AOL+TWX=???
Key Takeaways
Do the math, and you might wonder if this company’s long-term annual return to investors can beat a Treasury bond’s.
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Quick insights and key information
12 min read
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investment
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February 7, 2000
09:00 AM
Fortune
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Magazine·Time WarnerAOL+TWX=???By Carol J
Loomis “Frankly,” wrote a J.P
Morgan securities analyst just after the AOL Time Warner merger was announced, “it is difficult to ject the true potential of this new entity, but we know it is big.” That statement might not get far in a logic class, but it rather nicely captures the widespread confusion the payoff in this deal
The murkiness won’t be dispelled soon
Even at Internet speed, it will take some time for the world to judge whether AOL overpaid in offering 1.5 s of its stock for each Time Warner , or whether Time Warner sold its impressive assets too cheaply, or whether this is truly a marriage made in heaven
In this article, later on, we will ourselves take a stab at figuring out what this company may do for investors
But first recognize that “big” indisputably is the word for the deal by one basic measure
Even after the merger announcement had knocked AOL down in price, a forma AOL Time Warner had a market value of around $290 billion
That’s not Microsoft, which leads the nation at $585 billion
But it puts the new company fifth on the market-value list, ahead of such heavyweights as IBM and Citigroup
There’s another word that applies to this transaction in a vital way: “small.” In the torrent of early analysis the merger, it was amazing how little anyone talked earnings—real, bottom-line earnings
That could be, of course, because they are almost too measly to find
For its fiscal year, last June, AOL had earnings of $762 million, and for the 12 months in December, earnings were $1 billion
Time Warner’s 1999 results have yet to be reported, but its full-year net should be around $1.3 billion
So run a total and you have bottom-line fits for 1999 of roughly $2.3 billion
On that basis, the combined company is selling at well over 100 times earnings
But the $2.3 billion figure is also something of a fooler: It includes very large nonrecurring gains at both companies and also, at Time Warner, some dollars slated for preferred dividends
If these items were subtracted, to get an fit figure for common holders, the two companies together would have bottom-line fits of under $ 1 billion
That makes the price/earnings multiple climb to 300
But, hey, who cares? In both the Internet and media worlds, people seldom talk bottom-line earnings
Instead, they talk bigger figures, bearing strange, made-up names that begin with the letter “e.” Here it seems that AOL and Time Warner do not speak precisely the same language
AOL reports EBITDA (e-bit-v/i), which stands for earnings before interest, taxes, depreciation, and amortization
Time Warner reports EBITA (e-bit-io/i), which states earnings before that same list of interest, taxes, and amortization but acknowledges that depreciation—the year-by-year bookkeeping recognition of capital expenditures made earlier—is a real cost that ought to be subtracted before getting to anything called “earnings.” In this duel of “Ebs,” something is ly going to have to give when the two companies merge (assuming they make it to the altar)
And here, in fact, is their plan: Jerry Levin, CEO of Time Warner—and the CEO-to-be of AOL Time Warner—says that the merged company will go along with AOL’s practice and will report EBITDA
Hmmm: That means the very real and ever-present cost of depreciation—rising out of Time Warner’s big spending, for example, on its cable systems—is to be ignored in getting to “earnings.” The result, of course, is the highest figure you can get in choosing between the Ebs, which is convenient when you are trying to rationalize a big valuation
In this article—we are now getting to what the merger may do for investors—FORTUNE will not focus on either of the Ebs, or on bottom-line earnings, for that matter, but will instead get down to a fit figure that a true investor trying to size up a company would indisputably want to know
This figure is fits after depreciation, interest, and taxes—items that are inescapable costs—but before amortization of goodwill, which is a bookkeeping cost that may completely lack economic reality
By our estimate, AOL and Time Warner had $4.2 billion of these fits last year
This figure reflects a full bookkeeping charge for taxes, though neither company actually pays much in cash taxes right now
AOL, in fact, ran up so many losses in its early years that it has $7 billion in tax-loss carry-forwards, with these set to expire from 2001 to 2019
They will keep the tax collector away in AOL Time Warner’s early years
But this company has enormous growth in mind, and it should, in pretty quick order, be paying significant taxes
If that turns out to be an inaccurate prediction, the company won’t have flourished: A big company that doesn’t ever pay taxes is almost never a good
The key questions are how fast fits might grow and what a given rate of growth would mean to the investors who right now have this big bundle of $290 billion sunk in the two companies
Regardless of what numbers may dazzle you the deal, that is the one to focus on: the market cap that the company must push up a steep hill to continue rewarding investors (a blem d by such other highfliers as Cisco)
To start thinking how AOL Time Warner might meet its challenge, FORTUNE postulated an average annual growth rate for fits of 15% for 15 years, an assumption carrying the thought that growth would be faster than that in the early years and then slow down
This is by no means a growth rate to be sneered at: Most large companies would kill to lock in that kind of performance over a long period
A 15% rate, in any case, would get you, in these after-tax fits we’re talking , to $34 billion (and to more than $50 billion before taxes)
Those are huge amounts: For perspective, General Electric’s equivalent after-tax fits last year were an estimated $12.5 billion
In the second part of the exercise, we need to make a guess at what the market might pay for $34 billion coming out of a company that in its 15th year would look a classy winner yet also have gained a certain maturity
Maybe the market would accord those earnings a multiple of 20
That would be a market valuation of $680 billion, against today’s valuation of $290 billion
And what would that mean in terms of an annual return to investors? The stark answer is 5.8%, which an investor might not find acceptable from government bonds, much less AOL Time Warner
In fact, many analysts are saying investors will want an average annual return of 15% from this company, operating as it does in the high-risk world of the Internet
For now, at least, dividends won’t be helping: The new company will pay none
In any case, FORTUNE tried its jections out on Jerry Levin and found, unsurprisingly, that he really didn’t them
He said the growth rate we had postulated was simply too low
He didn’t offer a precise alternative, but he did make the point that multiples tend to exceed jected growth rates, often considerably
So let’s cut through the math and come out with a scenario that would allow AOL Time Warner to give investors what they supposedly want: an annual return of 15%
For them to get that over the next 15 years—hold your hats—the market cap of AOL Time Warner would have to reach $2.4 trillion
That’s what $290 billion will grow to in 15 years if it rises at a rate of 15% a year
This amount, eye-popping though it is, also happens to fit nicely with the stated ambitions of Levin and AOL’s boss, Steve Case, to make their company the most fitable and valuable in the world
So now we need a scenario that would transport us to $2.4 trillion
Here’s one: a 15-year growth rate in fits of 22% (to $83 billion after tax) and a multiple, in the 15th year, of 29
Can AOL Time Warner pull that off? It just doesn’t seem ly
Big companies run into the law of large numbers and slow down, as if mud had clutched their feet
Getting to $2.4 trillion would simply be a digious feat, implying superb execution—in a very complicated company—and a trashing of every competitor that counted
It also happens that $83 billion (with goodwill stripped out, to get down to net income) would bably leave AOL Time Warner accounting for more than 10% of that year’s FORTUNE 500 fits, which just doesn’t seem economically feasible. (In the coming FORTUNE 500 list, no company is ly to account for as much as 4% of the group’s earnings.) In short, the spects for a 15% return to investors over the long term, from the current level of $290 billion, do not look great
To be even discussing a distant horizon of 15 years is perhaps madcap, given that the Street’s analysts are for the moment obsessed with what the company might sell at just one year out, in 2001
In mid-January, with AOL trading at $63 a , Ulric Weil, an analyst at the Virginia firm Friedman Billings Ramsey, took FORTUNE through his thinking that AOL Time Warner could be around $90 in 2001 (a forecast not nearly as bullish as some others around)
He was going to apply an Internet multiple of 22 to AOL’s estimated revenues and a media multiple of 30 to Time Warner’s EBITA; take into account $2.5 billion of estimated “synergy” revenues, which he would also multiply by 22; get to a total value for the company of $500 billion; discount that by 15% to get to a present value; divide by 4.7 billion s; and, lo, you’d have an expected price of $90 a
Wait, said his listener. “Is there a logic to the multiples of 22 for revenues and 30 for EBITA?” “No,” Weil hooted. “If you’re looking for logic in cybercash, forget it!” The question of whether there are going to be synergies of convergence—you will please pardon those discredited words—is, needless to say, huge, and very much a part of the murkiness that surrounds the payoff in this merger
The two companies, anticipating they’ll be joined before the end of this year, have told analysts to expect $1 billion of incremental EBITDA in 2001
The “low-hanging fruit” in this corporate orchard, says one insider, is cuts that both companies can make in advertising and direct-mail costs as they begin to exploit one another’s marketing channels
Another kind of fruit that may be harvested right away was suggested by ten partnering arrangements that the two companies announced on merger day
The first arrangement? A plan for AOL to feature Time Warner’s In Style magazine
To be sure, a journey to $2.4 trillion must begin with a single step, but as the announcement duly noted, other Time Warner magazines have already had such arrangements with AOL—without a merger, obviously
That raises a point often talked in big deals: Do you really need to merge to make arrangements that are beneficial to both sides? No, is one cynic’s answer: “To drink milk, you don’t need to own a cow.” On the other hand, Jeffrey Sine, a Morgan Stanley Dean Witter investment banker who has worked closely with Time Warner for many years, says he is absolutely convinced that new es get “unlocked” when you merge companies and get people to think creatively and cooperatively what can be done
Amazingly, he pulls an example out of a deal usually thought of as having been a synergistic wasteland: Time Warner’s purchase of Turner Broadcasting four years ago
The example is the Cartoon Network, which has 61 million rs and, in Sine’s opinion, has grown into a $2 billion asset
This , Sine claims, could never have become a prize had not Turner, with its Hanna-Barbera library and expertise in cable networks, gotten to close quarters with Warner Brothers, which brought Looney Tunes and animation skill to the party
Sine thinks that the hookup of Time Warner and AOL has endless possibilities for creative thinking and that Jerry Levin, in particular, has the kind of intellect to be fascinated by the possibilities
Says Sine: “In Jerry’s mind, a lot of this is, How do I get into a position to tap into the whole new areas of value creation that no one’s heard of or even been thinking ?” That was surely one of the “fuzzies”—Levin’s term—motivating him to make the deal
But a dominant reason for him to talk merger at all, he says, was the premium he knew it would bring Time Warner’s holders
These folks suffered for years after Time Inc. and Warner Communications merged in 1989, until finally the stock price took off
Levin says he was “driven” by a feeling of obligation to the stockholders and by a desire to keep on giving them good returns
Okay, Levin has engineered a premium for his holders
Now, to make the merger work for investors, Case and Levin must move their $290 billion market cap to an extraordinary height
It will be pushing a boulder up an alp
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