America Online (NYSE: AOL).
What does that name mean to you? Although AOL's corporate identity is going to become "AOL Time Warner" -- because almost certainly the merger will go through -- the brand name "America Online" will still be used with consumers indefinitely. This leading online service has 8 times the number of subscribers of its nearest rival, at approximately 23 million, and it reels in an average $21.95 in monthly fees per subscriber.
Broadband Internet access is the rage, but for many of us who use the Internet mainly for e-mail and to read simple text, dial-up access could easily serve our online needs for several more years. Thus, AOL will continue to be rewarded with growing dial-up access revenue. People will continue to pay for a service that is friendly, familiar, and trusted, even when competing against free Internet service providers (ISPs). If free ISPs were certain to crush America Online, AOL probably would not have continued to add record numbers of new subscribers each of the past three quarters.
Given the near-term (meaning three years) certainty of AOL's primary revenue stream (subscription fees were recently 67% of its revenue), and given the quick growth of AOL's other revenue streams (advertisements and commerce), the only large uncertainty with the business and weighing on the stock is Time Warner (NYSE: TWX). We all know Time Warner, however. It's CNN, Turner Broadcasting Systerm, HBO, Sports Illustrated. It owns the second-largest cable network in the country. It has more than 1 billion worldwide viewers. Thanks to Time Warner, AOL will almost surely get onto AT&T's (NYSE: T) cable eventually. So, this is all pretty good. The biggest uncertainty regards how well the two companies will "merge."
Regarding content, the merger could be pretty simple. AOL is a great online content host and doesn't create much of its own content. Time Warner is a great content creator. Using broadband Internet technology, which eventually will be the main means of online access for everyone (perhaps in six or seven years), AOL will reel in online subscribers and Time Warner will provide much of the content.
How well the people from the two companies will merge is another question. However, this is an uncertainty that I don't feel worthy to analyze. Because I don't personally know the people involved, it is impossible for me to say how well these people may work together. In this case, most investors just need to have faith.
Given this faith, my overall opinion is that AOL's stock represents a good risk-to-reward opportunity at recent prices. I've owned some AOL since 1998, and at recent prices in the mid-$50s, I've considered buying some more. Why? Because I believe that at these prices the downside is limited and the upside -- even given the uncertainties -- should be attractive in the long-term. Overall, I believe that AOL's management can continue to create long-term value with or without Time Warner. Of course, we need to assume that it's "with."
Let's do that.
Don't tar and feather me, or burn me like a witch when I say this: I like to look at numbers and make forward estimates to get a grasp on where an investment may go. I have done this with AOL Time Warner. AOL had $4.7 billion in 1999 revenue and Time Warner had over $27 billion. Here are some sales estimates based on commonly anticipated growth rates of each business:
AOL, TWX Revenue Estimates (in millions)
2000E 2001E 2002E 2003E 2004E
AOL $7,920 $11,850 $16,050 $20,998 $27,110
% growth NA 49.0% 35.0% 31.0% 29.0%
Time Warner $30,130 $32,765 $36,070 $39,725 $43,650
% growth NA 8.7% 10.0% 10.0% 9.8%
TWE Adjustment ($2,870) ($3,150) ($3,490) ($3,770) ($4,120)
Total Revenue Est. $35,180 $42,465 $51,030 $60,553 $71,640
Annual % Rev. Growth NA 20.7% 20.1% 18.6% 18.3%
(The "TWE adjustment" refers to
Time Warner Enterprises accounting charges.)
As you can see, these numbers predict over $71 billion in combined revenue at the company in 2004. Now, if they were to merge right now, the new company would be valued at about $250 billion, or 3.5 times the 2004 sales estimate. However, much more important is EBITDA, or earnings before interest, taxes, depreciation and amortization. Media giants are best valued on a multiple to their EBITDA. From the sales estimates above, I created various EBITDA estimates based on how profitable the combined company could be. Again, these are based on commonly predicted profitability ratios. My EBITDA estimates for the new company are:
Combined AOL/TWX EDITDA Estimates (in millions)
2000E 2001E 2002E 2003E 2004E
Conservative Est. $8,040 $9,890 $12,100 $14,640 $17,670
Moderate Est. $8,060 $10,780 $12,450 $16,140 $20,120
Aggressive Est. $8,080 $11,080 $13,160 $17,250 $22,360
Many people believe that AOL Time Warner will trade at 25 times to 30 times its EBTIDA, especially if the company can grow earnings 30% annually, as it predicts.
For the combined company, you should assume 5 billion shares outstanding (with 200 million share dilution built in). Now, assume a $100 share price for AOL. That would mean a $500 billion company valuation, which is 25 times our 2004 "moderate" EBTIDA estimate of $20 billion.
So, on these estimates, AOL stock (which will come to represent AOL Time Warner) could trade at $100 or higher by 2003 or 2004. Here is a full table of possible stock prices for the new company. AOL's current price is about $59.
AOL/TWX Stock Price on
Various EBITDA Multiples and Results
Year EBITDA 22.5x 25x 27.5x 30x 32.5X 35x
2001 $10B $45 $50 $55 $60 $65 $70
2002 $12 $54 $60 $66 $72 $78 $84
$14 $63 $70 $77 $84 $91 $98
2003 $16 $72 $80 $88 $96 $104 $112
$18 $81 $90 $99 $108 $117 $126
2004 $20 $90 $100 $110 $120 $130 $140
$22 $99 $110 $121 $132 $143 $154
2005 $24 $108 $120 $132 $144 $156 $168
EBTIDA estimates are on the left side of the table in billions. I use the 30x column as the most likely EBTIDA multiple, thus the most likely stock prices if all goes well. This table shows a $144 stock price by 2005. About $100 by 2003.
Some people don't like these numbers. $100 per share in 2003, up from $59 per share, is not exciting enough for them. However, this would be a 69% return in three years, with downside risk that is quite low from prices in the $50s, in my opinion. If the merger stumbles and results in lower earnings and EBTIDA than commonly estimated, AOL's stock could probably go considerably lower than the $50s, But even in a bad case, how low? Below the $40s? I'd doubt it. Too many assets can prop it up. On the flipside, if the merger starts to perform well, uncertainties will lift and the company's EBITDA should justify steadily higher share prices. Meanwhile, if the merger is somehow called off, AOL's stock would probably rise, too.
AOL's stock will no longer be the 400% or 200% annual grower once it is attached to Time Warner. However, in a rip-roaring stock market with a lot of share prices that look "high," AOL's stock looks like one of the better risk-to-reward scenarios. If -- and admittedly it's a big if -- if things go well, the upside in AOL shares could be 60% or more in the near term (three years or so), and in the good old days, earning anything over 50% in three years would be a great investment.
For a full report on AOL, see AOL's page in Fool Research. The new report is 19 pages and costs some bucks.
Tomorrow we'll get to some thoughts on Excite@Home (Nasdaq: ATHM).
A quick final note today: Morgan Stanley "restarted" coverage on Celera (NYSE: CRA) with a $270 price target. I can't see the report to know why they have that price target, but I wonder why they stopped coverage in the past. Anyway, just a curiosity.
See you on the RB boards linked below. Fool on!
--Jeff Fischer, TMF Jeff on the boards.
