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Two is Still a Crowd

November 2005

Two is Still a Crowd

By Will Swarts
November 15, 2005  

THE FIELD OF bidders interested in buying a piece of Time Warner's (TWX: 17.62, -0.14, -0.8%) America Online unit has narrowed, but the ultimate winner of the high-stakes race for AOL eyeballs is far from certain.

Microsoft and Google remain the principal contenders after Yahoo dropped out of the running last week. (Cable provider Comcast has been linked to Google's overture in published reports.) Time Warner is shopping around a minority stake in its Internet service in a bid to reinvigorate its stock, which is down 8% this year. While management hasn't broken out subscription and advertising revenues for AOL, a sale of the ad segment of the business alone could fetch about $14 billion, according to Merrill Lynch analyst Jessica Reif Cohen. She arrived at the figure in an Oct. 26 research report that estimated AOL ad revenues at $1.4 billion in 2005 and $1.8 billion in 2006. (Reif Cohen doesn't own any of the shares mentioned; Merrill Lynch has investment-banking relationships with Yahoo and Google.) AOL traffic has helped make Time Warner's Internet properties collectively the No. 2 online destination in the U.S., with 119 million unique visitors in September, according to Internet traffic tracker comScore Media Metrix. Although its subscription-based dial-up Internet access is in decline, a victim of the growing popularity of faster broadband services, AOL still has 20.1 million U.S. users and another six million or so paying customers in Europe. Any deal in which AOL changes hands or pairs off in a new partnership would prompt a dramatic realignment of the most-visited rankings on the web. Yahoo is now the top destination, with 123 million unique visitors in September. Microsoft's Internet properties, including MSN, ranked third with 114 million visitors, followed by Google's 87.6 million users.

The 2001 merger between AOL and Time Warner has triggered billions in lost market value, a $2.4 billion shareholder settlement, an additional $600 million set aside for other shareholder claims, and a $5 billion boost in August to the company's stock-repurchase plan. Time Warner CEO Richard Parsons has a great deal riding on the next move for AOL, particularly with financier Carl Icahn, now owner of a 2.9% stake in the media conglomerate, publicly pushing for improvement in the stock price.

"Parsons was responsible for melding the culture of the two companies, and he seems to be among the first to admit that that melding has never taken place," says Ken Marlin, managing partner of Marlin & Associates, a New York investment bank specializing in technology and media. "He clearly understands that Time Warner can't walk away from the Internet as a distribution medium, but he also understands that Time Warner is a content company. For Time Warner, the definition of a perfect deal is one in which Time Warner retains either majority control or significant influence over AOL." (Marlin doesn't own shares of any of the companies mentioned; Marlin & Associates doesn't have an investment-banking relationship with any of the companies mentioned.)

Most analysts agree that management, despite its anxiousness to lift the stock price, will resist giving up control of AOL. By keeping a significant stake, Time Warner preserves an avenue for the online distribution of its considerable content and holds on to its chance to participate in any recovery of the AOL business. The question for Parsons & Co. is which investor makes more sense — and under what terms.

"Market forces are driving [AOL] away from the subscription model of access," says Rob Sanderson, an analyst at American Technology Research, an independent research firm in San Francisco. "The point for Time Warner is they know that the Internet is the fastest growing, most exciting category in media. What they need out of any [AOL] partnership are more ways of maintaining relevance with their user base. It's a question of how they maintain relevance with these people." (Sanderson doesn't own shares of any of the companies mentioned in this article; American Technology Research doesn't do investment banking.)
Instant messaging is one very relevant but often overlooked aspect of the possible AOL realignment that's sometimes lost in the shuffle. While no major media outlet has figured out how to make money with the now ubiquitous technology, Rob Enderle, president of Enderle Group, an independent technology research firm in San Jose, Calif., says its popularity and the web of technological relationships among big media companies is worth considering. (Enderle doesn't own shares of any of the companies mentioned; Enderle Group doesn't do investment banking.)

After years of sparring, Microsoft and Yahoo agreed last month to integrate their instant-messaging technologies so that users of both services could communicate. The pact should bring together MSN Messenger's 29 million active users together with Yahoo Messenger's 21 million users. It could also tap into the pool of about 120 million Microsoft users who aren't actively messaging yet. Google has its own instant-messaging program, Google Talk, which isn't nearly as popular as Yahoo's or Microsoft's. But Enderle says Google could soon integrate its search engine with its instant-messaging service in an effort to derive revenue from IM. That, he says, would leave Google less inclined to make Google Talk compatible with other IM services.

"Right now, there's no easy way for a consumer on one IM client to talk to another, and this would fix that," says Enderle. "Once you have a kind of standard communications model, they could start offering the kinds of things you now have with email client, like spam control and pop-up [ad] blockers."

In the end, though, deep pockets might trump a smoother fit, and Google has plenty of incentive to spend. It will get about 11% of its estimated $4 billion in revenues this year from its AOL partnership — Google has served as AOL's search engine since 2002 — and that could be worth a bigger bid. Google is certainly in a position to afford it. According to its third-quarter earnings report, Google has cash, cash equivalents and marketable securities of just over $7.6 billion. About $4.3 billion of that came from a secondary stock offering that was completed in the quarter.

"Search is in many ways a game of scale, so maybe it's a defensive move for Google not to allow Microsoft to get that kind of momentum in the search market, which they'd essentially buy in a deal with AOL," says Sanderson of American Technology Research. "The opportunity to integrate is probably higher on the Microsoft side, and on the Google side it's probably more of a financial investment."

So does Time Warner pick the deliberative Seattle nerd or the big spender from Silicon Valley? Or, does it choose neither and instead spin out a new company in which it retains a majority stake? With Yahoo out of the running, industry observers don't expect a hastily made choice.

"There's still a lot in motion here," say Sanderson. "Although certain people think something will happen by the end of the year, I don't know why."


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