Analysis by Bradley Johnson


Debate Flares as Messy Merger Flounders

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NEW YORK ( -- The AOL Time Warner merger so far is a bust. But the floundering media conglomerate is unlikely to get busted up any time soon.
Bradley Johnson is the deputy editor and editor-at-large of Advertising Age.
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Key obstacles -- skittish financial markets, a lack of qualified buyers, a new CEO who insists the merger still will pay off -- stand in the way of a split-up.

Investors and employees, who have seen the stock plummet 75% since America Online bought Time Warner in January 2001, want an end to their misery. For many, a bust up of the boom-time deal looks appealing.

Talk of a breakup in part reflects AOL Time Warner's failure to deliver on a central merger tenet: that the company would generate significant incremental revenue by reorganizing to sell ambitious cross-media ad packages. The idea flopped because of disputes between divisions and a tangled corporate bureaucracy -- not to mention questions among advertisers and agencies about what was in it for them. AOL Time Warner has largely pulled back from its centralized strategy, leaving units to work out smaller cross-division pacts when they make sense.

E-mail to employees
So where is AOL Time Warner going? In an e-mail to employees, CEO Richard Parsons said last week's management reorganization is "another step toward unleashing the combined power of our assets." But he concluded: "Getting AOL Time Warner on track and moving ahead as a united company, with one heart, spirit and purpose, remains our central challenge."

Mr. Parsons declined to be interviewed, though a spokeswoman said: "We absolutely believe that the

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whole -- AOL Time Warner -- is worth more than the parts."

Maybe not. An Advertising Age analysis suggests AOL Time Warner divisions are worth nearly twice the company's recent market capitalization of about $58 billion.

A case can be made that AOL Time Warner, the world's largest media company, should stay together. Merrill Lynch analyst Jessica Reif Cohen said she believes AOL Time Warner, despite its struggles, has an unmatched portfolio that still maintains its initial promise. "I don't think there's any reason to split it up," she said.

An eventual upturn in advertising and the economy would help AOL Time Warner. "If the market rebounds, then all of a sudden numbers look pretty good again," said Reed Phillips, partner in media investment bank DeSilva & Phillips.

Inflated Internet stock
True, AOL used inflated Internet stock to buy valuable old-media assets. But AOL and Time Warner both deliver ad-supported content to subscribers; the marriage, in theory, makes sense. The deal arguably made more strategic sense than Time Inc.'s purchase of Warner Communications a decade earlier.

J. Richard Munro, retired Time Inc. chairman-CEO and an architect of the first deal, argues that Warner "fit us like a hand in glove." But he also acknowledges that deal, too, was driven largely by the business climate. "We could not be a stand-alone," he said. "We were on everyone's hit list." The unlikely marriage of movie studio and old-line magazine publisher took years to gain traction.

AOL Time Warner, which reports second-quarter results July 24, faces a serious obstacle to acting as one company: Many Time Warner employees blame AOL for the stock implosion. "Morale sucks," said one former Time Inc. executive who is still owns stock and has commiserated with current staffers who have lost millions of dollars in stock holdings. Following seismic change in financial markets, it's hard to see how the stock will recover to the level when the deal was struck.

No buyers; a shortage of money
So a strong case can be made that AOL Time Warner is so unwieldy -- and divisions so entrenched -- that it should split. But breaking up could be hard to do. Two problems: few buyers and a shortage of money.

One deal seems plausible: a partial stock spin-off of the cable systems business to unwind Time Warner Entertainment, a joint venture with AT&T Corp. "It seems like all roads point to a cable IPO," said Merrill's Ms. Cohen.

John Billock, Time Warner Cable vice chairman-chief operating officer, addressing whether AOL Time Warner should spin off his unit, said: "We're so focused on managing our assets at Time Warner Cable that we know what we have to do. Whether we go out or stay in is really not the issue."

One scenario talked about -- at least in passing -- involves spinning off publishing as a stand-alone loaded with debt since its magazines could throw off the cash to pay down debt. A spin-off would find internal support among frustrated Time Inc. executives, but not if it means assuming heavy corporate debt.

Don Logan, chairman of the Media and Communications Group, declined to comment on any breakup-related matters. The AOL Time Warner spokeswoman said the parent doesn't comment on speculation regarding what it may or may not do.

$28.5 billion in debt
Beyond a TWE revamping, prospects for other near-term deals appear limited. Lenders aren't interested in making big loans for buyouts -- especially since AOL Time Warner sits on $28.5 billion of debt. Wall Street isn't much interested in floating new stock. Hal Vogel, CEO of Vogel Capital Management, doubts AOL Time Warner will spin off the traditional media businesses or sell divisions piecemeal to outsiders. "You are going to have to buy the whole company. Who has the wherewithal to buy the whole company?"

Even if divisions were available, there are few qualified buyers. Time Inc. remains the gold standard in magazines, and Mr. Phillips said it could command 15 to 20 times trailing earnings before interest, taxes, depreciation and amortization -- or $14 billion to $19 billion. That's a big hurdle. AOL, meanwhile, might be a good fit for a phone or cable company -- but those industries have their own problems. "I don't believe there is a logical buyer" for AOL, said Jordan Rohan, managing director, SoundView Technology Group.

There could be other ways to do deals. "The merger is a failure, but how do you get out of it?" asked one investment banker. "It wouldn't shock me to see a high-level deal with Bertelsmann where the two trade a lot of assets back and forth." AOL Time Warner this year bought out Bertelsmann's stake in AOL Europe.

Putting a value on the company
Putting a value on AOL Time Warner is challenging given all the questions: Uncertainty surrounding financial markets, the economy and the advertising recovery; investor skepticism; difficulty in valuing AOL; lack of logical buyers. Morgan Stanley puts the "fair market value" at $125 billion or $26 a share. Merrill Lynch's valuation using 2002 results is $90 billion or about $20 a share. Ad Age's consensus price is $110 billion. Mr. Vogel puts the breakup value at only $60 billion -- about the current market cap-because he thinks the stock will fall into the single digits.

Mr. Munro, 71, who pushed the first domino with the Time and Warner merger, watches the scene from his home in upstate New York.

"All I know is I'm sitting up here in the middle of the St. Lawrence river," he said, "and the stock price is at $13 and I didn't sell. ... As a shareholder, I'm a very unhappy guy. That's pretty obvious, right?"

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