For today's report, I'm sneaking into Rule Breaker Port territory to discuss its top holding and actual Rule Maker, America Online (NYSE: AOL), and specifically its pending acquisition of Time Warner (NYSE: TWX). Over the past month, most of the investment community has turned negative on this deal. But my perception is that the negativity is not driven by conviction, but by confusion. I've read everybody's opinion, pondered the possibilities, crunched the numbers -- and I'm here to say that the pessimism regarding this merger is entirely misplaced.
Five months ago, America Online's market cap stood at $146 billion. At the time, I penned a column in this space about how I believed AOL was making rules and taking names in the Internet world. In the ensuing five months since that piece, AOL's far-flung Internet businesses have scored all sorts of wins, including two solid earnings reports, several registration and membership milestones, a slick revamp of the AOL.com portal site, continued successful overseas expansion, and a whole host of multi-million dollar deals that will add to AOL's coffers.
What more could an AOL shareholder possibly ask for? A stock split, you say? Yep, there was even one of those, of the two-for-one variety. And yet despite the litany of favorable events, AOL's market value today is little better than it was five months ago.
As an AOL shareholder, myself, it hasn't been fun to watch the stock retreat more than 40% from its mid-December highs. But then again, the ride on AOL has never been a smooth one. The silver lining to the negative cloud that currently surrounds the stock is that you might find an opportunity to pick up top quality merchandise at a "damaged goods" price. Below, I've outlined seven reasons why I will continue to hold my AOL shares through this period of uncertainty.
1. Broadest consumer presence.
One of the surest signs of a Rule Maker is a company whose product or service is the default standard among millions upon millions of consumers. In the case of AOL-TWX, the number of combined consumer relationships is estimated to be on the order of 600 million, including 100 million paying subscribers (according to SG Cowen's excellent Internet Capitalist publication). Such a vast consumer presence opens the door to numerous revenue opportunities. One -- just one -- of those markets will be the $442 billion traditional and nontraditional advertising markets (numbers are, again, courtesy of the Internet Capitalist). Investors may come to view AOL-TWX as a virtual advertising tollbooth.
2. Broadband set-top box dominance.
As the #1 domestic cable system provider, Time Warner will give AOL digital broadband access to 20 million homes by the end of this year. Those cable assets will allow AOL to be the automatic default Internet access solution on the television set-top box -- pre-loaded with AOL software. For much of non-PC-using America, the set-top box will likely be the primary means for using the Internet.
3. A much-improved layout on AOL.com.
This one is unrelated to the TWX merger, but I'm much impressed with the new and improved version of AOL.com. The past iteration was an ugly conglomeration of links that I doubt attracted any use except by those individuals who used the AOL Web browser and never changed its default homepage setting. Finally, AOL has designed a portal that is fitting for the Internet's number two website. Check it out -- the new layout focuses on AOL's competitive advantages in instant messaging and e-commerce partnerships. (My only hope now is that they get rid of that pop-up banner that advertises AOL's ISP service.)
4. Best partners.
In the past few months, AOL has gone head-to-head with Yahoo! (Nasdaq: YHOO) in the race to lock up key partnerships. AOL's position of strength is evidenced by its consistently superior partners. Take a look: When it came time for the offline mass merchandisers to forge Internet alliances, AOL made a deal with Wal-Mart; Yahoo! with Kmart. In personal finance software, AOL partnered with Intuit, maker of the popular TurboTax and Quicken products; Yahoo! inked a deal with H&R Block. Among auto manufacturers, AOL partnered with General Motors; Yahoo! with Ford. This last one may be close to a tie, but draw your own conclusions from the other two.
5. Solid financials and cash flow.
Back to the AOL-TWX deal, I foresee the potential for excellent free cash flow growth, which is how I think this combined entity should be evaluated. Some investors have howled at the prospect of the amortization expenses that will be created by the acquisition's use of purchase accounting. My advice in this regard is to pretty much ignore the combined company's income statement. It will be a nightmare, no doubt. But the cash flow statement will reveal the company's cash profitability clear as day. The combined company has trailing free cash flow of $2.7 billion. Upon this base, management has promised growth of 30% annually, which would be more than satisfactory to justify today's share price by my estimates. Further, that pace of growth would be sufficient to pay off all of Time Warner's $17.8 billion in debt after only four years (if management so chose).
One of the greatest objections to the AOL-TWX deal is the argument that fast-growing AOL is tying itself to a slow-growth behemoth in Time Warner. In my opinion, that's a rearview mirror perspective on the matter. Consumers are demanding broadband, and if AOL hadn't worked out a way to fulfill this demand on its service, then consumers would have left AOL for an ISP connection with RoadRunner or AtHome. What would that have done to AOL's pace of growth? Sure, Time Warner's revenue has been inching along at only a single-digit pace for several years, but it controls unique assets that arguably have untapped potential which can be realized in combination with AOL.
6. Genuine prospect for synergies with Time Warner.
This last point -- revenue growth from synergies -- is the linchpin upon which investors will measure the success or failure of this deal. Investors are rightly skeptical when synergies are used to justify a deal of this magnitude. Yes, there is certainly risk -- execution risk -- that the hoped-for synergies will not emerge. It is this risk that investors are currently discounting into (read "selling") AOL's shares.
The new AOL-Time Warner will need to execute on the following initiatives: 1) Gain efficiencies by spreading its sales and marketing expenditures across a broader base of services; 2) Expand gross margins by increasing the mix of high-margin advertising and commerce revenues; and 3) Upsell and bundle a rich mix of entertainment and communication services including cable television, high-speed Internet, and telephony over cable. Yep, that last one is an especially interesting prospect if AOL can leverage its strong positions in instant-messaging communications. If AOL and Time Warner successfully combine their assets in such a manner and open up new growth avenues, then the stock has excellent upside in my opinion.
7. Proven management.
The success or failure of this deal ultimately rides on management's vision and ability to execute. So far, AOL's leadership in Steve Case and Bob Pittman has been impeccable. That gives me confidence that they will o'erleap this bar as well.
Have a great night! And don't forget to check out our Foolish Tax Area. Don't procrastinate this year!
Matt Richey
Related Link:
Dueling Fools: America On Time, 2/2/00
