America Online Acquires Time Warner: The Rise and Fall of a Vertically Integrated Internet and Media

America Online Acquires Time Warner: The Rise and Fall of a
Vertically Integrated Internet and Media Giant

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 Time Warner, itself the product of the world’s largest
media merger in a $14.1 billion deal in 1990, celebrated its 10th birthday by
announcing on January 10, 2000, that it had agreed to be taken over by America
Online (AOL) at a 71% premium to its share price on the announcement date. AOL
had proposed the acquisition in October 1999. In less than 3 months, the deal,
valued at $160 billion as of the announcement date ($178 billion including Time
Warner debt assumed by AOL), became the largest on record up to that time. AOL
had less than one-fifth of the revenue and workforce of Time Warner, but AOL
had almost twice the market value. As if to confirm the move to the new
electronic revolution in media and entertainment, the ticker symbol of the new
company was changed to AOL. However, the meteoric rise of AOL and its
wunderkind CEO, Steve Case, to stardom was to be short-lived.

Time Warner is the world’s largest media and entertainment
company, and it views its primary business as the creation and distribution of
branded content throughout the world. Its major business segments include cable
networks, magazine publishing, book publishing and direct marketing, recorded
music and music publishing, and filmed entertainment consisting of TV
production and broadcasting as well as interests in other film companies. The
1990 merger between Time and Warner Communications was supposed to create a
seamless marriage of magazine publishing and film production, but the company
never was able to put that vision into place. Time Warner’s stock
underperformed the market through much of the 1990s until the company bought
the Turner Broadcasting System in 1996. Founded in 1985, AOL viewed itself as
the world leader in providing interactive services, Web brands, Internet
technologies, and electronic commerce services. AOL operates two
subscription-based Internet services and, at the time of the announcement, had
twenty million subscribers plus another two million through CompuServe.

Strategic Fit (A 1999 Perspective)

 On the surface, the two companies looked quite different.
Time Warner was a media and entertainment content company dealing in movies,
music, and magazines, whereas AOL was largely an Internet Service Provider
offering access to content and commerce. There was very little overlap between
the two businesses. AOL said it was buying access to rich and varied branded
content, to a huge potential subscriber base, and to broadband technology to
create the world’s largest vertically integrated media and entertainment
company. At the time, Time Warner cable systems served 20% of the country,
giving AOL a more direct path into broadband transmission than it had with its
ongoing efforts to gain access to DSL technology and satellite TV. The cable
connection would facilitate the introduction of AOL TV, a service introduced in
2000 and designed to deliver access to the Internet through TV transmission.
Together, the two companies had relationships with almost 100 million consumers.
At the time of the announcement, AOL had 22 million subscribers and Time Warner
had 28 million magazine subscribers, 13 million cable subscribers, and 35
million HBO subscribers. The combined companies expected to profit from its
huge customer database to assist in the cross promotion of each other’s

Market Confusion Following the Announcement

AOL’s stock was immediately hammered following the
announcement, losing about 19% of its market value in 2 days. Despite a greater
than 20% jump in Time Warner’s stock during the same period, the market value
of the combined companies was actually $10 billion lower 2 days after the
announcement than it had been immediately before making the deal public.
Investors appeared to be confused about how to value the new company. The two
companies’ shareholders represented investors with different motivations, risk
tolerances, and expectations. AOL shareholders bought their company as a pure
play in the Internet, whereas investors in Time Warner were interested in a media
company. Before the announcement, AOL’s shares traded at 55 times earnings
before interest, taxes, depreciation, and amortization have been deducted.
Reflecting its much lower growth rate, Time Warner traded at 14 times the same
measure of its earnings. Could the new company achieve growth rates comparable
to the 70% annual growth that AOL had achieved before the announcement? In
contrast, Time Warner had been growing at less than one-third of this rate.

Integration Challenges

Integrating two vastly different organizations is a daunting
task. Internet company AOL tended to make decisions quickly and without a lot
of bureaucracy. Media and entertainment giant Time Warner is a collection of
separate fiefdoms, from magazine publishing to cable systems, each with its own
subculture. During the 1990s, Time Warner executives did not demonstrate a
sterling record in achieving their vision of leveraging the complementary
elements of their vast empire of media properties. The diverse set of
businesses never seemed to reach agreement on how to handle online strategies
among the various businesses. Top management of the combined companies included
icons such as Steve Case and Robert Pittman of the digital world and Gerald
Levin and Ted Turner of the media and entertainment industry. Steve Case,
former chair and CEO of AOL, was appointed chair of the new company, and Gerald
Levin, former chair and CEO of Time Warner, remained as chair. Under the terms
of the agreement, Levin could not be removed until at least 2003, unless at
least three-quarters of the new board consisting of eight directors from each
company agreed. Ted Turner was appointed as vice chair. The presidents of the
two companies, Bob Pittman of AOL and Richard Parsons of Time Warner, were
named co-chief operating officers (COOs) of the new company. Managers from AOL
were put into many of the top management positions of the new company in order
to “shake up” the bureaucratic Time Warner culture. None of the Time Warner
division heads were in favor of the merger. They resented having been left out
of the initial negotiations and the conspicuous wealth of Pittman and his
subordinates. More profoundly, they did not share Levin’s and Case’s view of
the digital future of the combined firms. To align the goals of each Time
Warner division with the overarching goals of the new firm, cash bonuses based
on the performance of the individual business unit were eliminated and replaced
with stock options. The more the Time Warner division heads worked with the AOL
managers to develop potential synergies, the less confident they were in the
ability of the new company to achieve its financial projections (Munk, 2004,
pp. 198–199).

The speed with which the merger took place suggested to some
insiders that neither party had spent much time assessing the implications of
the vastly different corporate cultures of the two organizations and the huge
egos of key individual managers. Once Steve Case and Jerry Levin reached
agreement on purchase price and who would fill key management positions, their
subordinates were given one weekend to work out the “details.” These details included
drafting a merger agreement and accompanying documents such as employment
agreements, deal termination contracts, breakup fees, share exchange processes,
accounting methods, pension plans, press releases, capital structures, charters
and bylaws, appraisal rights, etc. Investment bankers for both firms worked
feverishly on their respective fairness opinions. The merger would ultimately
generate $180 million in fees for the investment banks hired to support the
transaction (Munk, 2004, pp. 164–166).

The Disparity between Projected and Actual Performance
Becomes Apparent

 Despite all the hype about the emergence of a vertically
integrated new media company, AOL seems to be more like a traditional media
company, similar to Bertelsmann in Germany, Vivendi in France, and Australia’s
News Corp. A key part of the AOL Time Warner strategy was to position AOL as
the preeminent provider of high-speed access in the world, just as it is in the
current online dial-up world. Despite pronouncements to the contrary, AOL Time
Warner seems to be backing away from its attempt to become the premier provider
of broadband services. The firm has had considerable difficulty in convincing
other cable companies, who compete directly with Time Warner Communications, to
open up their networks to AOL. Cable companies are concerned that AOL could deliver
video over the Internet and steal their core television customers. Moreover,
cable companies are competing head-on with AOL’s dial-up and high-speed
services by offering a tiered pricing system giving subscribers more options
than AOL. Concerns mounted about AOL’s leverage valued at $23 billion at the
end of 2001. Under a contract signed in March 2000, AOL gave German media giant
Bertelsmann, an owner of one-half of AOL Europe, a put option to sell its half
of AOL Europe to AOL for $6.75 billion. In early 2002, Bertelsmann gave notice
of its intent to exercise the option. AOL had to borrow heavily to meet its
obligation and was stuck with all of AOL Europe’s losses, which totaled $600
million in 2001. In late April 2002, AOL Time Warner rocked Wall Street with a
first quarter loss of $54 billion. Although investors had been expecting bad
news, the reported loss simply reinforced anxieties about the firm’s ability to
even come close to its growth targets set immediately following closing. Rather
than growing at a projected double-digit pace, earnings actually declined by
more than 6% from the first quarter of 2001. Most of the sub-par performance
stemmed from the Internet side of the business. What had been billed as the
greatest media company of the twenty-first century appeared to be on the verge
of a meltdown!


The AOL Time Warner story went from a fairy tale to a horror
story in less than 3 years. On January 7, 2000, the merger announcement date,
AOL and Time Warner had market values of $165 billion and $76 billion,
respectively, for a combined value of $241 billion. By the end of 2004, the
combined value of the two firms slumped to about $78 billion, only slightly
more than Time Warner’s value on the merger announcement date. This dramatic
deterioration in value reflected an ill-advised strategy, overpayment, poor
integration planning, slow postmerger integration, and the confluence of a
series of external events that could not have been predicted when the merger
was put together. Who knew when the merger was conceived that the dot-com
bubble would burst, that the longest economic boom in U.S. history would
fizzle, and that terrorists would attack the World Trade Center towers? While
these were largely uncontrollable and unforeseeable events, other factors were
within the control of those who engineered the transaction.

The architects of the deal were largely incompatible, as
were their companies. Early on, Steve Case and Jerry Levin were locked in a
power struggle. The companies’ cultural differences were apparent early on when
their management teams battled over presenting rosy projections to Wall Street.
It soon became apparent that the assumptions underlying the financial
projections were unrealistic as new online subscribers and advertising revenue
stalled. By mid 2002, the nearly $7 billion paid to buy out Bertelsmann’s
interest in AOL Europe caused the firm’s total debt to balloon to $28 billion.
The total net loss, including the write-down of goodwill, for 2002 reached $100
billion, the largest corporate loss in U.S. history. Furthermore, The
Washington Post uncovered accounting improprieties. The strategy of delivering
Time Warner’s rich array of proprietary content online proved to be much more
attractive in concept than in practice. Despite all the talk about culture of
cooperation, business at Time Warner was continuing as it always had. Despite
numerous cross-divisional meetings in which creative proposals were made,
nothing happened (Munk, 2004, p. 219). AOL’s limited broadband capability and
archaic email and instant messaging systems encouraged erosion in its customer
base, and converting the wealth of Time Warner content to an electronic format
proved to be more daunting than it had appeared. Finally, both the Securities
and Exchange Commission and the Justice Department investigated AOL Time Warner
due to accounting improprieties. The firm admitted having inflated revenue by
$190 million during the 21-month period ending in the fall of 2000. Scores of
lawsuits have been filed against the firm.

The resignation of Steve Case in January 2003 marked the
restoration of Time Warner as the dominant partner in the merger, but with
Richard Parsons as the new CEO. On October 16, 2003, the company was renamed
Time Warner. Time Warner appeared to be on the mend. Parsons vowed to simplify
the company by divesting noncore businesses, reduce debt, boost sagging morale,
and revitalize AOL. By late 2003, Parsons had reduced debt by more than $6
billion, about $2.6 billion coming from the sale of Warner Music and another
$1.2 billion from the sale of its 50% stake in the Comedy Central cable network
to the network’s other owner, Viacom Music. With their autonomy largely
restored, Time Warner’s businesses were beginning to generate enviable amounts
of cash flow with a resurgence in advertising revenues, but AOL continued to
stumble, having lost 2.6 million subscribers during 2003. In mid-2004,
improving cash flow enabled Time Warner to acquire for $435
million in cash.

Case Study Discussion Questions

1. What were the primary motives for the AOL and Time Warner
transaction? How would you categorize them in terms of the historical motives
for mergers and acquisitions discussed in this chapter?

 2. Although the AOL Time Warner deal is referred to as an
acquisition in the case, why is it technically more correct to refer to it as a
consolidation? Explain your answer.

 3. Would you classify this business combination as a
horizontal, vertical, or conglomerate transaction? Explain your answer.

4. What are some of the reasons AOL Time Warner failed to
satisfy investor expectations?

 5. What would be an appropriate arbitrage strategy for this
all-stock transaction?

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