AOL Time Warner MergerAOL Time Warner Merger examine a famous merger caseexamine a famous merger case describe the unique valuation issues describe the unique valuation issues

surrounding mergers/acquisitionssurrounding mergers/acquisitions describe some unique accounting issues describe some unique accounting issues

surrounding mergers/acquisitionssurrounding mergers/acquisitions

answer the Zen question: what is answer the Zen question: what is

the value of an overvalued stock?the value of an overvalued stock?

AOL Time Warner MergerAOL Time Warner Merger

what business is each company in?what business is each company in?

what are the synergies between them?what are the synergies between them?

other motives for mergers in general?other motives for mergers in general?

Who brought what to the table?

TimeWarner

America Online

““Merger Facts”Merger Facts”

for each share of TW stock, get 1.5 shares of for each share of TW stock, get 1.5 shares of new AOL stock. new AOL stock. This much is clear!This much is clear!

pre-merger and pre-announcementpre-merger and pre-announcement TW has 1301.5M shares, trading at $64.75TW has 1301.5M shares, trading at $64.75 AOL has 2255M shares, trading at $72.88AOL has 2255M shares, trading at $72.88

The premium to TW shareholderThe premium to TW shareholder Value to TW shareholder= $72.88x1.5 = 109.32.Value to TW shareholder= $72.88x1.5 = 109.32. 109.32 – 64.75 = 44.57 premium, or 68.8% increase109.32 – 64.75 = 44.57 premium, or 68.8% increase

market’s reaction to market’s reaction to announcementannouncement

TW stock increases from $64.75 to $90TW stock increases from $64.75 to $90

AOL stock decreases from $72.88 to $72AOL stock decreases from $72.88 to $72

Is this a common reaction?Is this a common reaction? Target price increase from one month prior to Target price increase from one month prior to

delisting ranges averages from 53% in 1989 to 72% delisting ranges averages from 53% in 1989 to 72% in 1993.in 1993.

Hostile takeovers have premiums 30% larger than Hostile takeovers have premiums 30% larger than friendly mergers.friendly mergers.

Acquirers’ stock price declines 4%.Acquirers’ stock price declines 4%.

Should the stock price change Should the stock price change when a firm issues new shares when a firm issues new shares

of stock?of stock? Firm’s assets etc. worth $20 and 1 Firm’s assets etc. worth $20 and 1

share outstanding.share outstanding. Issue 1 additional share for $20.Issue 1 additional share for $20.

beforebefore afterafter$20 of assets/1share ($20 of assets + $20cash)/2 $20 of assets/1share ($20 of assets + $20cash)/2

sharesshares

But is the $20 of cash still worth $20?But is the $20 of cash still worth $20?

Salomon Smith Barney Salomon Smith Barney evaluation of 1.5 exchange evaluation of 1.5 exchange

ratioratioEstimate 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. 1952/1301.5 = 1.5.

creating value by issuing creating value by issuing over-valued stockover-valued stock

Suppose intrinsic value of AOL was $35.43/share Suppose intrinsic value of AOL was $35.43/share 78020 MktVal /2201.8 shares in eVal = $35.43/share78020 MktVal /2201.8 shares in eVal = $35.43/share

If TW is worth $142,000M, and can get it for If TW is worth $142,000M, and can get it for 1301.5M x 1.5 shares of AOL stock, then new 1301.5M x 1.5 shares of AOL stock, then new intrinsic value isintrinsic value is

(78020 + 142000)/(2201.8 + 1301.5x1.5) = (78020 + 142000)/(2201.8 + 1301.5x1.5) = $52.97/share$52.97/share

EPS growth through EPS growth through acquisitionacquisition

A stock acquisition generally A stock acquisition generally improves EPS improves EPS ifif the P/E of acquirer is the P/E of acquirer is greater than the P/E of target.greater than the P/E of target.

butbut beware of takeover premia, goodwill beware of takeover premia, goodwill amortization and merger-related costs.amortization and merger-related costs.

EPS growth through EPS growth through acquisition – acquisition – an examplean example

Acquirer has $100 NI and 50 shares, so Acquirer has $100 NI and 50 shares, so EPS=$2/shareEPS=$2/share. Price/share = $40, so . Price/share = $40, so P/E = 20P/E = 20..

Target also has $100 NI and 50 shares. But Target also has $100 NI and 50 shares. But Price/share = $20, so Price/share = $20, so P/E = 10P/E = 10..

Acquirer buys Target by issuing 25 new shares Acquirer buys Target by issuing 25 new shares to target shareholders. (50 x 20)/40 = 25to target shareholders. (50 x 20)/40 = 25

New Firm has $200 NI and 75 shares, so New Firm has $200 NI and 75 shares, so New Firm EPS = $2.67/shareNew Firm EPS = $2.67/share..

But what if paid $44 per share for target, so But what if paid $44 per share for target, so had to issue (50x44)/40 = 55 new shares? had to issue (50x44)/40 = 55 new shares?

New Firm EPS = $1.90/shareNew Firm EPS = $1.90/share..

•AOL P/E ratio = $72.88/.37 = 197AOL P/E ratio = $72.88/.37 = 197

•using 6/30/99 basic EPSusing 6/30/99 basic EPS

•TW P/E ratio = $64.75/1.51 = 43TW P/E ratio = $64.75/1.51 = 43

•using 12/31/99 basic EPSusing 12/31/99 basic EPS

•At TW premium price of 109.32, At TW premium price of 109.32,

•P/E = 109.32/1.51 = 72P/E = 109.32/1.51 = 72

So why is AOL Time Warner pro forma EPS still So why is AOL Time Warner pro forma EPS still lower than AOL’s EPS?lower than AOL’s EPS?

What is the EPS effect of the Merger?

Pro Forma AOL- Time Warner Income Statement 6/30/99

Deal closes on January 11, 2001

-- 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

Regulatory Constraints on Deal

What Happened?What Happened?Deal finally closed on Jan. 11, 2001. Value went from $162B to $106B.

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