Assessing the 'Millennium Merger'

The AOL-Time Warner deal proves that in a world ruled by finance, it is speculative stock value rather than real assets which is being treated as a better indicator of wealth.

C. P. CHANDRASEKHAR

MEDIA mergers are now passe. Through the 1990s, media giants either merged with each other or swallowed smaller players to generate the conglomerates which now straddle the globe. Yet, when America Online (AOL), the world's leading Internet service provi der with more then 20 million subscribers worldwide, and Time Warner, the media giant straddling print and television media, film production, publishing and above all the cable industry, announced an all-stock deal to merge, it was virtually hailed as a made-for-the-millennium merger.

Four features of the merger, which would lead to the creation of AOL Time Warner, won it well-deserved attention. First, the fact that it is the largest ever such merger. Taking the value of share prices that ruled a day prior to the merger, the $165 bil lion stock-paid 'take-over' of Time Warner by AOL creates a $335 billion company. The deal, though declared a 'strategic merger of equals', virtually amounts to a take-over, since AOL shareholders, with a 55 per cent shareholding in the new company, woul d have material control over it - a fact reflected in the agreement to have AOL Chairman Steve Case as the Chair of the new company as well.

The timing of the proposed merger rendered its scale inevitable. This deal comes in the wake of a series of mergers and acquisitions and processes of internal growth which each of the players had been through in the past enhancing their respective sizes. Time Warner itself emerged out of a merger between Time and Warner Communications in 1989 and a subsequent merger with Turner Broadcasting in 1996. One of its original components had ensured the successful launch of Home Box Office (HBO) in 1975 and lat er pioneered digital video disc (DVD) technology. The merger with Turner Broadcasting helped expand its reach to 75 per cent of homes in the United States through cable and gave it control of the CNN news group with 75 million subscribers in the U.S. and double that number worldwide.

America Online started with a relatively small asset base as Quantum Computer Services in 1985, built its online brand since then and acquired or started up leading players including Netscape, Compuserve, ICQ, Digital City and Moviefone along the way. It s success in terms of membership and usage helped it ride the Internet-stock boom, after some initial glitches, taking its market capitalisation to levels way beyond what was warranted by its real assets. Buyers of AOL shares were bidding them up by spec ulatively betting on the earnings stream and the share price trajectory of the company. Before the deal was announced, AOL's market capitalisation at around $160 billion was roughly twice that of Time Warner's. Given this history, large size was an inevi table corollary of the current merger.

Second, by combining AOL's Internet leadership with Time Warner's cable distribution network, the deal paves the way for mass availability of high-speed, broad-bandwidth connectivity which would allow delivery of content- and graphics-rich, interactive s ervices to consumers. Through its acquisition of CNN and sundry other cable operators, Time Warner had built itself up to be the second largest cable company in the U.S. after AT&T. Though AOL now has ten times the number of dial-up subscribers as its ne arest competitor, it is hamstrung by having to deliver content over telephone lines. It is well known that the major obstacle to the enhancement of Internet content today is the speed at which most subscribers access the Web through their telephone lines . Capped at 56.6 kbps, that speed restricts comfortable access to graphics-rich content including moving images and high quality sound. Accessing the Web via cable not only does away with the problem of meeting local telephone charges but takes download speeds to levels that are many multiples the speed available through the conventional telephone line.

With AOL now having unrestricted access to a large number of cabled households, it is likely that cable-based connectivity to the World Wide Web would become the standard in the U.S.

This has two implications. To start with, it puts under challenge a range of other technologies seeking to provide economical high-speed access to households, including Digital Subscriber Line (DSL) technology, which offers all-the-time connectivity to t he Net using the same copper cables which provide telephones to homes. Since speeds over cable, using cable modems, are known to be higher than through DSL connections, this is the preferred medium if costs are comparable. If AOL Time Warner bundles cabl e access to the AOL Internet service, it has the chance to use economies of scale to ensure cost competitiveness, encouraging a migration of subscribers to its cable network and its own Internet service - unless competing providers like Yahoo choose to a ssociate themselves with rival cable operators.

Third, AOL Time Warner's Internet offering is to be substantially beefed up using Time Warner's obvious content-providing skills in areas varying from news to publishing and music. The deal exemplifies the tendency towards convergence within the media an d information technology areas, as noted by analysts for some time now but accelerated by the consolidation of the World Wide Web. The Internet, it was becoming clear, would be the principal, if not sole, vehicle through which consumers would access both information and entertainment. This, it was argued, made an Internet presence not just unavoidable but imperative for media companies. This deal between two leaders from the Internet and media worlds more than confirms that argument.

Finally, and above all, the deal epitomises how in a world dominated by finance, market capitalisation, reflecting not just real value but speculative investor sentiment with regard to Internet shares, is treated as being a better indicator of wealth tha n real assets, a relatively stable stream of income and immense amounts of goodwill. Even a cursory look at the actual products that Time Warner and AOL bring into the new company makes the former the clear leader. Time Warner can boast of 13 million sub scribers to its cable television systems, 35 million to HBO, its premium cable television channel, and 28 million to its publishing division. AOL has just 22 million subscribers to its main online service. And, though real asset value figures are difficu lt to come by, it is clear from accounts relating to operations over the year ended September 1999 that Time Warner would provide the new entity with 82 per cent of its revenues and 70 per cent of its operating cash flow. Yet Time Warner has taken a lowe r shareholding in the new company and ceded control of the new company to AOL.

But wizards from the financial world are at pains to argue that the deal involves an innovative and 'fair' valuation of each of the companies involved. Recognising the 'real' importance of Time Warner, it is argued, AOL has offered Time Warner shareholde rs a hefty 70 per cent premium on their shares, by converting each Time Warner share into two shares in the new company. Going by stock prices prevailing the day before the deal was announced, an equal merger would have given Time Warner shareholders onl y a 32 per cent holding in the new company as compared with the 45 per cent it has actually got.

But even in a financial sense, the relative shareholding in the new entity remains puzzling. America Online's stock was priced at $73.4375 before the merger. If this is taken as the value of each share in the new company, the implicit value of a Time War ner share which amounts to a claim of 1.5 shares in the new company stands at $110.60175. With shares currently held by Time Warner's shareholders estimated to number 1.5 billion, the total value of that company would be placed at $166 billion. If the co mbined value of the new entity is placed between $330 billion and $335 billion, as the media have done, the shareholding of Time Warner stockholders in AOL Time Warner should amount to between 49.5 and 50.3 per cent. The difference may be owing to the in clusion of Time Warner's reported $17 billion in debt in the valuation, and/or the fact that in the negotiations Time Warner's own Internet assets were stripped off and valued lower than that of AOL. Whatever the explanation, it is clear that the final d eal is less favourable to Time Warner than the financial pundits suggest.

BUT that is not all. Is the relative shareholding an indicator of the value of the assets that Time Warner brings into the new company or a reflection of the stock market-determined relative "wealth" yielded by the shareholding of the two sets of stockho lders? If it is the latter, as market analysts insist it is, then what is being valued are volatile stock price-based wealth. Given that volatility, does the implicit 70 per cent discount on AOL's share value enough of a price it needs to pay to convert its speculative "asset" value into real value? An examination of the time trend in the market capitalisation yielded by AOL's stock prices seems to suggest that it is not. For a major part of 1998, AOL's market capitalisation was well below (about a thir d) of Time Warner's. A boom in its stock prices which began late in 1998 continued into 1999, taking its market capitalisation to more than double that of Time Warner's. This was followed by a slump, reducing AOL's share price by more than half and bring ing its market cap close to that of Time Warner's early in the second half of 1999. Subsequently, a second boom took share values to levels that rendered its relative market capitalisation around two times that of Time Warner's by the end of 1999.

It was at this point that Steve Case, the Chairman of AOL, chose to strike the deal, exploiting the current obsession with Internet stocks in leading stock markets. This makes relative stock valuation a matter of timing. If the deal had been struck a yea r back, a 50:50 split in the new company would have been the starting point of the negotiation, which would have resulted in a clear majority for Time Warner shareholders rather than AOL's owners.

All this is important because Time Warner did have its own options. It controls the content. It owns the cable network that ensures broadband connectivity. It has already begun exploiting that advantage through Road Runner, its high speed Internet acces s network which signed up 100,000 new subscribers in the third quarter of last year. All it needed was to bundle all these together and launch an aggressive marketing effort, and results may not have been hard to come by.

What, then, encouraged Time Warner shareholders to go ahead with what seems by all accounts to be an unequal deal? The lure of "quick riches" through a rise in their share valuation-based wealth seems to provide the answer. They clearly expect their enha nced holding in terms of number of shares in the new company to combine with a share-value close to the current price of AOL shares. At present that seems a real possibility. Time Warner's share price leapt $25 5/16 to $90 1/16 the day the deal was annou nced. In a world ruled by finance, real asset values seem to matter little. Accumulating "financial wealth" is the name of the game. If, however, speculative fever surrounding Internet stocks wanes, the volatility that characterised AOL share prices may afflict AOL Time Warner adversely, driving down the financial valuation of the wealth of Time Warner shareholders. They may then rue the day they did not veto the decision to hand over control of their large and successful media empire to an Internet ups tart.

Whatever the outcome, the deal does influence the face of the media business. All media companies are now under pressure to straddle multimedia content generation, Internet service provision and high-speed delivery networks. This would obviously make the capital base associated with media presence extremely high, paving the ground for the dominance of a few companies over the media landscape. Unfortunately, as experience shows, media conglomerates do not just serve up infotainment, they also become opin ion builders who influence the social and political environment.

It is indeed true that using the gateway that the service provider offers, Internet subscribers could reach even small, alternative content providers. But the wide-ranging content the big players offer could reduce the number of those who are even in sea rch of alternatives. In their drive to accumulate speculative wealth, Time Warner shareholders may have dealt one more, though not decisive, blow to pluralism in the media.