AOL Betting on Time Warner

By Richard McCaffery (TMF Gibson)
July 18, 2000

Internet services company America Online (NYSE: AOL) and cable television giant Time Warner (NYSE: TWX) shocked the world January 10 when they agreed to merge in a deal worth $350 billion. (It's now worth a lot less.)

It is the biggest proposed marriage between old-world and new-world media companies, a deal that creates a global communications giant that will offer original content, e-commerce, and entertainment services across the full range of media platforms, including the Internet, television, movies, magazines, books, and music.

The new company will be called AOL Time Warner and has a stable of brand-name properties such as Time, CNN, CompuServe, Warner Brothers, Netscape, Sports Illustrated, People, HBO, TNT, and Fortune in the fold. It will have revenues topping $30 billion, and a market value in the $235 billion range.

Though regulators are closely scrutinizing the deal, especially AOL's dominance of the instant mail market, company officials expect the merger to close this fall.

Still, the markets haven't reacted quite the way AOL CEO Steve Case hoped. AOL stock is down about 32% since the company pulled the curtains back on the year's biggest play.

What's the hang up? Growth rates and debt loads. AOL Time Warner may be able to grow earnings about 30% annually following a merger. Before the deal, AOL was expected to grow 50% annually. The company's size clearly puts the brakes on white-hot growth, and AOL Time Warner will have to drop some pounds to hit its goals. On the debt side, Time Warner brings $18 billion in debt to an enterprise that finished 1999 with just $1.6 billion in long-term notes payable.

Many investors have focused on this rather than the assets Time Warner brings to the table, such as its status as the country's second-largest cable operator. These wires give AOL broadband access to millions of consumers' homes. That was clearly the driver behind the deal for AOL. Could AOL thrive in a broadband world without Time Warner?

As Rule Breaker manager Jeff Fisher wrote in January: AOL relies heavily on dial-up access for most of its revenues, and its broadband strategy lags far behind schedule as Digital Subscriber Line (DSL) access rolls out slowly. So, taken by itself, AOL's near-term future (three years) can look pretty spotty given the anticipated demand for broadband, AOL's slower-than-anticipated solution, and the potential decline in attractiveness of dial-up access. And, in this business, if you lose your leading edge, you lose your advantages quickly.

Clearly there's risk in the coupling. More than anything, the two companies will have to prove they can execute as a single entity -- no simple trick for businesses coming from such different worlds.

What's the investing lesson here? Learn to think through mergers on your own using the tools at your disposal. One look at all the different opinions at Fool headquarters makes it plain there's more than one way to view this deal.

e-Commerce Meltdown »