Will AOL and Yahoo Trade Places?


By David Shook With AOL Time Warner's (AOL) stock down 31% this year, how can investors know for sure when it has bottomed out? One clue might be if and when the shares fall below those of AOL's former archrival, Yahoo! (YHOO) -- something that hasn't happened since late 2000.

With Yahoo at $18 and change, up more than double from its 52-week low, and AOL at $21 or so, virtually at the bottom of its 52-week trough, the two stocks are perilously close to meeting. And with the announcement on Apr. 9 that Barry Schuler, chief executive of the AOL service, is being demoted, investors might sense that AOL's first-quarter earnings report, due on Apr. 24, could deliver another disappointment.

For many shareholders, it's probably as startling as it is reassuring that Bob Pittman, AOL Time Warner's chief operating officer, will temporarily take over responsibility for the AOL unit, a job he held before the Time Warner merger more than a year ago.

PSYCHOLOGICAL IMPACT. AOL's market value remains substantially larger than Yahoo's -- $97 billion vs. $11.2 billion. Still, the narrow margin in share price can't help but have a psychological impact. At the height of the dot-com bubble, analysts never mentioned one stock without referring to the other. Yahoo was the largest Web portal, AOL the fastest-growing Internet-access provider.

Yahoo's business nose-dived a year ago, when the dot-com startups whose advertising it thrived on began to fail in droves. It soon became startlingly apparent that one of Yahoo's weaknesses was that it didn't own much of value. Certainly, it had nothing approaching Time Warner's magazines, Warner Bros. studios, CNN, and HBO -- all properties that AOL picked up with its acquisition of Time Warner on the way to creating a $38 billion company.

So how is it that, just 15 months after the $115 billion America Online-Time Warner merger, the stock of this huge company with the world's best-known media brands is setting new lows by the month, while Yahoo is enjoying a reasonable degree of buoyancy?

"MOST HATED STOCK." The answer seems to have a lot more to do with AOL than with Yahoo. Analyst Jordan Rohan at investment bank Soundview Technology Group attributes the decline to investor frustration. "AOL is quite simply the most hated stock of all the companies I cover right now," he says (see BW, 4/8/02, "AOL, You've Got Misery").

At the top of the list of reasons are AOL Time Warner's two profit warnings over the past six months. Those included one in early January in which Pittman and incoming CEO Richard Parsons, who'll replace the retiring Gerald Levin in May, failed to quell concerns over decelerating subscriber growth rates at the America Online service or to clear up the company's strategy for launching higher-margin broadband Internet services in place of its older dialup system.

Analysts and institutional investors became so upset that they began unloading their huge holdings in AOL Time Warner -- inundating the market with AOL shares and driving down their price. The company's biggest shareholder, Janus Capital, has sold more than 60 million shares, or 25% of its holding, over the past several months (see BW Online, 4/3/02, "Janus: Tiptoeing Out of Tech").

LITTLE LIGHT. Add to that the concerns over AOL's debt level -- $23 billion at last count, and climbing. Under a prior agreement, AOL is buying back from Bertelsmann, its former European partner, a 49.5% stake in money-losing AOL Europe for $6.75 billion. And AOL Time Warner's cable-TV holdings are in a state of flux, with AT&T seeking to sell back to AOL a 25.5% stake in Time Warner Entertainment that analysts say is worth about $10 billion.

So far, AOL management has shed little light on those negotiations -- or on how AOL will sell America Online's services over the systems of cable companies that compete with its own, a key step if AOL is to migrate its customers to broadband. "AOL must sign deals with the other cable operators," says Youssef Squali, analyst for First Albany -- and it shows no signs of doing so yet.

With all of these questions unanswered, investors seemingly have lost the justification for assigning AOL a higher premium in the market than they award rival media giants such as Viacom, whose stock is up 14% this year, thanks to an improving market for radio and TV advertising (see BW Online, 3/4/02, "Viacom: A Survivor -- and Much More").

PLENTY TO PROVE. Yahoo, meanwhile, seems to have benefited by maintaining a low profile since Terry Semel, the former Hollywood mogul and longtime Warner Bros. chairman, took the reins from Tim Koogle in May, 2001. Despite a gut-wrenching contraction during 2001, Yahoo exceeded its fourth-quarter sales and earnings targets.

And on Apr. 10, it reported first-quarter revenues of $192 million, better than expected and higher than last year's $180 million for the same period. Yahoo turned an operating profit of $10.5 million, or 2 cents per share, vs. a loss of $11.5 million, or 2 cents per share, last year. Including a one-time charge, Yahoo's net first-quarter 2002 loss was $53.7 million, or 9 cents per share, compared with a net loss of $11.5 million, or 2 cents per share, the year before.

Yahoo still has plenty to prove, considering that it continues to derive the bulk of its revenues from the not-always-dependable online ad market. Semel says he plans to reignite growth and make the company solidly profitable by increasingly emphasizing fee-based services -- a neat trick considering that Yahoo still doesn't own much to offer.

With Yahoo's stock severely devalued compared with its all-time high of $237, Semel has been able to buy only one company -- HotJobs.com, the online job site that's a distant No. 2 to Monster.com -- for $436 million. Yet that acquisition, plus Yahoo's growing share of the online ad market as other big Web sites wither, has given it more credibility on Wall Street than AOL Time Warner enjoys.

LESS CASH FLOWING. Given AOL Time Warner's holdings across all areas of media and entertainment, analysts who follow both companies think AOL has a brighter long-term future. But first, it will have to show better results than it's likely to announce for the first quarter.

First Albany's Squali estimates that revenues in the period for the AOL service were $2.39 billion, about flat with a year earlier, mainly due to a contraction in online advertising and commerce. Quarterly cash flow for the AOL unit -- including AOL Europe -- was about $499 million, he estimates, down from $507 million a year earlier. Net subscriber growth receded from 4.1 million new domestic customers in 2000 to 3.7 million in 2001 -- and may fall to 2.5 million in 2002, Squali believes.

Thus, the unit that was supposed to be AOL Time Warner's growth engine will do no better in the first quarter than the overall company. Analysts expect its revenues to be flat at about $9.5 billion and its earnings to merely equal the 15 cents a share in the same quarter a year earlier. And that's not counting any unpleasant surprises from the AOL service that Pittman may yet unveil.

AOL FOR FREE? The Apr. 9 announcement of Schuler's new role could be just such a grim harbinger. "Of course, it's a demotion," says First Albany's Squali. "It reflects the flagging performance of the AOL service, the most important unit of the company."

Such disappointments notwithstanding, Squali thinks AOL Time Warner is shaping up as a bargain. "From a valuation perspective, splitting AOL Time Warner into its premerger elements yields a $23 value for Time Warner alone," he figures, which is why he has a strong buy on the stock. "This implies," Squali adds, "that an AOL Time Warner investor today is getting the AOL business virtually for free."

Such an analysis must be doubly sobering for any investor who has ridden the stock from a post-merger $58 to its current lows. If the Street really values AOL as a free bonus, then it's worth a lot less right now than its old foe, Yahoo. Shook covers the markets from New York for BW Online


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