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Giving up on AOL Time Warner

Two years into its merger, the much ballyhooed media giant is a shambles. Was the merger ill-conceived to begin with? Wharton weighs in.

When America Online bought Time Warner for $103.5 billion in January 2001, the plan was to meld new-economy Internet prowess with old-economy content and cutting-edge broadband delivery. The scheme's designers boasted they would create the world's largest corporation. Two years later, AOL Time Warner is a shambles.

Was this just bad luck? Was the merger ill-conceived? Or is this disastrous performance--the stock has fallen nearly 90 percent--an object lesson in the perils that confront any mega-merger?

Peter S. Fader, Wharton marketing professor, suggests that perhaps the AOL Time Warner strategy wouldn't have worked even if the Internet bubble had not burst and the economy had not skidded into recession. "Synergies can't be manufactured," he said. "In fact, in many cases, synergies are more a myth than a reality. To the extent they exist, it is serendipity."

Some analysts believe the stock, trading around $10 compared with $91 in late 1999, is at or near bottom. And some argue it could surge if the economy improves, if the company faces no new accounting scandals and if the turmoil in the executive suite subsides. But only about one-third of those covering the company recommend it to investors.

The America Online unit suffers the biggest problems. Advertising has shriveled. And the number of subscribers declined, for the first time, in the fourth quarter of last year. The Securities and Exchange Commission and Justice Department are investigating accounting irregularities that appear to have inflated revenue. Advertising has also fallen at Time Warner publications although some units, such as HBO, are doing well.

In addition, AOL Time Warner has blindsided investors with announcements like a recent $45.5 billion asset write-down, mostly for lost goodwill in America Online. In January, it announced a staggering $98.7 billion loss for 2002.

Aggressive accounting
Most alarming to investors and analysts is evidence that the problems are not confined to the America Online side, which has been troubled for two years, but also include Time Warner's cable operations. Analysts have been annoyed by the company's habit of aggressive accounting for advertising revenue. Advertising for new cable deals was booked for the year the deals were established even though many of those fees would not come in for years. Other companies spread the accounting for such revenue over the life of the contracts.

Then there are the battles for control. The two chairmen who engineered the merger, America Online's Steve Case and Time Warner's Gerald Levin, have stepped down, as has vice chairman Ted Turner. Most of the top America Online executives who had dominated the company after the merger have been driven out. Time Warner executives are in control.

The faith in synergy--the foundation of the merger--has been shaken.
The current chief executive, Richard Parsons, is struggling to reduce the company's enormous $29 billion debt to preserve its investment-grade debt rating and may resort to selling the book publishing, music and other units. A minority portion of Time Warner Cable is to be sold in an initial public offering this spring. AOL Time Warner's share of Comedy Central, Court TV and three sports franchises in Atlanta are on the market. There's even speculation that the most troubled part of the business, America Online, will be sold. AOL Time Warner's share of satellite company Hughes Electronics was sold in January, fetching $800 million, about half what the company paid for it in 1999.

Most important, the company is rethinking its initial strategy of bringing diverse content, Internet and cable operations under one roof. The faith in synergy--the foundation of the merger--has been shaken.

To be sure, the Internet meltdown, recession and slow recovery have made things worse than they would otherwise have been.

"There is the bad luck part," says Daniel A. Levinthal, a Wharton management and economics professor, who was skeptical about the strategy from the beginning. "You have this melding, and it turns out that it's not worth nearly as much as in the heady days of the bubble." Just as the tech bubble had inflated America Online's value, the tech bust caused it to collapse. And the weak economy has undercut many businesses that rely on advertising.

And yet many experts had doubts about the strategy from the start. In any merger, said Levinthal, the key question is whether it will accomplish something that could not be done more simply in other ways.

Siren song of content
In announcing the merger, for example, executives of the two companies said that they wanted to provide America Online's Internet subscribers the music and publishing information offered by Time Warner and that they wanted to use Time Warner's cable operations to deliver that data online at lightening speed.

Much of this, according to Levinthal, might have been accomplished with licensing agreements and joint ventures, while keeping the companies separate. That would have avoided all the difficulties of blending two very different corporate cultures, and it would have made it easier to abandon joint projects that weren't panning out.

Time Warner...had long failed to make cross-selling really work.
"The fact that there is a potential leveraging doesn't automatically mean there ought to be a merger," he says. "There can be a big gap between the latent economic opportunities and the organizational challenges to making it happen."

One of the expected synergies, he notes, was cross-selling--each company selling its services to the other's customers. But Time Warner was already an enormous, diverse company with movie, music and publishing operations, and it had long failed to make cross-selling really work.

Gerald R. Faulhaber, professor of business and public policy and management, said that when the merger was announced, he and many other experts assumed the real motive was for America Online to get access to Time Warner's cable systems, even though the companies emphasized their goal of offering Time Warner's content to America Online customers. "Turns out we were wrong and they were telling the truth," Faulhaber said. "They thought it was about content...I never thought that made any sense whatsoever."

America Online didn't need to pay a fortune for content, he said, because many content providers were eager to provide it. Many, in fact, were paying for the privilege.

"I think the merger in some sense caused them to focus on the wrong stuff," said Faulhaber, who was chief economist at the FCC while it was evaluating the proposed merger. America Online "tried to become a content company. I think it was a huge mistake for them to do that."

America Online's success came from its expertise as a brash consumer marketing company skilled at providing peer-to-peer services such as chat rooms and e-mail, he said. "They do it very well, and that's why people like it," Faulhaber said. Faulhaber adds that Case "lost touch with his basic success strategy." America Online, for example, had a hit with instant messaging. "Well, what's the next instant messaging? They haven't had it. They've been too busy screwing around with television programs."

A big public hug
At the same time, AOL Time Warner has not been very aggressive about capitalizing on the broadband potential in its cable operations. It has not kept up with competitors such as Comcast, which is pushing on-demand television programming, and Cox, which is developing cable telephone service, Faulhaber said, pointing out that "Time Warner basically isn't a leader in any of those things."

In addition to unlucky timing and flaws in strategy, the AOL Time Warner merger suffers from problems often found when big companies try to get together.

Big mergers are often driven by executive ego or other factors aside from sound business strategy.
"There's really something to be said for corporate culture," says Fader. "A big public hug is not enough to make two organizations sync up with each other...It's almost like doing an organ transplant. Each organization is going to reject parts of the other, and in the process make itself less healthy. Both organizations really lost a lot, including people who had to, or chose to, go elsewhere."

According to Faulhaber, big mergers are often driven by executive ego or other factors aside from sound business strategy. "Small mergers happen because people think very carefully about them," he said. "With big mergers you would expect people to think more carefully about them, but for some reason they don't. Some of the big mergers tend to be smoke and mirrors...and they crash and burn."

This is a crucial year for the company. AOL Time Warner CEO Parsons has vowed to drastically reduce debt, and that will probably require it to unload major assets.

"The irony of it all is that in the long, long, long run, their plan makes perfect sense," Fader said. "In the long run, the kind of convergence they were talking about will occur...Perhaps eventually they will be proven right. But the bleeding between now and then is hard to justify...The only way out is, indeed, to sell chunks and try to focus on each of the separate businesses. I think that's the right way to go."

Faulhaber, however, asserts that AOL Time Warner could turn itself around if it regained some of the innovative thinking represented by the old Steve Case. Faulhaber is not convinced asset sales are the solution. "To me, that's giving up," he said. "That's basically saying, 'I don't know how to manage my business.'"

 
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All materials copyright © 2003 of the Wharton School of the University of Pennsylvania.