ON TIME WARNER/AOL STRIKING OUT WITH GOOGLE, YAHOO! AND MICROSOFT?

LET'S (NOT) MAKE A DEAL

Saul Hansell of the New York Times reports tonight that "Time Warner may not be selling a piece of America Online after all".  As the article explains:

"...most of the possibilities under discussion do not involve either company's buying a stake in AOL, an executive briefed on the negotiations said yesterday. Rather, they would involve cooperation on Web search, advertising sales and possibly other areas, the executive said."

The Wall Street Journal seems to report a variation on this scenario, with a Time Warner deal with Microsoft being potentially more likely:

"Time Warner Inc. is closing in on an agreement with Microsoft Corp. to build an online advertising service designed to compete with Google Inc., say people familiar with the negotiations.

After months of on-again-off-again negotiations, the two companies are now focused on a deal that would combine advertising-related assets – with minimal, if any, money changing hands. An agreement is expected to be struck sometime before year-end, but it is still possible that AOL could choose instead to deepen its relationship with Google at Microsoft's expense."

The article goes on to state:

"Under the negotiations, AOL would drop Google as its primary provider of Internet search and use Microsoft's MSN service instead, say people familiar with the talks. Currently, AOL relies on Google's search-engine, and Google gives AOL a cut of the advertising revenue generated by AOL customers. Last year, Google turned over $300 million in revenue to AOL. Their current contract runs well into 2006."

Wow, talk about deja vu. 

Remember when AOL cut a deal with Netscape back in March, 1996 to use it's browser technology instead of Microsoft's?  This was when Netscape was the king of the browser hill.  Then literally over night, AOL cut a deal with Microsoft to exclusively use Internet Explorer instead of Netscape, and essentially began what was a dramatic erosion of Netscape's browser market share vs. Microsoft over the next couple of years* (see footnote for more history).

Google is a whole different story in terms of it's market position on search, but it seems like old habits die hard for Microsoft and AOL.

So looks like anything can still happen, but hefty equity investments in AOL by these third parties may be less likely. 

This has always been a tough proposition from the beginning for a number of reasons:

1. Time Warner is said to want a valuation in the range of $15-20 billion based on the CURRENT value of the AOL cash-flows from it's core ISP subscription business.
2. The subscription business of course continues to erode as the secular trend continues to move the mainstream from narrow-band dial-up to broadband.
3. AOL is trying to move from a "walled garden" subscription environment to a "free", ad-supported portal model like a Yahoo! for it's AOL.com property.
4. The difficulty of separating the ISP from the content businesses, especially given that these are twin businesses are joined at the hip.  Cutting the connection might accelerate the "death" of one or both of the businesses.
5. Time Warner is gun-shy of accepting stock in other "Internet" business given that they feel that they were "burnt" by the AOL merger a few years ago.  And most of the potential partners are likely more inclined to trade stock than a ton of cash given their relatively high valuations.
6. Activist Time Warner investor Carl Icahn and his partners continue to lobby for as aggressive a valuation for AOL as possible.

In many ways, this is reminiscent of the difficulties that the other leading dial-up leaders CompuServe and Prodigy had in the early and mid-nineties, making transitions to their business models while THEIR corporate parents' were struggling with the strategic choices of going it alone and/or selling some or all of the businesses to competitors.  The parents in those two cases were H&R Block for CompuServe, and Sears and IBM for Prodigy.

Time Warner in this instance has been unable  and unwilling to exploit the synergistic opportunities that briefly existed with it's various divisions and AOL for the past five years.  As an outsider it seems it's been because of internal resistance by the various divisions to keep their own turfs rather than to lose individual power at the expense of a stronger and potentially faster growing whole in the longer term.

That being the case, I've been of the opinion for some time that the best alternative for AOL is as a standalone company again.  With the right, focused management, AOL as a standalone has some potent opportunities given the current "Web 2.0" trends and the broader Internet technology tail-winds, EVEN at this seemingly late date.

However, given the reality Time Warner is UNLIKELY to make AOL a standalone entity again, the SECOND most likely outcome is that  the AOL properties are better off WHOLLY with a third party. 

These "third parties" are likely to be a different tier of companies than the "GYM" companies currently kicking the AOL tires in a potential joint venture with TIme Warner.  Joint ventures generally do  not work strategically in the fast-moving technology industries other than in tactical instances. 

These "third parties" are potentially companies like Barry Diller's IAC, Earthlink or even eBay or an Apple.  But those companies are not likely to come anywhere near the valuations currently sought by Time Warner and it's vocal investors.

So Time Warner has some tough decisions to make with no easy answers and alternatives.

But the probability that Google and Microsoft may shy away from equity investments after Yahoo! walking away last month, speaks volumes of the difficulty of coming up with a win-win-win scenario.

In the meantime, AOL continues to melt like ice in an Web world that's heating up again.

FOOTNOTES:

DISCLOSURE:  I was one of the equity research analysts covering AOL as a public company since 1995.

* "How a Giant Software Maker Played Hardball", New York Times, October 1998:

"For both software companies, a deal with America Online, which had five million subscribers at the time, could mean a big surge in browser use and market share.

Netscape seemed the natural partner for America Online, since both companies were Microsoft rivals. On March 11, America Online did announce that it would buy Netscape technology, but it was a standard licensing deal based on a payment-for-use formula. The next day, America Online announced a more significant deal with Microsoft making its browser the default technology -- the browser America Online subscribers would use unless they specifically asked for Netscape's Navigator.

To win the deal, Microsoft offered to give America Online a start-up icon on the Windows desktop -- precisely the kind of equal treatment on the main Windows screen that Case had asked the Justice Department to require of Microsoft. "After we agreed to its Internet Explorer browser, Microsoft allowed us to be bundled on the Windows desktop," Case said. "It was an example of Microsoft's pragmatic side."

Comments

[Chet Geschickter]

Good analysis. I agree that AOL is melting away. There is a good base to monetize. The battleground is the agency world, not the board room.

See my post:

http://www.openmethodllc.com/2005/12/lemonade_part_ii_time_warner_b.html#more