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AOL Shareholders Take Notice: Deal May Mean End to Soaring Revenue Growth
By Pat Dorsey    

America Online shareholders had better get one thing straight right away: The salad days of 50% revenue growth and 100% earnings per share growth are long gone.

When the recently announced merger with Time Warner is completed, the combined company will have revenues of around $40 billion--and you don't grow a $40 billion top line at 50% per year. (For perspective, Time Warner's revenues increased around 6% between 1998 and 1999.)

I mention this sobering little fact not to throw ice water on the boundless joy with which this merger is being greeted, but simply to remind AOL shareholders (of which I'm one) that they now own a very, very different company than they used to.

Aside from the difference in sheer size, there's also the minor issue of indebtedness. Time Warner is a heavily leveraged company with almost $18 billion in long-term debt on its books, which AOL will assume as part of the merger.

Time Warner paid about $1.5 billion in interest costs during the first nine months of 1999--which is a lot of money when you consider that Time Warner and AOL combined would have only pulled in about $4.6 billion in operating income during the same period. That's 32% of operating earnings that would have gone to interest expense.

There's also the not-so-small issue of goodwill, which is an accounting item created in mergers when the acquiring company pays more for the acquired company than its book--or tangible--value. (For more on goodwill, click here.)

Although Time Warner has a lot of tangible stuff like cable networks, it also has a lot of intangibles, like well-known brand names. What this means is that the combined company will likely have more than $100 billion in goodwill sitting on its books after the deal closes. Because goodwill has to be gradually charged off against earnings (or amortized), it's pretty likely that AOL Time Warner won't be reporting positive net income for many years.

That's the bad news.

The good news is that Wall Street doesn't seem to be focusing on these accounting issues, and it's reasonably likely--though by no means certain--that AOL Time Warner will be judged on its financial performance without taking into account such niceties as goodwill charges and interest expenses. If this is the case, then the deal looks like a smart move from a strategic perspective.

The biggest advantage for AOL, of course, is that it now has access to Time Warner's Road Runner unit, which provides high-speed Internet access over cable lines. Although it was certainly nice for AOL to get its hands on all of Time Warner's valuable media properties, don't be fooled. AOL already has ton of content and would have had zero difficulty licensing more.

The main reason for this deal was Time Warner's massive cable network and the fact that brands such as HBO, CNN, and Sports Illustrated came along with the package was just icing on the cake.

The deal also diversifies AOL's revenue stream in a very big way. Although AOL has recently been getting a greater proportion of its revenue from high-margin sources such as advertising and e-commerce, the company still derives about two thirds of its revenue from old-fashioned subscription fees.

Given that the fee portion of the company's revenues is arguably under siege from the availability of free Internet access, a move toward more diversified revenues is positive. (I'm somewhat skeptical of the just how big the free access threat really is, but that's less of an issue now than it was before the merger. I guess it never hurts to hedge your bets.)

Finally, this deal is a huge win for consumers. AOL Time Warner is a very credible challenger to Excite@Home ATHM, the current 800-pound gorilla of the cable broadband market, and this competition should lead to greater consumer access to broadband services and greater consumer choice of a broadband ISP.

Although Excite@Home's service has about three times as many subscribers as Road Runner's, I would imagine that the AOL marketing machine will do wonders for Road Runner's growth rate.

We do live in interesting times, don't we?

—Pat Dorsey is a senior stock analyst at Morningstar.

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