ISBN: 0-03-028931-9

Chapter 21 Mergers, LBOs, Derivatives, and Holding Companies

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AOL and Time Warner Merger Stuns the Financial Markets

Early January 10, 2000, the wire services reported the proposed blockbuster merger between American Online (AOL) and Time Warner. The announcement stunned the financial markets, and it sent shockwaves throughout the investment community.
When it was announced, the deal represented the largest proposed merger ever. While described as a "merger of equals", in fact AOL will effectively acquire Time Warner. Time Warner's shareholders will exchange each of their shares for 1.5 shares of the new company, and AOL's shareholders will receive 55 percent of the new company's shares. After taking into account the cost of assuming Time Warner's debt, AOL will be paying $160 billion for Time Warner.
Before the announcement, AOL's equity had a market value of $160 billion versus $90 million for Time Warner. Based on these premerger valuations, AOL's value was 64 percent of the combined companies' $250 billion value – considerably higher than the 55 percent that AOL's shareholders will end up with. This led some to conclude that AOL is paying too much for Time Warner. Indeed, in the days immediately following the announcement, Time Warner's stock rose 35 percent while AOL's fell more than 10 percent. However, others argued that AOL's stock had been overvalued prior to the merger and that its managers skillfully used their overvalued stock to buy a blue chip company with real assets, earnings, and cash flow.
The difference in the two companies' valuations is startling when you consider that Time Warner's revenues are $26.8 billion versus AOL's $4.8 billion. Clearly, AOL's 78 percent higher market value reflects the market's belief that its growth prospects are considerably greater than Time Warner's. The announced merger dramatically underscores the phenomenal growth of the Internet in recent years, and it caps a remarkable turnaround for AOL and its often-underestimated CEO, Stephen Case. Just five years prior to the deal, AOL's equity market value was less than $2 billion, while Time Warner's value was more than $20 billion. At that time, many thought that AOL would have a hard time surviving, and that its best prospects lay in being acquired.
Regardless of who got the best deal, the new company brings together some interesting elements. AOL, with more than 20 million subscribers, is currently the dominant Internet service provider. More than half of all U.S. customers use it to access the Internet. Combining AOL's subscriber base with Time Warner's cable franchise, AOL/Time Warner has the potential to bring high-speed broadband Internet access to many millions of households. If you add Time Warner's impressive content (which includes valuable assets such as Warner Brothers Studios, Warner Music, CNN, HBO, Time, People, Sports Illustrated and Fortune), the merger provides an opportunity to bring together the best elements of the new and old media.
Despite the deal's remarkable upside, the combined company will still face a number of potential pitfalls. First, the deal is attracting regulatory and congressional scrutiny. Second, it will probably induce other companies to form similar alliances that will vigorously compete for customers. Finally, even deals that look good on paper sometimes fail miserably because of the difficulties of combining two very different cultures. AOL/Time Warner brings together an impressive management team including AOL's CEO Stephen Case and president Robert Pittman and Time Warner's chairman Gerald Levin and vice-chairman Ted Turner. However, history has proven that talented people often have a hard time working together and managing their egos. Over time, the financial markets will determine how well this deal succeeds.

DISCUSSION QUESTIONS:

1. Do you think that the AOL/Time Warner merger has been a successful venture?
2. Are mega-mergers good or bad for the economy? Or, in other words, does the creation of mega-companies through mergers pose a monopolistic threat?
3. Do you think it is a good idea for a single company to provide all multimedia services to consumers? What are the potential benefits and disadvantages of this?
4. Sometimes a larger company purchases a smaller, undervalued company for the sole purpose of liquidating its assets and breaking the company apart. Consider the hypothetical case of a small community dependent upon a local company that is being taken over and liquidated. To what extent should societal benefit be considered in contrast with shareholder wealth maximization for the acquiring firm? Present arguments for both sides.

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