1. AOL Time Warner Merger examine a famous merger case
describe the unique valuation issues surrounding mergers/acquisitions
describe some unique accounting issues surrounding mergers/acquisitions
answer the Zen question: what is
the value of an overvalued stock?
This case posing the Zen question – what is the value of an overvalued stock?
Valuing a merger is basically like any other valuation, except for one key aspect – are there synergies between the two companies that need to be valued as well?
Market evidence, by the way, is that the are generally NOT synergies in mergers. Combined value of two entities falls slightly on announcement. (more later)
TW offers content and access to cable subscribers and infrastructure
AOL offers “new media” channel, tons of users (20M subscribers and growing)

2. AOL Time Warner Merger what business is each company in?
what are the synergies between them?
other motives for mergers in general?
Valuing a merger is basically like any other valuation, except for one key aspect – are there synergies between the two companies that need to be valued as well?
Market evidence, by the way, is that the are generally NOT synergies in mergers. Combined value of two entities falls slightly on announcement. (more later)
TW offers content and access to cable subscribers and infrastructure
AOL offers “new media” channel, tons of users (20M subscribers and growing)

3. Who brought what to the table?
who brought what to the table? Lots of glowing mgt quotes that sound funny now, but remember that these were the heady times of Jan I was living on the coast of australia, times were good.
Who was making more money? The AP write says AOL by a factor of 4, but the financial statements show a more complicated story.

4. America Online
TimeWarner

5. “Merger Facts”
for each share of TW stock, get 1.5 shares of new AOL stock. This much is clear!
pre-merger and pre-announcement
TW has M shares, trading at $64.75
AOL has 2255M shares, trading at $72.88
The premium to TW shareholder
Value to TW shareholder= $72.88x1.5 =
– = premium, or 68.8% increase
the number of shares are questionable, as is the price of AOL (73.75 shows up twice in the case, but is the amount in the proxy statement in the case). I took the number of shares from the basic EPS calculations in the proxy statement, and they jive pretty well with the SEC filing subsequent to the merger. Ignore options etc.
premium calculation assumes 1 share in new entity is worth Think of as AOL issues x 1.5 more shares and gets TW assets. (This is exactly how they account for it.) How much is an additional share of AOL worth? Without considering synergies, it is worth about
Alternatively, could say that they now own approximately 45% of X, where X is the value of the new entity. Using this approach we get the same answer with X= That is, total value of shares in NewCompany held by TW shareholders is (1.5)X and value they had before deal is (64.75). So premium in total $ is difference, and if X is 72.88, then get same premium as on slide, but in total $. Divide by to get per share, and have same answer as before. But, maybe synergies make X bigger!
values: X64.75 = 84272M for TW and 2255X72.88 = 164B. So, premerger, there is =248B of market value. (last slide shows that as of 3/15/2004 there is 78B in value).

6. market’s reaction to announcement
TW stock increases from $64.75 to $90
AOL stock decreases from $72.88 to $72
Is this a common reaction?
Target price increase from one month prior to delisting ranges averages from 53% in 1989 to 72% in 1993.
Hostile takeovers have premiums 30% larger than friendly mergers.
Acquirers’ stock price declines 4%.
see exhibit 2 news article.
Why didn’t the price of TW jump all the way to ? -- deal might not go through.
arbitrage example. buy 1 share of TW at 90 and get, when deal completes, 1.5X, where X is price of AOL at time of close. Then sell short 1.5 shares of AOL. Together, earn
1.5X – 90 on TW and earn 1.5(72 – X) on AOL, so arb is 1.5(72) – 90 = = 18, AS LONG AS DEAL GOES THROUGH!
reactions to merger announcements are taken from a few different studies.

7. Should the stock price change when a firm issues new shares of stock?
Firm’s assets etc. worth $20 and 1 share outstanding.
Issue 1 additional share for $20.
before after
$20 of assets/1share ($20 of assets + $20cash)/2 shares
But is the $20 of cash still worth $20?
Does issuing stock create value? Ans is NO unless proceeds are expected to fund some project that will return more than the cost of capital. Empirically, ans is that price falls about 5% on the announcement of a secondary issue, so mkt thinks the firm is gonna waste the money, or that it knows the stock is over-valued.
Could also argue that the mkt can’t absorb the extra share – not sufficiently deep, so that demand curve is not perfectly elastic.

8. Salomon Smith Barney evaluation of 1.5 exchange ratio
Estimate that TW plus synergies is worth $109.32/shr.
109x(1301.5M) = $142,280M needed in value for TW. Divide by $72.88/AOL shr = 1952M shares to issue / = 1.5.
Where does the 1.5 exchange ratio come from? Hire a bunch of suits (each side), and they do valuation exercise. Here is an example: a) ratio of current mkt values --
note the HUGE range – this is why they never get sued!

9. creating value by issuing over-valued stock
Suppose intrinsic value of AOL was $35.43/share
78020 MktVal / shares in eVal = $35.43/share
If TW is worth $142,000M, and can get it for M x 1.5 shares of AOL stock, then new intrinsic value is
( )/( x1.5) = $52.97/share
NOTE: ans changes using eVal2 because terminal growth is 5%!
note that I am using the eVal # of shares M for AOL. answer is similar if use the 2255M
so, increased the INTRINSIC value by the acquisition! So what, again, is the intrinsic value of AOL?
Suppose, alternatively that AOL was trading at $35.43/share, so to acquire TW at 142B would need to issue 4008 shares (rather than the X1.5, which means that the new exchange ratio is 3.08!). In this case ( )/( ) = 35.43!

10. EPS growth through acquisition
A stock acquisition generally improves EPS if the P/E of acquirer is greater than the P/E of target.
but beware of takeover premia, goodwill amortization and merger-related costs.

11. EPS growth through acquisition – an example
Acquirer has $100 NI and 50 shares, so EPS=$2/share. Price/share = $40, so P/E = 20.
Target also has $100 NI and 50 shares. But Price/share = $20, so P/E = 10.
Acquirer buys Target by issuing 25 new shares to target shareholders. (50 x 20)/40 = 25
New Firm has $200 NI and 75 shares, so
New Firm EPS = $2.67/share.
But what if paid $44 per share for target, so had to issue (50x44)/40 = 55 new shares?
New Firm EPS = $1.90/share.
And then need to lower NI of 200 by goodwill amortization, merger-related charges, extra depreciation on revalued assets, etc.
So, is the TW acquisition accretive to EPS? (ans NO, due to GW.)

12. What is the EPS effect of the Merger?
AOL P/E ratio = $72.88/.37 = 197
using 6/30/99 basic EPS
TW P/E ratio = $64.75/1.51 = 43
using 12/31/99 basic EPS
At TW premium price of ,
P/E = /1.51 = 72
So why is AOL Time Warner pro forma EPS still lower than AOL’s EPS?
Pre-merger PE ratios. For AOL it is $72.88/.48 = For TW it is 43.
Clearly didn’t increase EPS, BUT

13. Pro Forma AOL- Time Warner Income Statement 6/30/99
Will the TW acquisition increase AOL EPS? answer is no, as seen in pro formas given in proxy statement.

14. Deal closes on January 11, 2001
10-K says purchase price was 147B.

15. Regulatory Constraints on Deal
-- Instant Messaging: Option 1: AOL can't offer advanced services, such as video streaming and voice communications, over its Instant Messenger until it grants access to at least one IM rival. Within six months, AOL would have to open up Instant Messenger to at least two more rivals, or shut down advanced services ISPs: AOL and Time Warner mustn't restrict Time Warner's cable subscribers from choosing an Internet-service provider other than AOL Interactive TV: No restrictions on interactive TV, the system that allows viewers to access digital information in real time with television programming. But the FCC said it would begin an inquiry into ways to ensure competition AT&T: AOL-Time Warner and AT&T can't enter into exclusive agreements with each other that will affect rival ISPs' access and terms of access to AOL-Time Warner and AT&T's cable systems. Source: FCC

16. Deal finally closed on Jan. 11, 2001. Value went from $162B to $106B.
What Happened?
Deal closed at around $30/share for AOL. ouch!

17. $60B writedown of goodwill from the TW acquisition
AOL Time Warner Lost $1.82 Billion; Dismal 4th-Quarter Result, While Expected, Sends Stock to 3-Year Low The Washington Post; Washington, D.C.; Jan 31, 2002; Alec Klein;
2001 EPS = $-1.11
Revenue per subscriber at AOL declined for the first time in its history in 2001.
$60B writedown of goodwill from the TW acquisition
Changed name to Time Warner in October 2003
AOL has 10% reduction in subscriber base in 2003
Case, Levin under investigation by SEC
Levin retires Is May Case travels the world making speeches, but does little operational work. Replaced in 2002.
The SEC investigation in october 2003 isn’t related to the deal, at least not directly. Just before the merger, AOL purchased the ownership interest in AOL Europe for Bertlesman. Part of the $7B deal involved Bertlesman agreeing to purchase $400M in advertising from AOL online. AOL booked this as advertising revenue, while the SEC contends that is was really just a rebate on the purchase price (hence, not an income event).
Jerry Levin, Time Warner's "resident genius," lost his job, lost his reputation, and, in the view of some people, simply "lost it." Steve Case, the visionary leader of AOL, was forced out of the company he had created. Gone too was the telegenic wonder-boy Bob Pittman, and his gang of fast-talking salesmen. As for Ted Turner, he resigned from his post as vice-chairman of AOL Time Warner in early 2003, bitter, wiser, and $8.5 billion poorer.
most recent quarter, rev was up for every segment EXCEPT AOL, which was down for the 4th quarter, and year. (yearly was 8.6B).
Home access to the web as of 12/31/2003 was 75% of US. AOL in 2/2003 announces that they will no longer offer broadband access bundled with their content. (very few people were actually buying the bundle, chosing instead to buy their broadband elsewhere. Current mtk cap of TWX is 77B.