Post of the Day
February 4, 2000

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America Online

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Subject:  Value Creation
Author:  Goofyhoofy

There has recently been a controversy on the AOL board about the value of the Warner Brothers film library. (Well, and about a good many other things, too!) So I went and did a little research, and found..

There are 6 major studios which account for 95% of the box office receipts in any given year. It's been that way for at least a decade. Between 1994-97, Warner Brothers occupied the #1, #2, #3, and #4 slots once each. According to one poster here, they bounced back into the top slot in the late 90's. Frankly, I'm not sure it matters, at least in the context of the argument, which is about the value of the back catalog. (Obviously it will matter greatly to the profitability of the new corporation going forward!)

But what I've been thinking about is Value Creation. You know, the underpinnings of the price of your stock? Because without value creation, there is no growth. Without growth, well, you can complete the sentence for yourself.

Value creation, as I see it, comes in three flavors. The first, and easiest to spot, is "more sales and therefore more profits." We see this one when we check to see AOL's subscriber growth, AOL's e-commerce sales, Coke's case shipment volumes, Taurus' sales figures, and Wal-Mart's monthly retail grosses.

This is simple stuff, although it may be clouded by "same store sales" versus "total growth" or other issues. But I think we all comprehend what I'm talking about here. In fact I'm going to take it on faith that every employee of every business everywhere and every investor for all time understands this one. More sales is a good thing.

The second flavor, and always easy to spot in retrospect, is the creation of a new business or industry which did not previously exist. Microsoft. AOL. Qualcomm. Blockbuster. Just about anybody "gets" the difference between "no software industry" and Microsoft. This is value creation on a different level, the start of new industries and new distribution channels and new sales techniques and new customer bases and new service and support staffs. It's as true of "before McDonald's" and "after McDonald's" as it is of software, cellular phones, or any other new industry.

The third flavor, and the one I think the "Warner Brother library" arguers are missing, is the unlocking of value or the creation of new value from old products. As one anecdotal example I offer Ted Turner. His "early" value creation was of the "new industry" type: WTBS, CNN, Headline News. Later, he bought MGM and used it in several ways: one, to provide content for his already existing cable channels (turning a "shortage" of content, and therefore increasing royalty cost over time into an amortizable asset, decreasing his costs over time.). But he also used it to create an entirely new cable channel (Turner Classic Movies) which instantly created a billion dollars in value, and cash flow from a previously dormant asset. Why didn't MGM "monetize" the library this way? They didn't see it. And even if they did, they didn't have the knowledge, clout, or wherewith all to do it and sell it to the cable operators, who now happily send a couple of dimes per subscriber to Ted (TWE, actually) every month for the privilege of "having the channel." How did the Cartoon Network come to be? Same play, different celluloid. What is it worth? Another billion. Maybe more.

"What changed? Value, by the billions and billions."

This is the kind of "value creation" Bob Pittman talked about when he mentioned "cable channels" and "CD's." Before Ted, "cable" was just dead coax, bringing you better reception of already existing programming. A no glamour, low margin, very low growth business. "After content", it became an entirely new industry, creating billions of dollars in value. If you didn't notice, the "cable" is still the same boring black wire, sheathed mesh around a copper center. What changed? Value, by the billions and billions.

CD's, a different game entirely, encouraged people to 1) dispose of old technology (record players), and 2) repurchase all the same content in a new package. Value creation (not to mention landfill!) worth billions more almost out of thin air.

Now to take on the "Wizard Of Oz" argument, some people are looking only at the "value creation" in Flavor 1. "More sales." Or rather, fewer sales over time. That is true in today's model, where the asset plays occasionally on cable TV and where they sell a few home videos and one copy to each new video store that opens its doors. End of story.

But you can see that the incremental sales do NOT stop at the video store, which rents and rents and rents the video to consumers. The "content owner" profits only once. In a different model, the movie would be delivered to consumers directly over broadband wires (whatever they be, including wireless) for a transaction fee, all of which goes to the content owner. It is conceivable that the actual viewings of "Wizard Of Oz" could increase with simplified delivery (no returns!) and occasional consumer promotion (for which there is no current incentive) and the profits increase greatly from present levels. And no, I don't think it will happen next month or even next year. I'm making a leap several years into the future, or at least trying to.

Music is a little easier to see, perhaps. Right now there is one humongous revenue stream (records/CDs/tapes) and several smaller ones (royalties/radio/performance/management). The giant revenue stream is dependent on cajoling independent business owners to purchase and carefully monitor inventory of millions of pieces of product, to purchase display space in thousands of stores for up-and-coming artists, to front load deliveries in towns where tours are appearing, and to monitor the delivery of literally billions of pieces of very low raw materials cost but high priced (can you say "shrinkage"?) product across the country and the world. A gigantically more efficient, more controllable, more targetable process is e-delivery of audio. And that, of course, is something the new AOL, assuming broadband capability, can be quite good at.

There are three models for that business, the traditional "buy it once, play it forever", the pay-for-play (jukebox), or subscription (a la MTV or VH1.) The first model reduces costs - the retail overhead, the trucking and shipping and shrinkage, etc. The second two are value creation on a different level, and have the potential to change how the music industry works altogether. Arguably, 40 AOL/TWX music channels available via broadband subscription could wrest some of the "exposure" power from radio program directors or from Redstone's cable TV music channels. This improves the "front end" of the business, as well as providing a revenue stream direct from consumers.

(It's perhaps worth a note that the music industry, like the film industry, lives off its mega-hits, to the detriment of the mid-tier and lower-tier artists' releases, because the simple costs of gearing up and pressing hundreds of thousands of discs and tapes is so huge. It might be nice to "flatten" the pyramid and let more people play at the middle of the game. Just a little personal opinion creeping in there.)

Well anyway, I'm not saying it will drive music stores out of business any more than I think Amazon is on the verge of closing up Wal-Mart. But every "online" transaction is of higher margin with lower costs, less shrink, and more control. That is a business model.

If you noticed, the value creation in flavor three has come primarily from the application of "old" content across a new distribution channel or mechanism. "Old" content may be anything from a 1939 movie to the column in Time Magazine that went to the printer a half-hour ago. It is the repurposing of content to new audiences that holds such unbridled potential.

To those who wonder why AOL has to "own" the content, truthfully, they don't. Disney will also benefit if the model changes. So will Seagram. But, there will be a middleman somewhere collecting a delivery charge, just as Blockbuster does now. I suspect AOL or AT&T or someone will be standing astride the wire with their hand out. The "content" came along with the deal for the wire. So be it.

And it's certainly worth mentioning that Case has always believed in "content", particularly "branded content." Yes, AOL prospered because of e-mail and chat rooms and all manner of unbranded content, but Steve has always pushed for high-end content for the service. I'm assuming that he, standing behind the screen somewhere and watching all the dials and counters, knows a little something about what makes the service work. And he, as proprietor of a computer bulletin board service in 1985, has some history of "chat rooms" and "discussion boards" and he still thinks branded content matters.

Please note: I'm not saying all, or even any of these futuristic things will come true at least in the near term. I'm merely positing that to argue about the "content" in the context of "today" is as nearsighted as those companies who thought "I'm not putting my content on the web for free!" just four or five years ago. The times they are a changin'.

Now although I said there were three, there is a fourth method of "value creation" and it is the often derided and even more often abused concept of "synergy." (I am more guilty of the derision and abuse than most, I'll admit.)

AOL spent $800 million last year marketing to consumers. If they merely took half that amount and spent it on the Turner cable networks, the WB network, and in Time, People, and all the rest of the TWX properties - it would represent a savings of hundreds of millions of dollars - without reaching one fewer consumer! Turn the equation around and find out how much Time and People are spending, find out how much in "promotional givebacks" the WB is spending on billboards in local markets, and all the rest, and capture a fair share of that expenditure and route it through AOL and you have perhaps a billion dollars in costs saved. And that's the easy part. There are others, from the billing costs for magazine subscriptions which could be delivered electronically to the ability to cross sell advertisers on multiple platforms to reach a highly targeted mass of consumers.

Finally, I should say that like timm, I am not unmindful of the difficulties and challenges of combining two massive and disparate enterprises like Time Warner and AOL. There will be turf wars, there will be failures, and there will be some just plain bad ideas tried and discarded. No doubt. There is even the real possibility of a bad marriage. It happens.


I am arguing for a far more expansive view of what this combination might hold, bigger than "How much did TWX make off "The Wizard Of Oz" last year. In the scheme of things, whatever the answer to that question is, it's irrelevant.

Multiplied by the entire back catalog, it's still irrelevant, because it's an outmoded way of doing the business. My local video store guy tells me that he does most of his volume on the new releases. He makes most of his money on the old ones. Funny, huh?

It is that expansive value creation and futuristic view that I believe the company is pursuing. It's not simply that "more sales is better."

I didn't buy AOL because it was a "sure thing". I bought GE and a few others for that. I bought AOL because I thought the management there had a view of the future and was working to make it come true. I still think so. And I still think it's as risky as it was when my broker first told me not to buy it in 1995. There's remains a ton of upside, and with my full admission of "risk", some downside possibility as well.

I don't know that this was the "best" move, or even the "right" move. But to those who want to go back and make "no move", that would be the worst move, and one which would put AOL in a cramped little box from which, given another year or two, there would be no exit. That the share price is slipping is not a surprise. The investor base of the company is, to a significant degree, changing.

I'm willing to roll with Case; he's done OK by me so far. He's looking at the pool balls five and six shots ahead, as he should. I'm hoping he continues to run the table - and carry me along with it.

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