Putting a price tag on AOL Time Warner

The answer is no trivial matter for investors, as it will be the key to determining how AOL shares are valued, either as a rapid-growth Net company or as a plodding media conglomerate.

"How should investors value it?" asked John Corcoran, the Internet and new media analyst for CIBC World Markets. "That's a great question."

AOL Time Warner, which secured approval from the Federal Trade Commission on Thursday, unites the leading Internet service provider with one of the largest cable operators in the United States. The $109 billion merger still faces scrutiny by the Federal Communications Commission, but the company is likely to sail past its final regulatory hurdle and become a merged entity.

Under the deal, Time Warner shareholders will receive 1.5 shares in the combined company for each share they hold, while AOL shareholders will receive one share.

But for new investors and shareholders weighing whether to accumulate or sell, divining the value of the stock will be vastly more complicated than the simple terms of the stock swap. Although the stock market has in recent months resumed its reliance on traditional financial benchmarks to value companies, determining the value of AOL Time Warner is likely to remain a murky exercise.

AOL trades at a price-earnings ratio of about 89. Time Warner, however, has an even higher price-earnings ratio of about 110, largely because the stock has been tied to the lofty AOL price since the merger was announced last January.

Shares of Walt Disney--which might be considered a similar company because of its vast content and ownership of ABC Television Network and the ABC Radio Networks--trade at a price-earnings ratio of about 50.

Analysts say the stock market will probably not value the company like any of its current competitors, which range from Internet portal Yahoo to major media companies such as Viacom and News Corp. That means AOL Time Warner will probably not produce overnight millionaires based on rapid increases in the stock price, but it will also avoid the dramatic declines that many Internet stocks have suffered this year.

Analysts also doubt that AOL Time Warner will behave as steadfastly as traditional media company stocks, which generally rise and fall in sync with economic cycles and rarely reach the peaks or valleys of the tech sector.

Up in the air
But other than those general guidelines for divining what AOL Time Warner stock will be worth in six months or a year, analysts say, the value of the stock is anyone's guess.

"It's something that really can't be pigeonholed," Corcoran said. "It's not a major online company that bought a small piece of the Old Economy. It's not the Old Economy company buying a small piece of the New Economy...We can't say, 'We expect a (price-earnings) ratio of y.' This company has moved beyond that because the two parts were so big as standalones."

Complicating the task of trying to estimate 12-month target prices--a common estimate required of many financial analysts--is the stock market shift that has radically changed the values of Internet companies in recent quarters.

Although the late-'90s bull run was predicated on the idea that the Internet would fundamentally change the way people conducted and created businesses, investors have beat a steady retreat from tech stocks since the spring, when the Nasdaq hit an all-time record and economists began to worry that the markets were overvalued.

Although AOL has not hit the dramatic lows of some competitors, its value has changed significantly since the merger was announced in January. Based on their market capitalizations at the time of the announcement, a combined AOL Time Warner would have had a value of about $350 billion. Today, the combined company will be worth closer to $214 billion, with AOL's market value at $116 billion and Time Warner's at $98 billion.

Some analysts say that AOL's stock price has become artificially deflated because of the downturn of the broader tech sector, and that it represents a unique buying opportunity.

Robert Martin of investment house Friedman Billings Ramsey in Arlington, Va., ranks AOL a "buy" and has a 12-month target price of $90 per share--nearly double its current price. He noted that the company is growing at roughly twice the pace of traditional media rivals.

When asked whether the markets will perceive AOL Time Warner as an Internet company or a more traditional media company, Martin didn't hesitate.

"Neither," he said. "It's a cash-flow company."

Positive overlap
Martin and other analysts mentioned the company's intention to reap $1 billion in synergies from the deal, based on economies of scale from cross-promotional marketing campaigns and bulk advertising buys.

In October, executives of both companies made a compelling case for how they might reap potential synergies of $1 billion. They said that of the 100 biggest advertisers on AOL, the top 100 in Time Inc. magazines, and the top 100 on Turner cable networks, only four were on more than one list. Skeptics say that lack of overlap represents little more than faulty coordination at Time Warner, but others say that it is a major opportunity for the combined company.

Martin also said that the Time Warner component of the new company creates something of a "backstop" against the massive stock declines of other companies that are more squarely in the technology sector.

"In investors' minds, they're evaluating the risk of AOL's story, and the risk is now less than prior to the merger based on consistency of cash flow of the Time Warner entities," he said. "But keep in mind those entities are growing at much slower rates of growth."

Analyst Abhishek Gami, principal at the Chicago office of investment firm William Blair, rates AOL a "strong buy" and believes the combined entity could emerge as "the best of both the old and new worlds if they execute well." But he and others noted that the company is difficult to analyze from a financial standpoint, and several analysts who have covered AOL and Time Warner are bailing out of coverage as the companies merge.

"For AOL analysts, the business model was very straightforward--easily understandable and modelable," Gami said. "But Time Warner, they run in six or seven different industries, from music to film and TV, and each has its own growth rates, growth drivers, etc. For modeling purposes, blending the two becomes an exercise in advanced mathematics.

"I wouldn't say anything new has been created out of the merger," Gami continued. "The same Time Warner numbers out there before the merger you can still use to predict valuations. But now we have to see how much AOL can goose the Time Warner numbers through cross-promotion and marketing deals, and how much Time Warner can goose the AOL numbers. It will be rough."