so since analysts haven't paid much heed to it. Doug's target for AOL stock is the low 20s. |
