More on the AOL Time Warner merger, which this book described as "the con of the century." Ouch. Hindsight is 20/20, and it's easy to forget that much conventional wisdom celebrated the merger when it was announced. But if you examine the facts on the ground at the time in the context of certain unbreakable laws of business economics, as they were known to the participants at the time, it's difficult to escape the conclusion that the AOL Time Warner merger was . . . the con of the century. Specifically, Time Warner's decision to give half of itself away in exchange for half of AOL was unjustifiable even in those heady days.
Only two things could have possibly justified Time Warner's decision. The first is that there were enough merger-related synergies, either marginal revenues that only a merger could bring about and/or marginal cost cuts that only a merger could enable. The AOL Time Warner crew trumpeted total potential EBITDA synergies of $1 billion, which no one should have believed. AOL's total EBITDA at the time was $1.8 billion; it was more than a stretch to believe that number could nearly double just by joining the Time Warner family. If you want to read more, check out "The Curse of the Mogul."
The second thing is that AOL was actually worth what Time Warner gave up for it. What was the ex ante probability that that was true?
a) Time Warner was technically acquired at a 71% premium to its market price--if you invert the math you can also say that Time Warner bought AOL at a 42% discount to its market price.
b) AOL's stock closed at $73.75 on the eve of the merger announcement. With about 2.61 billion diluted shares outstanding, that means it had a merger-day market cap of $192.5 billion.
c) AOL's EBITDA for the FY ended 6/30/2000 was about $1.8 billion. Give the company the benefit of the doubt and assume that EBITDA is a useful proxy for the cash generating ability of the business--it works out to 26% margins on FY 2000 revenue of $6.886 billion. That's a good business.
d) $192.5 billion divided by $1.8 billion equals 107. AOL was trading for 107 times that year's cash flow when it merged. Time Warner paid a 42% discount, so it paid a multiple of 62 times that years' cash flow for AOL.
Under what circumstances is it justified to pay 62 times cash flows for a business? Only when the future cash flows of that business are so high as to justify it. Did Time Warner have reason to believe this when it decided to give half of itself away? Consider the following:
i) Just on general capitalist principle, it's extremely rare that a large public company ever grows into a cash flow multiple of 62 times. There is a chart on page 107 of my edition of "Stocks for the Long Run" that shows the "warranted P/E ratio" of each of the legendary Nifty Fifty stocks of 1972, those companies widely considered the best companies in the world. "Warranted P/E ratio" is defined as: that P/E ratio that would have produced a total return from 1972-1997 equal to the 1972-1999 returns of the S&P as a whole. In other words, "warranted P/E ratio" answers the question "How much should an investor have paid, as a multiple of that year's earnings, for a stock, given its subsequent earnings growth?" Of the entire Nifty 50, only three had a warranted P/E ratio above 62 times. One sold water flavored with sugar, caffeine, and some other stuff listed in a bank vault in Atlanta. One sold little sticks of tobacco that happened to be addictive. And the third sold pharmaceutical drugs. Everyone else came up short. It's extremely rare for a public company to grow into a cash flow multiple of 62 times.
ii) Just on general human nature principle, it's extremely rare that when someone comes to you and offers to sell his company to you for the "bargain price" of 62 times cash flow, that you are in fact getting a bargain. "Why come to me? What have I done to deserve such generosity?" is the better response.
iii) The only way to be one of the extremely rare companies that can grow into a 62x multiple is to have a really really good moat in a growing industry, and the former is more important than the latter. That AOL was in a fast-growing industry was true. That it had a really really good moat was less true.
Let's examine the state of AOL's moat as of January 2000. Think back to the supply chain that allowed a layperson like me to access this new thing called the internet:
1) First I turn on my computer. More than likely this computer was a PC running Microsoft Windows.
2) I click on the "dial in to AOL" button, which triggers my modem to dial a telephone number and make that noise we all remember.
3) On my screen appears "Welcome to AOL" and "You've Got Mail!" and off I go. There are many many web pages owned by AOL, and I spend my entire session on them, looking at AOL-sold advertisements in the process.
Who did I pay along the way? I paid something to Microsoft when I bought my PC, for access to its operating system. I paid something every month for the use of the phone line that my modem used. Then I paid AOL a monthly subscription for its very user-friendly way of accessing the internet, and for its very fun and informative and user-friendly web pages it directed me to. As a bonus, a bunch of advertisers paid AOL to show their ads on its virtual real estate that I viewed. These advertisers paid a lot of money to AOL because the internet was new and exciting, and because AOL had all these customers seemingly locked in. It was a "walled garden," and in fact the AOL Time Warner merger even drew scrutiny from antitrust authorities and experts like Lawrence Lessig because they thought that with the addition of all the Time Warner online content the new company would be even more of a walled garden, favoring its own sites over non-AOL and non-Time Warner sites.
That was how I and many others accessed the new thing called the Internet circa January 2000. AOL had two moats: it was a toll bridge that charged consumers about $20/month for its user-friendly way of getting on the internet. And it was a toll bridge that charged advertisers for the privilege of selling stuff to its 23 million subscribers.
Now I have a confession to make. I've been fibbing a little. That was not how I accessed this new thing called the internet circa 2000, which, it's important to note, wasn't so new by then. It was how my mother accessed the internet circa 2000. I, on the other hand, was a senior in college by then. Here is how I accessed the internet. See if it sounds familiar:
1) First I turned on my computer. This computer was a PC running Windows, an operating system I paid Microsoft for up front when I bought my computer. I also paid Microsoft up front for the operating system when I bought a new computer in 2007. And I'll probably pay them a little when I buy my next computer. Something tells me you will too. As this guy might say: "That's not a moat . . . THAT's a moat."
2) I didn't need AOL at all to help me access the internet, nor did I need a phone line. My college had wired my dorm with ethernet, so I just plugged my computer into the ethernet jack. I didn't click an AOL button either because by that time my Windows operating system had a button that allowed me to open a browser called Internet Explorer. The browser allowed me to get right on the internet with no problem and no AOL. And it was free to use--actually it was bundled into the upfront cost of my operating system, but I didn't pay much attention to that at the time. Microsoft fought something called a "Browser War" for the right to bundle its browser with its operating system. It won that war: by the time of the AOL Time Warner merger it had a browser market share of 80% and growing, up from approximately zero in 1996.
3) When I finally reached the internet, I had very little interest in AOL's websites or email. I had my own email address by then, and by then there were maybe a billion web sites that were not owned by AOL or Time Warner. I cared about investing, so I spent a lot of time on Yahoo! Finance. I cared about my college, so I spent a lot of time on my college's web site. I cared about fitness, so I spent a lot of time on the web sites of a few gurus who knew how to build web sites from their basements using something called HTML. I cared a lot about sex, so . . . never mind. The point is, by the year 2000 you could spend the entire day surfing the internet without ever encountering one AOL web site. And the growth of non-AOL web sites was expotential. So exponential, in fact, that a bunch of people were already trying to figure out how to help organize it all. One team, two Stanford graduate students named Larry and Sergei, had just six months before managed to attract $25 million of venture capital. And advertisers were paying attention. With every passing month AOL's advertising real estate diminished as a percentage of the total advertising real estate available. As far as I was concerned, AOL's moat was non-existent.
Again, hindsight is always 20/20, but Time Warner really had no excuse for assuming AOL's moat would continue:
1) As a general rule, technology that's easy for college students to use eventually becomes easy for their mothers to use.
2) Time Warner could have and should have known that non-AOL and non-Time Warner advertising real estate was growing exponentially, which would inevitably diminish the value of its own real estate.
3) Most importantly, and most inexcusably, the seeds of AOL's eventual moat destruction were being sown . . . within Time Warner itself! Time Warner Cable was hard at work upgrading its systems to allow always-on broadband connectivity to the internet. It had a new service called Road Runner that was dedicated to providing faster and more reliable online access, a superior product to telephone modems.
Then as now, a very bad deal.