Is AOL Paying Too Much for Time Warner?

The most telling–and remarkable–line in all the reams (virtual and real) of commentary and analysis already written about America Online’s $184 billion acquisition of Time Warner was this one, by Justin Lahart of “The high price that AOL is willing to pay for Time Warner suggests that media companies can carry much higher valuations.”

Now, whether it really suggests that at all is an interesting question, which we’ll get to in a minute. But the important thing about this line is the way it illuminates just how dramatic the shift in power in the media world has been over the past three to four years, and how real certain of these supposedly inflated Internet valuations have become. Because in Lahart’s formulation, it’s not Time Warner that’s validating AOL’s business by merging with it. On the contrary, it’s AOL that has that power of validation, not just for Time Warner but apparently for the entire world of offline media. By acquiring Time Warner, AOL seems to be saying, “Content still does matter. There is a market for more traditional forms of journalism and entertainment.” This is a nice thing for “content providers” to hear. But what’s awesome–in that old sense of the word–is that it took AOL to say it for the market to believe it.

From this perspective, what’s really impressive about the deal is that it’s an all-stock acquisition (aside from Time Warner’s debt, which AOL will assume). In other words, this validation of the media business that AOL is apparently performing is being done with a currency that old-media types always used to slag as “debased” or “overinflated.” But neither Time Warner’s management nor the market seems to have any problem with that. As Gerald Levin, Time Warner’s CEO and the prospective CEO of the new company, put it, “We think 45 percent of AOL Time Warner [which is how much Time Warner shareholders will get in the new company] is worth more than 100 percent of Time Warner.” And since Time Warner’s shares ended the day up about 40 percent, investors do, too. Internet money, it seems, is now real money.

That is, as it happens, how it should be. Although there are plenty of Net stocks whose shares are overinflated–just don’t ask me which Net stocks–AOL is not one of them. The company is generating huge amounts of free cash flow every year, its return on invested capital is only going to rise in the future, its subscriber growth remains startling, and switching costs for Internet subscribers are actually higher than people imagine. If Time Warner was worth $83 billion at the end of last week (which the market said it was), AOL was probably worth the $161 billion at which the market was valuing it.

If you think that last sentence is pure madness, then the rest of this will seem equally nutty. But for the sake of argument, let’s say that AOL really is worth what the market says it’s worth. If it is, then the obvious question is: If AOL was twice as valuable as Time Warner on Friday, why is its management making a deal on Monday that treats it as only 1.2 times as valuable as Time Warner?

There are two answers. The first is that Steve Case and Bob Pittman really think their stock is overvalued, and that this is their chance to acquire some assets with real value before the Internet bubble bursts. But I don’t believe they think this at all (and you know Jerry Levin is hoping they don’t). The second, obviously, is that they believe the combination of AOL’s assets with Time Warner’s–both its content (magazines, publishing, TV, movies, and music) and its cable lines–will create more value than the two companies would have created had they remained apart. In other words, they think there actually will be real synergy between the two sets of assets.

Synergy is the great will-o’-the-wisp of mergers, and although I think there’s a plausible case that some real value will be created because of this deal than otherwise would have been (click here for some thoughts on this issue), the only question that matters is whether that value will be equal to the premium AOL is paying for Time Warner’s shares. And given that AOL’s shares actually fell almost 4 percent today, the market’s initial answer is that it won’t. Right now, the market thinks AOL overpaid–as acquirers almost always do–for Time Warner.

Let’s be clear about what it would mean if the market’s right. It wouldn’t mean that AOL Time Warner won’t become the most powerful media company in the world. It wouldn’t mean that the company won’t be incredibly profitable in the future. It wouldn’t even mean that AOL Time Warner isn’t going to create lots of shareholder value in the future. What it would mean is that the difference between the value AOL Time Warner will create and the value AOL would have created on its own (and that includes whatever return it could get on the $184 billion it’s shelling out) will be less than what AOL just paid for Time Warner.

The problem, of course, is that no one keeps track of these things, and a decade from now, when AOL Time Warner has 200 million global Internet/cable TV/wireless subscribers and a market cap of $700 billion, it’s going to be hard to say the deal was a mistake, even if it was. But before we jump to the conclusion that this deal means that other media companies are worth a lot more than we thought they were, it’s worth remembering that if the stock market has been valuing Time Warner and other media companies at X–and has been valuing them that way for a while, since Time Warner’s share price essentially didn’t move in 1999–and AOL comes along and says Time Warner is actually worth almost 2X, our default assumption should not be that media stocks have been undervalued. Steve Case and Bob Pittman are, no doubt about it, brilliant guys. But if you want to know what CBS and Disney are really worth, you’re better off trusting the market than trusting them.