How to Undo AOL Time Warner


By David Shook There's no clearer indication of the pressure cooker that AOL Time Warner (AOL) now lives in than the rumor that Chairman Steve Case has muttered more than once in frustration that he should just take back America Online -- which he built -- by spinning it off from Time Warner.

It's easy to feel Case's pain, news of which first appeared in The Wall Street Journal: America Online, the world's largest, best-known, and most profitable Internet company, gets blamed for everything from a 12-month, 64% decline in AOL Time Warner's stock and an embarrassing Securities & Exchange Commission accounting probe to the fact that the value of Vice-Chairman Ted Turner's holdings have plunged from about $6.5 billion to a pauperish $1.7 billion or so.

Unwinding the biggest corporate merger in history would be a lot harder than saying "Make it so." And yet, imagine the possibilities. Freed of its online albatross, the old Time Warner might reclaim a stature befitting the world's largest media company. It might show improved earnings, offload a chunk of its $28 billion in debt, and with a little luck, boost the holdings of its shell-shocked stockholders to maybe half the $55 a share they once were worth, analysts say.

SKEPTICAL FROM DAY ONE. Set free to fly again as a public company, the Internet division might become a $4 to $5 stock for AOL Time Warner shareholders -- even if it had to assume perhaps six times the debt it carried before daring to play in media's big leagues. Experts who've watched the melodrama of the matron and the brash young prince wouldn't be surprised by a divorce: "Many of us were skeptical from the day we first saw Case and [former AOL Time Warner CEO Gerald] Levin on stage announcing the deal in January, 2000," says James Owers, finance professor at the Robinson College of Business at Georgia State University in Atlanta.

In Owers' view, a spin-off wouldn't be all that hard to accomplish: He argues that AOL Time Warner could simply separate the Internet division from the mother ship -- giving shareholders stock in both the old Time Warner empire and the America Online unit. AT&T essentially did the same thing in 1996 when it split into three companies -- the long-distance phone carrier (T), NCR (NCR), and Lucent Technologies (LU).

It's an idea that stockholders would likely embrace. Alternatively, shareholder approval might not even be necessary if the Internet division were spun off as a dividend payment to AOL Time Warner shareholders, says James Jalil, securities expert for the New York law firm Shustak, Jalil & Heller.

DEBT SUPPORT. From a financial standpoint, in fact, the only big obstacle would be coming up with a formula for dividing AOL Time Warner's debt. UBS Warburg media analyst Chris Dixon likens that to "trying to unscramble eggs." And yet, the apportionment could be fairly logical. Though no prenuptial agreement exists, experts speculate that each side could end up with the debt it came into the merger with or has incurred since then.

That would leave the old Time Warner with slightly more than $18 billion or so in debt. AOL would pick up the $1.5 billion it had at the time of the deal -- plus an additional $8 billion or so that AOL Time Warner has taken on because of AOL's pre-merger obligation to buy back half of AOL Europe from former partner Bertelsmann. That transaction took place earlier this year.

Most likely, analysts believe, America Online would have to assume about $9 billion in debt, resulting in annual interest payments of about $500 million, based on its current net interest expenses. With America Online likely to have $1.6 billion in operating cash flow this year -- a 46% decline from a year ago -- it could probably handle the interest payments, though its debt might be rated at junk levels, credit analysts say.

ESCAPE FROM A NIGHTMARE. "I'm not sure AOL on its own could easily support that much debt," says Youssef Squali, analyst for First Albany Corp. In a pinch, Time Warner might have to offer some kind of guarantee to keep lenders happy until AOL's cash flow improved. Not ideal, for sure, but perhaps Ted Turner & Co. would be willing to pay that price to escape the nightmare it's living.

Plus, Time Warner might look more attractive to investors without AOL on its back. According to Squali, the merged company is trading at a cash-flow to stock-price multiple of 9.6, compared with 14.2 for Viacom (VIA), a close rival. If management separated America Online from Time Warner, then Time Warner alone would be trading at a cash-flow multiple of about 12 -- closer to Viacom's market value -- so its stock would at least hold its own, and maybe rise.

Time Warner also would probably look more financially fit if it didn't have AOL's debt -- which might lower its cost of borrowing. Prior to the merger, Time Warner had roughly the same credit rating that the merged company has today, but Time Warner's operating cash flow has improved significantly over the past year, while America Online's has declined. Moreover, Standard & Poor's, like BusinessWeek Online, a division of The McGraw-Hill Companies, has placed AOL Time Warner's credit rating under review specifically because of the America Online unit's declining fortunes.

NO VALUE NOW. Shares in the debt-laden AOL division wouldn't exhibit their pre-merger pizzazz. But the online giant would still be profitable, say analysts -- enough so, Squali guesses, to merit perhaps a $4 stock. In its third quarter, America Online had operating income of $432 million, down 41% from $736 million a year earlier, while revenues climbed slightly, to $2.2 billion from $2.1 billion.

Though AOL's earnings deterioration is a bad omen, an incipient turnaround in the online advertising market plus wide acceptance of AOL's new 8.0 browser software, could help reverse the negative trends (see BW Online, 10/31/02, "What's New in Online Ads: Improvement"). Squali and other analysts believe that investors are now assigning no value to America Online -- a company with 35 million paying subscribers. Squali doesn't expect a spin-off, but he says in the event of one, the still-profitable AOL division could have a decent market value.

Just look at two other online pioneers, Yahoo! (YHOO) and Amazon (AMZN), which have less debt but also are much less profitable. Yahoo is trading around $14.80 a share, as of Oct. 31, and has a market capitalization of nearly $9 billion. Amazon is trading around $19 and has a market cap of $7.2 billion.

FRUITLESS VISION. Of course, a spin-off would involve some big trade-offs. Though the AOL division and Time Warner's entities might retain the type of "partner" relationship that AOL pioneered with other media companies, gone would be Case's and Levin's vision of a monster competitor that ultimately would dominate every medium from online and print publishing to TV and film. Gone, too, would be the presumed synergies that AOL was to foster between Time Warner's various groups.

But then, that vision has gone nowhere -- and in fact has led to more conflict than cooperation between the company's fiercely independent divisions. Just how much so was dramatized earlier this year by the departure of Chief Operating Officer Robert Pittman, who had made cross-promotion and selling at AOL Time Warner a top priority.

A divorce would also be an admission that the past two years were a colossal waste of money and effort. That gives pause to new CEO Richard Parsons, who trumpeted the merger and still calls himself a believer in its long-term potential. For both reasons, many analysts believe, Parsons and several members of his board aren't yet ready to give up on the deal -- especially now that AOL Time Warner's stock has risen more than 40% since July, to around $14.80 as of Oct. 31.

MONEY TALKS. Two wild cards could change their minds, however. One is the view on Wall Street, where AOL Time Warner has lost tons of credibility because of its frequently changing financial projections and its plummeting stock price. The other is Co-Chairman Turner, who by all accounts played a major role in the departure of former CEO Levin and who evidently has suggested lately that Case should walk the plank, too. Considering what has happened to his own wealth, Turner is no fan of the AOL deal -- and money talks. If it talks loud enough, Parsons and his board may have to listen.

A lot will depend on how quickly America Online can right itself under the direction of new President Jon Miller, a former top exec at Barry Diller's USA Interactive (USAI). If America Online bounces back quickly and once again contributes to AOL Time Warner's growth, talk of a spin-off will subside. But if the Internet division continues to falter, Steve Case's mutterings could turn into a self-fulfilling prophecy. And the road map for what would happen next is already pretty clear. Shook is a reporter for BusinessWeek Online in New York


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