********AOL BULLS MUST READ*********
And bears will weep
THE RAGING BULL'S CYBERSTOCK INVESTOR REPORT
"Your Weekly Internet Stock Newsletter"
January 5, 1998
Editor: Matthew W. Ragas
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Chat with Tim Mullaney on his Message Board- Who
should be worth more? AOL or Disney? You decide.
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**Special Article by RB Staff Writer**
Is AOL Really Worth More Than Disney?
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By Timothy J. Mullaney
You could almost hear the tut-tutting from the establishment press last week,
when America Online shares roared to $160. The word was out that AOL was about
to receive the sine qua non of the American Corporate Big Time: membership in
the Standard & Poor's 500-stock index.
AOL is now worth more than Walt Disney, several reports pointed out. Isn't
that nuts?, they asked between the lines.
Well maybe, and maybe not. Figuring that out is the point of this little
exercise. And along the way, valuing AOL (worth $73 billion before the slide of
the last two days) side-by-side with the Walt Disney Co., the high priest of
old media and bearer of a $63 billion market value), reminds us all of the real
source of the new economy's value: it's not just the information technology,
but the business models the technology makes possible.
The traditional press argument that newcomers like AOL or Yahoo! can't be worth
as much as mainstays like Disney has its merits. Size does matter. But the
market's belief that the new companies actually are more valuable than
venerable names -- especially in the case of AOL, which is much farther down
the same advertising and e-commerce driven path than other Net stocks and has a
different, better business mix -- makes sense too.
Especially when some of the traditional titans, including Disney, have been
becalmed: Disney actually lost value last year as the market surged.
So is AOL worth more than Disney? Here's a rundown, with the techno-bull case
first because, to tip my answer, it ultimately makes more sense. In both cases,
a tip of the hat to Merrill Lynch & Co., whose analyst research on both
companies is currently available free on the firm's Website.
AOL is Worth More Than Disney Because:
AOL is in a faster-growing, less cyclical business. AOL has gone from 800,000
customers to 17 million in four years. And it's a good bet they'll post the
same absolute growth -- if not the same rates -- over the next four years. It
wouldn't even take much to make that happen over the next two years. Disney
hasn't done anything close. And won't.
AOL is more valuable than Disney, this view goes, because the Internet is too
new to be affected much by macroeconomic cycles -- at least short of a
full-blown recession. And that's basically true.
That's why AOL's membership has expanded 20-fold, why its e-commerce and
advertising revenues jumped 133 percent in the first quarter of fiscal 1999 to
an annual pace that could reach $500 million, and why profits, once achieved,
have begun to come in earnest.
Merrill analysts Jonathan Cohen and Tonia Pankopf say AOL will earn $400
million a year by fiscal 2000. That's 96 percent growth in 1999 and 50 percent
in 2000. The kind of macroeconomic microadjustments that make cyclical stocks
move up and down between recessions don't affect AOL. Not yet.
On the other hand, Disney has ABC, a television network getting clobbered by
audience erosion. They have a bunch of TV stations – but TV station stocks were
have been hammered in the second half of 1998 by fears of an advertising
downturn in 1999 -- a fate no one expects to hit the much smaller Net
advertising market. They have ESPN, which is slowing its profit growth because
of more expensive sports broadcasting rights and the launch of ESPN magazine.
Disney also produces lots of movies that cost tens of millions up front to make
(and offer hit-or-miss returns) and theme parks that cost millions to run and
are growing at a fraction of AOL's pace.
That's why Merrill says Disney earnings will grow only a penny a share in
fiscal 1999 -- about 1 percent as fast as AOL. That, in turn, is why Merrill
only values Disney at 12 times cash flow. And that, dear reader, is why Disney
is buying 43% of Infoseek. But there's more. AOL has growing operating
leverage; Disney doesn't.
The economics of AOL's business are almost as good as Disney's and are getting
a lot better faster, for the reason successful Net businesses are great
businesses in general: once they get profitable, they turn astonishing amounts
of every new sales dollar into profits. Disney's margins are shrinking even as
its business doesn't grow.
Many AOL services cost almost nothing to provide -- especially in its
faster-growing (but smaller) advertising and e-commerce segment. It costs
almost the same amount to provide Web content to 15 million people as to 8
million -- and neither amount is much. AOL's real spending is on providing
connectivity, itself an excellent business, and on marketing. And AOL is
beginning to prove the Internet-craze premise that revenue growth will outstrip
marketing spending and send margins through the roof.
In AOL's first quarter (ending September), operating margins jumped to a record
13.1% of sales -- from 5.0% during last year's corresponding quarter, a 160%
plus gain on a much bigger revenue base. Marketing expenses plummeted to 12.2 %
of revenues from 18.7%. That's more than 50 percent. And in percentage terms,
these margin figures are just beginning to heat up.
Disney has no such advantage. Its operating margins are a healthy 17.5% -- the
point of this argument isn't that Disney is run by stiffs -- but they were 19.5
% in 1994. And revenue from Disney's biggest division -- creative content --
has been stagnant since 1996.
AOL can raise prices; Disney can't. One of the many things that was supposed to
kill AOL in 1996 was the idea that the Net is so aggressive that no one can
raise prices without losing customers. So how come AOL raised its basic access
rate $2 a month last year, to $21.95, with nary a downturn in its subscriber
base? Disney, Merrill analyst Jessica Reif Cohen notes, has been unable to
raise prices.
Finally, AOL's already bigger than the press realizes. Not only has AOL joined
the S&P 500 -- this year it will join the Fortune 500 as well (last year it was
714). Its revenue during the first quarter was $858 million enough to make AOL
a $3.4 billion company this year even if its growth stops dead. That may not
justify a $73 billion valuation just yet, or even the $65 billion or so AOL
fell to by Monday, but it's getting along fast.
As For the Other Side of the Story?
Disney is bigger, and it still makes more money in absolute terms. It had $23
billion in revenue last fiscal year (Disney is on a September year) and net
income of almost $1.9 billion -- almost five times what AOL will do in 2000 if
Merrill is on target.
That's an argument with obvious virtues. But investing is about the future, and
Disney is stagnant in both revenues and profits, producing the kind of low
multiples that let an AOL's valuation catch up ahead of its time.
AOL's modest size for its valuation is enough to sustain an undertow of talk
that the stock is overvalued -- a constant of AOL coverage since I began
covering the company in 1996, when the stock, adjusted for splits, was at less
than $10 a share after a springtime short-sellers' run on AOL. (AOL is
overpriced! This time we really mean it!) Disney's size, brand strength and
traditional profitability are why the press can't quite believe the two
companies' curves crossed last week. The disbelief is understandable. It's also
overdone.
AOL faces risks: risks that the Net won't take off, risks that AOL's plans to
build brand loyalty won't take. But anyone who still believes those things
after last year's price hike and consumers' non-response(especially with
portals clamoring to provide many AOL services for free and discounting
connectivity through carrier alliances like Lycos' deal with AT&T) ought to
think again about brand loyalty.
AOL has it.
And this year's E-Christmas bonanza ought to make them think again about the
idea that the Net's growth won't sustain seemingly outrageous multiples. When
your kid goes online, it's a novelty. When your mother-in-law does, it's a
company. And that's what's happening, led by AOL.
This doesn't mean every Net stock is worth infinity: I still think eBay is
ridiculously overvalued because most of what's sold on its site is junk. Junk
is junk even if you do have killer margins. But it does mean that a leading
Internet company providing both connectivity services and leading the
e-commerce race hasn't begun to achieve everything it can.
Of course, I've been an AOL bull since I first looked at the stock in 1996,
when Allan Sloan was tearing it apart in two Newsweek columns and Heard on the
Street was piling on.
In The Baltimore Sun, I quoted Steve Case putting his finger on the heart of
the issue, after his stock had fallen $40 in two months: "The view we've had is
that a new medium is developing. America Online is in a position to lead that
medium, and if we do the stock will reach new highs."
Case's stock has been a 20-bagger since he said that. But it's just as true
today.
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