It’s already shaping up to be quite a year for AOL Time Warner. Last week, Netscape, the Web browsing company now owned by AOL Time Warner, filed suit against Microsoft claiming antitrust violations resulting from actions by the software giant against Netscape’s Internet browser. Consider it another round in the continuing battle of the titans. AOL, which bought Netscape in 1999 for $10 billion, said it filed suit “to help restore competition to the computer desktop.” Microsoft, in response, accused its competitor of “squandering its asset” and now seeking to gain in the courts what it lost in the marketplace. AOL Time Warner, Microsoft says, “wants to blame Microsoft for their own mismanagement.” This latest battle has come along at a time when AOL still must answer many critics over core business issues resulting from its $109 billion merger with Time Warner. Initiated two years ago when the Internet was flying high and completed one year ago just as the U.S. economic bubble burst, the merger of America Online and Time Warner created the world’s largest media company that true believers said would change the world. Now the new browser war promises to add a major new wrinkle – and possible distraction – to AOL Time Warner’s fortunes this year and for many years to come. Regardless of its feud with Microsoft, AOL Time Warner is indeed the unquestioned number one worldwide media company, especially with the phenomenal box-office successes of Harry Potter and Lord of the Rings. Some of the anticipated synergies have actually come about and the company has successfully met a number of its goals, according to industry observers. Detractors, however, can point to several unexpected and/or unwelcome developments over the past five months. The company, for example, surprised many by suddenly naming a new CEO and also announced that it will incur a $40 billion to $60 billion non-cash charge in the first quarter. (This writeoff of goodwill represents the decline in the value of Time Warner stock between the time that the AOL deal was announced and when it closed a year later.) This is after it reported that 2001 financial earnings would underperform and scaled back its 2002 expectations. “Moving forward,” announced Gerald Levin, who will be leaving the post of CEO in May, AOL Time Warner “will be taking a conservative approach … We will not, as we did last year, make assumptions about economic growth.” Or, as incoming CEO Richard Parsons told analysts, the company should “underpromise and overdeliver” in the future. That’s a bit toned down from the heady days of one year ago, when AOL chairman Steve Case talked about synergies with content-and-cable powerhouse Time Warner and told Wall Street and investors to prepare for fast-paced growth. Consumers, meanwhile, were advised to be prepared for trend-setting [products] that would offer them a better combination of “old” and “new” media. The new message, however, is more in line with the views of analysts. Company executives had long adhered to the aggressive target of $40 billion in revenue and $11 billion in EBITDA (earnings before interest, taxes, depreciation and amortization) despite obvious signs the advertising market was depressed; recently, AOL executives said revenue will come in at $38 billion with EBITDA hitting $10 billion. On top of that, AOL Europe reported a $600 million loss. The majority of analysts say AOL revenue growth for 2002 will run a meager 5% to 8% or 8% to 12% EBITDA. The numbers have prompted some analysts to suggest that AOL Time Warner’s stock has fallen from the growth into the value category. More Than the Sum of its Parts? AOL Time Warner’s market capitalization today is $133 billion. It has traded as high as $58.71 during the last year and as low as $27.40 and is currently hovering around $30 a share. While AOL still dominates the Internet, it appears to have gone from a high-flying eagle to a mere hawk in AOL Time Warner’s corporate crown. Many observers continue to question whether there is real value in the combination of AOL and Time Warner or if they would be better off as separate companies. Some even suggest that AOL Time Warner more closely resembles the old media Time Warner than the new media AOL. Levin is being replaced by Parsons, another Time Warner top executive. Not only were AOL executives
“If you look at our company, there is one issue we are facing,” Robert Pittman, co-COO, told analysts in early January. “It’s called an ad recession. In 2000, we had 24% ad commerce growth. In 2001, it was negative 3%. If we had done just half of that 24% growth rate, the company could have met” its original projections.
“Is there a synergy that goes beyond elementary financial synergies?” asks marketing professor David Schmittlein: “The jury is still out about putting together the content and delivery systems.” Adds marketing professor Peter Fader: “My prognostication for the year ahead is based on what AOL would have done on its own and what Time Warner would have done on its own. When you add those two together, I don’t see the magical synergistic breakthrough occurring this next year.”
Both Schmittlein and Fader are still waiting for AOL Time Warner to be something more than the sum of two big parts. While acknowledging that the “first year has gone well,” Fader says it’s “not because of the merger but because Time Warner got lucky with a couple of big movies and because AOL has not saturated the market yet.” The fact that they “haven’t suffered as much as other media companies,” he adds, “is more [the result of] good luck than [the result of] the merger.”
Gerald Faulhaber, professor of business and public policy, concurs. At the time of the merger, he says, there was a lot of discussion about putting together the assets of AOL and Time Warner in order to bring new products to customers. “I haven’t actually seen that,” he notes. In addition, Faulhaber wonders why AOL would even need Time Warner content. “AOL never had trouble getting content from anybody because everybody wants to be on AOL.”According to Fader, AOL Time Warner is “grasping at straws for synergy.” He calls the bundling of AOL software CD’s with Time Warner magazines “cheesy” and downplays the use of Warner recording artists to promote AOL services. “Is there a natural synergy between content and delivery?” he asks. “Each of those markets is subject to enough competition and random fluctuations so that whatever synergistic benefits there might be are dwarfed by other things that could happen. The only real benefit to having a merger like this is to reduce costs by eliminating redundancies, but that by itself” is not enough to justify the move.
Proponents of the merger claimed that AOL would have access to Time Warner’s 21 million cable customers and its broadband system. Recently, however, AOL Time Warner, the nation’s number two cable company, lost out to Comcast Corp., the number three company, in acquiring AT& T’s cable division.
Meanwhile, AT&T still owns 25% of Time Warner Entertainment, and Pittman told analysts that AOL is open to buying back the full stake “but only if it’s a good deal for us.” AT&T eventually plans to sell its share in Time Warner Entertainment if the proposed merger of its cable unit with Comcast closes. Pittman has indicated that AOL is still interested in acquiring cable properties, but does not elaborate, while AOL chairman Steve Case recently confirmed that the company is in talks with Comcast, which will become the nation’s largest cable TV company when the merger with AT&T concludes. Case talked about a possible “broader partnership” involving shared ownership of Time Warner Entertainment that could include a provision giving AOL’s media properties greater access to Comcast’s vast cable network.
“Faulhaber questions whether AOL Time Warner should even be in the cable business long-term. He views the company’s cable business as a “pipes in the ground,” utility-like business. When Time Warner originally put its content business with its cable properties, it expected synergies between content and conduit (much as Disney did when it bought ABC/Cap Cities). But such synergies have proved elusive; cable firms have little trouble contracting for the content they need, and content firms have little trouble contracting for the distribution they need. Vertical integration seems to add little to the equation.”
If owning the “conduit” has any short-term advantage for AOL Time Warner, adds Faulhaber, it is in negotiating deals with other ISPs … using its cable as a big bargaining chip.” He predicts that AOL Time Warner will eventually get completely out of the “cable utility” business.
From Dial-Up to Cable Broadband
On the Internet side, AOL must prove it can maintain its paramount position by signing deals across the entire cable industry while it opens its Time Warner cable pipes to competitors. If it can’t, AOL’s position as the undisputed leader in the consumer Internet business could begin to slip. Today, according to published reports, AOL has more than 33 million subscribers worldwide – 25 million in the U.S. – and analysts expect AOL to sign 6.2 million new members for the year. AOL’s Pittman believes that eventually between 90 million and 95 million U.S. homes will be connected to the Internet. Last year, AOL Internet subscribers spent $33 billion online, 67% more than they spent the year before.
America Online has thrived by making it cheap and easy for millions of people to get onto the Internet using a standard open-access phone line and modem. With all of the hype about broadband, nearly all of AOL’s current subscribers still use dial-up “narrowband” connections, which are far too slow to accommodate the growing demand for rich media that consumers increasingly want from the web.
By 2005, some industry observers estimate that 50% of U.S. homes will have broadband, with two-thirds of that supplied by cable operators – one reason given for AOL acquiring Time Warner. How AOL converts its dial-up subscribers to cable-broadband customers is the company’s biggest online challenge, according to some company observers. They say AOL can’t be a national player in broadband without across-the-board access to cable, and that AOL absolutely needs to have national coverage in cable. In speaking about high-speed Internet services, Pittman recently stated that the company had to put the brakes on marketing the delivery of AOL over cable because the demand outstripped capacity.
According to Schmittlein, however, “convergence is happening much more slowly than even the most pessimistic analysts would say … because people just don’t need to change habits or media usage in any dramatic way overnight.” Right now there is no compelling reason for convergence to happen in the next few years, but when it does it will be a “genuine explosion like [there was in] cell phones,” he predicts.
The “long-term strength of any brand is to keep customers on board and to extract a premium” from them, says Fader. “AOL has been very successful in that regard.” Broadband, he adds, is a “tremendous wild card” that “to date has been negligible” but will “eventually be ubiquitous,” although not this year. “It’s an industry in its infancy and for that reason it’s hard to justify the merger on that basis.”
So don’t expect to see any notable synergies – in content or broadband – in 2002 or 2003, Fader says. At the same time, however, AOL has no real competition and is still “adding people and boosting revenues in a much healthier way than almost any other firm in their area.”
Some analysts would agree. “Although the headlines have been negative lately,” says Robert Schiffman, a credit analyst at Credit Suisse First Boston, “I think AOL-Time Warner is an investment grade powerhouse. There are very few companies where a transition at the CEO level and lower financial earnings for the upcoming year would not have a real impact on the business.”
Schiffman says that the $40 to $60 billion non-cash charge is not very significant, even if AOL Time Warner is taking what may be “the largest write-off of all time.” He suggests that the company is playing “a little catch up with what the equity market has already done by adjusting its market value some $60 billion” since the merger. “It certainly makes for great headlines, but it doesn’t really create that much volatility in trading rooms. This is a non-cash write-off that has absolutely no effect on credit. AOL may be the first, and the largest, but we will see a variety of other large media companies also taking large goodwill write offs.
“Stepping back from the headlines,” Schiffman adds, “here’s a company that generates significant and stable cash flows, is well managed and, despite the economic decline, is still far outperforming the general market ….”
The Year Ahead
As AOL Time Warner begins 2002, not only does it have to answer many critics over core business issues, but now it has declared legal war against Bill Gates & Co. in an epic struggle that industry observers say could go on for 10 years or more with billions of dollars at stake.
In the end, however, the “true success” of the AOL Time Warner merger will be “won or lost,” Faulhaber says, “on the company’s ability to leverage its promising collection of cable networks into something more than just a way to see the latest episode of HBO’s ‘Sex and the City.’ That will only be done by bringing AOL’s online expertise into alignment with Time Warner’s stable of media properties, and adding a broad vision of the next chapter of the Internet. This means being the first to create an invisible high-speed grid to deliver interactive services and entertainment to consumers without muss or fuss … anywhere, any time, over any device. If AOL Time Warner can do that, the company may be able to create the most ironclad and lucrative relationship with the consumers of the future.”
