Steve Case Buys a Cable Company

New York -- Five years ago, America Online Inc. chairmanSteve Case told a group of industry analysts in Boston how much he admired the cable-TVbusiness model.

At that session on July 14, 1995, sponsored by theInteractive Services Association, Case went so far as to give the cable model of bundlingcontent and distribution into affordable packages for consumers partial credit forAOL's ascension to the top of the Internet heap.

Last week, Case extended that argument as far as possible.He agreed, stunningly, to pay what last Thursday was $152.8 billion in AOL stock andassumed debt for Time Warner Inc., the No. 1 cable operator, with 13 million pro formasubscribers, and owner of a passel of cable networks and other media brands.

Much of AOL's meteoric growth was fueled withacquisitions of such outfits as CompuServe Interactive Services Inc. and NetscapeCommunications Corp. "[Case] is a deal junkie," one analyst noted last week."The next deal always has to be bigger."

The biggest one of all may be harder to sell to AOLshareholders. AOL's high-flying stock dropped about 18 percent during the first threedays of last week. On Thursday, though, AOL rebounded nicely, rising about 9 percent. TimeWarner rose 6 percent the same day.

"Clearly, what most people are starting to face isthat the AOL stock they've loved for so long isn't AOL anymore," said DavidSimons, managing director of Digital Video Investments in New York. "On strictly apro forma basis, AOL has gone from high-octane rocket fuel to unleaded medium."

A continued sell-off in AOL shares could even put themerger in jeopardy, although AOL executives have been scrambling to meet with largeinstitutional investors and calm fears.

The deal contains breakup fees, which have not beenpublicly disclosed yet. Published reports last week said AOL would have to pay Time Warner$5.4 billion or Time Warner would have to pay $3.9 billion, depending on which side didthe scuttling.

Still fresh in memory was last year's attempt to meldnew media and old media -- USA Networks Inc.'s deal to buy Lycos Inc. That, too, wasan all-stock transaction, and industry analysts touted it as a winning combination. ButLycos shareholders rebelled, put off by a dramatic decline in Lycos' stock price andthe prospect of significantly lower growth rates, and the deal cratered.

There are some significant differences here. AOL will ownabout 55 percent of the combined equity, compared with the minority stake Lycos holderswould have had. (Based on the hugely disparate market values at the time this deal wasstruck, Levin had to fight hard to get that much equity for his shareholders.)

But Credit Lyonnais Securities analyst Richard Read seesscary similarities between USA-Lycos and AOL-Time Warner. Both mergers were meant to offercross-promotional opportunities across different lines of business, and the "oldmedia" company provided solid cash flow based on real assets.

Time Warner's solid base delivers substantially slowergrowth rates than its merger partner, as was the case when USA was compared with Lycos.Historical stock-price charts published last week depicted AOL as Mount Everest next to aTime Warner anthill.

"[With AOL and Time Warner], you have two differentkinds of shareholder bases --businesses that are on two different trajectories -- and Ithink you've got real big valuation issues," Read said. "If AOL [stock] isgoing to drift low enough, I think shareholders could all of a sudden have aproblem."

Sometimes those gaps get filled, though. Whendividend-paying, profit-making AT&T Corp. agreed to buy unprofitable,cash-flow-oriented Tele-Communications Inc., AT&T's stock stumbled badly. Butthat deal was completed partly because AT&T holders who didn't like the newcombination sold out to folks who did.

Valuing this new combined entity is equally tricky. Is AOLTime Warner an Internet company, an entertainment company or a hybrid?

"There's a different mentality about Internetvaluation," Read said. "I don't think anybody is thinking about what isthis thing worth -- it's more about momentum, growth in orders and unique visitors. Idon't think anybody is making any judgment about what kind of cash flow or capitalstructure is this company going to have in five years' time and, therefore, what isthe real fair trading value today. That's a totally different mind-set than thetraditional media-entertainment companies."

While the new company will have revenue of $40 billion andcash flow of $10 billion in its first full year of operation, revenue and profit-margingrowth rates will only be one-half of what AOL enjoyed on its own. The 12 percentfive-year profit-growth rate Wall Street has projected for Time Warner is one-quarter ofwhat AOL was assigned.

"What does that boil down to?" Simons asked."Assuming no change in projected rates for the individual businesses, it would takethree years for the profit margins of the combined company to equal those of AOL today. Itwould take a decade to match Microsoft [Corp.'s] current profit margins, which AOLhad expected to do within five years."

AOL and Time Warner executives, of course, look at thenumbers and like what they see.

"The numbers look pretty interesting," TimeWarner chairman Gerald Levin said during the press conference. "I don't thinkthere's [another] merger where on day one, it was said that it's not going to bethat hard to get $1 billion in synergy and EBITDA [earnings before interest, taxes,depreciation and amortization] precisely because we have these multiple revenuestreams."

Levin also rationalized the fact that upstart AOL'smarket value was nearly double that of Time Warner's. "The market capitalizationin the Internet space, I accept," Levin said. "While most may have somedifficulty with those valuations, to me, it's really quite simple, because it'sa belief that the present value of future cash flow is so significant that this is how youjustify it."

He added, "When Steve and I began to have ourconversations, it became clear to me that I could accelerate my own development, but also,I saw how I could accelerate AOL's development. In my own mind, I have been sayingfor the past year that it's probably likely in the year 2000 that we're going tosee somebody transact, figure out how to bring these companies together. I decided Iwanted us to be first because we could be proactive, and the new currency we could providewould enable us to continue to grow."

But dramatic growth is probably at least a few years off,and Internet investors are unlikely to wait that long.

On the surface, the deal makes incredible sense: It finallypairs up the two highest-growth media sectors -- cable and Internet -- and it begins tolevel the playing field between the two.

Time Warner is the granddaddy of media companies, withstellar assets in publishing; broadcast- and cable-television distribution andprogramming; films; and music.

AOL, on the other hand, is the largest Internet-serviceprovider in the world, with more than 22 million subscribers and access through its ownInternet sites and those of partners to roughly 135 million people, or, according to AOL,80 percent of the Internet users in the world.

With AOL, Time Warner finally gets the Internet strategy itcraved. AOL gets access -- through Time Warner Cable properties and its 38 percentownership in the Road Runner high-speed data-over-cable service -- to a broadband pipe.

While Time Warner content properties like Time and Peoplemagazines and cable networks Cable News Network, Home Box Office and Turner NetworkTelevision attracted content-happy AOL, the real driver was broadband access.

AOL was desperate to gain access to high-speed cablenetworks, funding numerous groups to lobby Washington to force cable to open its pipes.Some analysts believe Case determined that the federal government was leaning toward apro-cable stance on open access, prompting him to quickly gobble up the best cable assetshe could.

"We figured that AOL pushed for this merger becauseAOL suspected that the judge on the AT&T appeal would rule in a pro-cablefashion," PaineWebber Inc. vice president of research Thomas Eagan said. "Itmakes much more sense for AOL to negotiate with a cable operator before that decision, andnot afterward."

Many industry observers believe Time Warner gets the bestof the deal because the merger gives it an instant Internet strategy and provides a liftto its stock price that it could never have accomplished on its own.

AOL agreed to pay a nice premium for Time Warner. TimeWarner shareholders will get 1.5 shares of the new company for every Time Warner sharethey owned -- a 70 percent markup on Time Warner stock the day the deal was announced.That dropped to about 15 percent by Thursday, though, based on AOL's closing price of$64.31 and Time Warner's closing price of $84.

Those same observers also believe Levin -- who will becomeCEO of the new company -- engineered a deal where his company is absorbed, but it leaveshim wielding the most power.

"Case as chairman can't act unilaterally,"said one analyst who asked not to be named. "He can't tell the CEO what to do --only the board can. In terms of real power, Levin retains it."

Sharing space at the top of the new AOL Time Warner Inc.with Levin and Case are AOL president Bob Pittman, Time Warner president Richard Parsons,Time Warner vice chairman Ted Turner and AOL chief financial officer J. Michael Kelly.

Pittman and Parsons would be co-chief operating officers ofAOL Time Warner, while Turner and Kelly would retain their respective roles. The newcompany would also have a 16-member board, with equal representation from AOL and TimeWarner.

Turner agreed to vote his 100 million Time Warner shares --9 percent of the total -- for the merger. Although he seemed pleased at the pressconference, he downplayed one aspect of the deal that was on many minds -- how everyonewould get along.

"There will be some speculation with the possibilityfor [management] friction," Turner said during the press conference, "but Idon't think that is going to happen."

Of course, that possibility loomed even larger when TimeWarner bought Turner Broadcasting System Inc. But Levin worked well with Turner, one ofthe country's most outspoken and unpredictable executives.

"One thing Levin has demonstrated is an ability todeal with these people," one analyst said. "If he can handle Turner, he canhandle them."

The companies said they expect to close the deal by the endof the year.