What's The Deal: Rewinding The Spinoff Strategy

When will AOL Time Warner Inc. issue a tracking stock for the fast-growing online part of the combined business?

The question is facetious, but the concept it represents has been the guiding light for many mainstream companies and Internet stock investors.

All manner of major companies, from CBS/Viacom and the New York Times to Tandy Radio Shack and Wal-Mart have been organizing their Internet activities so that stakes in them can be sold in IPOs. The idea is to "unlock the value" of the Internet operations and create stock that can be used to acquire other Netcos and deter employees from defecting to dot-com startups.

Many of these re-orgs are more than paper shuffling. The Internet units are actually separated from the core business. The theory is that they need space from the old economy operations they are destined to replace.

By their deal, AOL and Time Warner say that's wrong. They are betting $200 billion of stock market value that tight integration of their assets and skills is essential to long term success.

To look at the numbers though, you'd think AOL is crazy because the deal lowers the octane level of AOL's growth from rocket fuel to unleaded medium.

At the outset, the combined company will have a revenue growth rate only half that of AOL alone. That's because Time Warner's revenue is more than four times AOL's but is growing less than half as fast. What's more, the profit margin of the new company will begin at barely half that of AOL alone; and the 12 percent, five-year profit growth rate Wall Street has projected for Time Warner is just a fourth of that projected for AOL.

Assuming no change in projected rates for the individual businesses, it would take nearly three years for the profit margins of the combined company to equal those of AOL today. It would take a decade to match Microsoft's current profit margins, which AOL was expected to do within five years.

Obviously, AOL envisions that becoming enmeshed with Time Warner can create growth and profit that will make up the difference; and that the impact of lower-octane stock options on retaining employees is manageable.

All of this has to make mainstream companies rethink the wisdom of spin-off-your-dot-com.

Of course, whether AOL and Time Warner can seamlessly combine to greater glory isn't yet known. To be fair, their deal was possible only because AOL is profitable. The Internet operations of most mainstream companies gush red ink.

Investors don't like to see that messing up the bottom line of the core business. But they willingly accept the losses packaged in dot-com stock.

Still, the AOL-Time Warner deal says that the old economy is worth a lot more than Net stock investors have come to believe. Their immediate focus is on how humongous Net stock valuations such as AOL's enable the new economy media to buy old media. That had the immediate effect of goosing shares of companies such as News Corp. and Disney.

The alternate perspective is that Netcos' need for the assets of the old economy means that Internet valuations are too high, and those of the old economy too low. After all, AOL valued Time Warner at a 70 percent premium in the deal.

Most importantly, the deal's focus on the companies' long-term melding forces investors to think at least subconsciously about Internet businesses more as businesses than as stock that exists in another dimension.

Unfortunately, greed smothers intellect. Whether the deal really changes the rules remains to be seen. Investors are already grappling with the realization that the AOL stock they've loved for so long just isn't AOL anymore. The year or more that it will take for the deal to close and to gain traction is several Internet lifetimes.

So maybe the question of whether AOL Time Warner will create a tracking stock won't turn out to be facetious. Eventually though, it will become irrelevant, just as AOL and Time Warner envision. Exactly how the old and new economies will blend is another question, but companies that focus on keeping the two separate may not be around to find out.

David Simons is managing director of Digital Video Investments, an institutional research firm. Write to him at mailto: simonsd@digvid.com.

At the time of publication, neither DVI nor any of its employees had securities positions in any of the companies mentioned herein. This column is solely for information purposes. Under no circumstances is it to be construed as a recommendation to buy or sell securities. Neither DVI nor the author can provide investment advice to individuals.

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