AOL Time Warner: Analysts vs. Investors


By David Shook A gaping hole plunges into the ground behind a construction barricade just west of Columbus Circle in the middle of Manhattan. The new AOL Time Warner headquarters will dominate this corner of the Big Apple skyline in the not-too-distant future. When it's finished, this Midtown monolith will stand as a symbol of the merged company's likely dominance in major media -- from magazines to movies to the Internet.

Just one problem: As Time Warner (TWX) and AOL (AOL) wait for final regulatory clearance from the Federal Communications Commission before closing their marriage, investors have been burying, not building up, the two stocks. Since the merger announcement on January 10, 2000, investors have bid down AOL shares nearly 50%, to $41 a share. Meanwhile, Time Warner shareholders have watched a 70% premium initially placed on the deal's value all but disappear. What was once expected to be a $190 billion merger -- the largest in history -- is now worth $110 billion.

Both stocks got a nice boost over the past few days from the Federal Reserve's surprise interest-rate cut on Jan. 3. Time Warner jumped from below $50 a share to $62 by Friday, Jan. 5. But a startling disconnect persists between the market's view of this deal and the mostly positive opinions of Wall Street professionals. Analysts still overwhelmingly favor the deal and consider AOL Time Warner the No. 1 or No. 2 pick of the media sector. Only Viacom (VIA) gets as many top votes among analysts. Granted, the Street's forecasting record is spotty at best. But the experts have likely picked the winner in this contest.

BLIGHTED TROTH? Investors, however, remain skeptical. Stockholders ranging from media consultants Allen & Co. to Dell Computer Chairman Michael Dell have sold stakes in AOL, according to securities filings. (Dell sold a tiny stake worth about $57,000 last year, the company acknowledged.) Take James Joaquin, president of the Internet photo company Ofoto and a large AOL shareholder. He says he remains "very bullish" on the company. But that hasn't stopped him from selling 10,000 and 20,000 share lots of AOL stock over the past few months, or from unloading options on the stock he is still holding. These options give buyers the right to buy Joaquin's AOL shares at a specific price above the current market value for a small fee -- just one way to hedge a bet on the deal. "But because AOL's stock has been going down, these calls have never been triggered," Joaquin acknowledges.

Investors seem to have decided the marriage is doomed before the wedding cake has even been cut. Analysts think they'll be vindicated on Jan. 31, by which point everybody now assumes the merger will have been consummated by the Federal Communications Commission and when fiscal 2000 results for both AOL and Time Warner will be released, and detailed expectations for the new company in 2001 will be unveiled.

"Those numbers have to be reached for investors to be satisfied by the end of the year"

Look for AOL Time Warner to stick by its earlier predictions for $11 billion in cash-flow earnings in 2001 -- roughly a 30% increase over the previous year. "Can they hit those numbers? That's the big question," says one analyst at a major investment bank. Adds Jeff Cino of Jefferies & Co.: "Those numbers have to be reached for investors to be satisfied by the end of the year. I would certainly cite that as one of the biggest concerns."

For now, Wall Street has given its heart to Bob Pittman, AOL's president and the man designated to forge the merger. There is little reason to think he can't do it, analysts say (see BW Cover Story, 1/15/01, "Show Time for AOL Time Warner"). AOL's ambitious earnings promises have certainly been fulfilled under Pittman's watch. But doubt lurks when it comes to Time Warner. In December, the company lowered its guidance on 2000 earnings.

DEVIL OF TIME. The shortfall was due in part to the disappointing box office for Warner Bros. and New Line Cinema flops such as Little Nicky, starring Adam Sandler, and the John Travolta travesty Battlefield Earth. The earnings shortfall would probably amount to $25 million less for the merged company -- a pittance for such a colossus, says Cino. But could an earnings disappointment be a harbinger of bad news in 2001? Not likely, says Cino. "Right now, AOL Time Warner looks very attractive. The company isn't getting credit for its expected growth rate.

Of course, AOL Time Warner is merging just as the economy is facing its sharpest slowdown in a decade. But the Street says AOL Time Warner has less exposure than its peers to the downturn expected this year in advertising spending. It's better positioned than Disney (DIS) and News Corp. (NWS), to name a few, and it remains on a par with Viacom, say the analysts. The reason is subscriptions. Bernstein & Co. notes that both AOL and Time Warner have revenue models that are more subscription-based than either Disney or Viacom. That model will likely be amplified by the merger. As a rule, magazines, cable service, premium network HBO, and AOL all rely heavily on subscription revenue that are not tied to advertising.

At the same time, cost-cutting and revenue gains could reach nearly $2 billion by 2002 if Pittman and AOL Time Warner CEO Gerald Levin play their cards right, some estimates suggest. Bernstein & Co. has assembled a 41-page report on potential cost-savings and revenue-maximization schemes that AOL Time Warner might implement this year. Take last year's robust growth in Time Inc. magazine subscriptions. By offering and renewing subscriptions online through AOL or Netscape, Time is already drastically cutting its customer-acquisition and -retention costs. "If you subscribe to Sports Illustrated on AOL, you can get an evergreen subscription that just keeps renewing itself. It's a tremendous advantage," says one analyst.

LOTS OF MAYBES. Not everyone sees so much opportunity in 2001 for AOL Time Warner. Clearly, investors are worried about the overall advertising downturn as well as slow implementation of Time Warner's broadband cable services. That's why these stocks are under so much selling pressure. It's also why Shannon Reid, fund manager for the $800 million Evergreen Select Strategic Growth Fund, sold his fund's AOL shares on the day the two media giants announced the marriage. "We sold [nearly] at the peak of dot-com mania," he says proudly. Reid might consider buying the stock if the prices drop a little further, but that isn't likely. "What we're seeing now is a company better positioned than anyone on the Internet -- but also facing a loss of ad revenue and possibly weaker revenue and cash-flow growth," he says.

You can believe Reid and other investors who have lost the faith, or you could put your money with Bob Pittman and the bullish Wall Street analysts. Remember: This wouldn't be the first time Pittman has been underestimated. Just mark Jan. 31 on your calendar. It's a day when many of the questions about the benefits surrounding this megamerger might finally start to get cleared up. Shook covers financial markets for BW Online in New York


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