Wall Street’s New Challenge: How to Decide Worth of Hybrid Firms?

There have been two worlds on Wall Street in recent years.

There was the Internet world, in which stocks traded with seemingly no regard to fundamentals such as earnings or cash flow, but rather on the basis of outrageous hopes, even fantasy.

Then there was the rest of the market, where some sense of fundamental valuation still applied.

With the proposed America Online-Time Warner deal--and the likelihood of more such mergers between “new media” and “old media”--Wall Street now is forced to ask itself how it will value these hybrid companies.

The initial response Monday was that AOL was worth less than before: Its stock fell $1.13 to at $72.63 in trading that included after-hours activity. That may reflect that the newly merged company would be growing more slowly than the old AOL and that its profitability would be limited for some time.

Time Warner, meanwhile, soared $27.50 to $92.25, and pulled the share prices of all other traditional content companies higher. But it ended 18% short of the indicated purchase price, reflecting uncertainly about the deal.

The valuation issue is paramount: If AOL stock should fall sharply, it could be a deal breaker--as in the case of last year’s failed bid by Barry Diller’s USA Networks for Lycos, the Internet portal.

But despite AOL’s dip Monday, analysts said the proposed transaction at least initially appeared well accepted by the investment community.

In major deals, the acquiring company’s stock typically drops while that of the target rises--at least if the purchase price is substantially above what the target was selling for before the deal was announced.

Based on Friday’s close, AOL’s bid of 1.5 shares of its stock for each Time Warner share represented a 71% premium over Time Warner’s price of $64.75.

That makes it far different than USA/Lycos, where the Internet firm was the target instead of the acquirer and where USA offered less than Lycos’ market price.

The willingness of an established, 78-year-old firm such as Time Warner to accept AOL stock as its sole payment in the deal was the most impressive demonstration yet that the Internet is no fluke.

Also, the deal “definitely says there is value in older content players,” said Gabe Birdsall, analyst for Aim Capital Management. “The market is telling you that in the price for Time Warner and in the rising prices for other content firms today.”

Surprisingly, it may be AOL investors who are required to take the bigger leap of faith.

They would be paying a hefty premium for a company whose stock languished for more than six years after the 1989 merger between Time Inc. and Warner Communications. The stock didn’t do much last year, either. Friday’s closing price was 17% below the stock’s 1999 high price.

Moreover, if Internet companies get rapped for not producing profits, what about Time Warner? Like many cable-TV companies with massive investments in coaxial cable and other equipment to write down over the years, it generates little net income. Instead, Time Warner tries to focus investors’ attention on cash flow and earnings before interest, tax, depreciation and amortization payments--or EBITDA.

John Schreiber, assistant portfolio manager of the Janus Fund, the largest institutional shareholder of AOL and Time Warner, said the dip in AOL shares Monday may represent “a little digestion by Internet investors who previously hadn’t given much thought to ‘real media’ cash-flow valuation and now are getting a crash course.”

And prospects aren’t good for the combined company, AOL Time Warner, to be generating much net income any time soon.

AOL plans to use “purchase accounting” for the deal, which means that over the next 20 years it would have to write off the “goodwill,” or the amount it pays in excess of Time Warner’s net worth. Analysts Monday estimated the goodwill at as much as $150 billion.

But Schreiber noted that Time Warner already has mountains of goodwill from its 1996 purchase of Turner Broadcasting System. “In a way,” he said, “running more goodwill through the company will only hammer home the focus not so much on reported earnings as on what really matters--cash flow.”

One thing that may help prevent AOL’s shares from falling much further is that the merged firm would be “a must-own stock for any growth-oriented money manager,” Schreiber said.

While institutional portfolio managers may have found reasons not to own an Internet firm such as AOL or a media/entertainment giant such as Time Warner, “you’d be taking a huge risk not to own this behemoth,” he said.

“My only concern is what happens to top-line [revenue] growth,” said Ned Brines, a fund manager at Pasadena-based Roger Engemann & Associates, which owns 7 million AOL shares.

AOL’s revenue has been growing at 50% a year, while Time Warner’s growth is in the “low teens,” Brines said.

Internet “pure players” have always justified the stratospheric price-to-earnings multiples of the online sector by pointing to the stratospheric revenue growth. Will they settle for something slower, albeit more predictable and stable?

From the perspective of Time Warner shareholders, Monday’s closing price fell about 18% short of the indicated value of the offer--1.5 times AOL’s closing price.

Analysts said that reflected both normal uncertainty about regulatory or other legal obstacles to the deal being completed and uncertainly about whether AOL’s highly valued shares will hold up over the next year.

In addition, the spread reflects the dwindling number of risk arbitrageurs--professionals who speculate on merger deals. Normally, such speculation would narrow the gap between a target company’s current price and the future value of a deal on the table.

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A Marriage of Titans

Both AOL and Time Warner have seen their stocks rocket just in recent years. Both also share another trait: Neither has made much money for shareholders in terms of bottom-line earnings. In Time Warner’s case, a heavy debt load from the company’s formation has kept earnings limited-- and kept the stock depressed for many years. A comparison of the two giants:

Time Warner

Quarterly closes and latest: Monday: $92.25, up $27.50

* Market capitalization: $119 billion

* 1999 est. revenue: $27.3 billion

* 2000 est. earnings per share: $68 cents

AOL

Quarterly closes and latest: Monday: $72.63, down $1.13

* Market capitalization: $162 billion

* 1999 est. revenue: $4.8 billion

* 2000 est. earnings per share: 32 cents*

*For the year that will end June 30 (estimates from Zacks Investment research)

Revenue estimates from Value Investment Survey

Source: Bloomberg News

History: The Long and the Short of it

Events that shaped the deal in which a tech start-up might devour a venerable media empire founded in 1923.

Time Warner Inc.

* 1923: Henry Luce and Briton Hadden found Time Inc.

* 1923: Harry, Abe, Jack and Sam Warner found Warner Bros.

* 1958: Warner Bros. Records is launched.

* 1961: Time-Life Books is created.

* 1967: Seven Arts Ltd. buys Warner Bros.

* 1969: Warner Bros. is bought by Steven Ross’ Kinney National Services, publisher of Superman Comics and Mad magazine.

* 1972: Warner Bros. changes its name to Warner Communications Inc. Time launches Money magazine and pay-TV service Home Box Office.

* 1958: People magazine is launched.

* 1989: Time Inc. purchases Warner Communications Inc. for $14 billion, resulting in Time Warner, the world’s largest entertainment and media company.

* 1990: Time Warner launches Entertainment Weekly magazine.

* 1996: Times warner and Turner Broadcasting System merge in a $7.6-billion deal.

America Online

* 1985: Steve Case founds America Online Inc. as Quantum Computer Services, an online service for owners of Commodore computers.

* 1989: America Online service is introduced for Macintosh computers

* 1991: Service introduced for IBM-compatible computers. Name changed to America Online

* 1992: AOL begins selling stock on the Nasdaq

* 1994: Service reaches 1 million subscribers

* 1995: AOL teams with Bertelsmann to offer online services in Europe

* 1997: Service reaches 10 million subscribers

* 1998: AOL acquires CompuServe and Net Channel, a provider of interactive TV

* 1999: AOL acquires Netscape Communications, whose browser helped popularize the World Wide Web, and MovieFone, a provider of online movie listings and tickets. Also invests $1.5 billion in DirecTV to develop high-speed services via satellite. Has registered more than 20 million members.

* Jan, 10, 2000: AOL announces purchase of Time warner and plans to become AOL Time Warner Inc.

--SUNNY KAPLAN, Los Angeles Times; and Associated Press