AOL Learns a Hard Lesson on the Internet
There is a sad truth about the failed synergies behind the merger that created AOL Time Warner Inc., which led to last week’s resignation of Chief Operating Officer Robert W. Pittman, a key merger architect.
It is that the America Online division would have prospered if it had concentrated on offering customers new services on the Internet instead of trying to wed movies, television and magazines--yesterday’s technologies--to the new technology of the Internet.
The Internet is not television. People don’t merely watch it--they use it and interact with it.
That’s why some Internet companies are highly successful. EBay Inc., the service through which customers buy, sell and trade goods and services, is thriving.
Expedia Inc., the publicly traded online travel reservation service, is doing well. Expedia is one of more than half a dozen firms that form USA Interactive Inc., Barry Diller’s holding company for providers of online purchasing services. And USA Interactive is prospering. What all those firms have in common is that they rely on transactions for which they can charge fees.
Particularly interesting is the success of education on the Internet, as exemplified by University of Phoenix Online, which has grown to more than $200 million in revenue and more than 125,000 students in the last three years.
University of Phoenix is a subsidiary of Apollo Group Inc., a Phoenix-based holding company for several adult education businesses.
So far, much of the adult education field is led by privately owned firms--prominently Knowledge Universe, a educational service holding company launched six years ago by financier Michael Milken and Oracle Inc. founder Larry Ellison.
Education is a field uniquely suited to interaction with students or customers.
(Yes, pornography is successful on the Internet too. But that is not surprising--porn has been successful in every medium dating at least to Pompeii.)
AOL has been a huge success in its basic Internet business. It has 30 million subscribers who pay monthly fees. And AOL benefits from advertising. Last year, fees and advertising brought the AOL segment of AOL Time Warner $8.7 billion in revenue and almost $3 billion in pretax profit.
AOL’s biggest attraction is its e-mail and instant-messaging services that allow customers to easily keep in touch with family and friends. Some of the greatest businesses in the world have been founded on serving the humble needs of family and friends. Think, for example, of Eastman Kodak Co., founded when George Eastman invented a Brownie camera so families could take pictures on a Sunday afternoon.
If AOL had concentrated on offering new Internet services to its customers instead of getting caught up in movies and such, the stock market might have seen more value in its success. After all, AOL’s main rival as an Internet service provider, Microsoft Corp.’s MSN, has only 7.5 million customers.
But submerged within AOL Time Warner and seen as a failed experiment, AOL essentially is granted no value by investors in the current stock price of the parent company, says analyst Jeffrey Logsdon of Gerard Klauer Mattison, a New York-based investment firm. AOL Time Warner closed Friday at $11.58 a share in New York Stock Exchange trading .
The Time Warner side of the company--the cable, movies, cable networks, music and publishing businesses--might be better off today if they never had merged with AOL. The Time Warner segments might have attained valuations comparable to those of Viacom Inc. or Walt Disney Co., diversified entertainment firms that are not trying to achieve the scale of Internet synergies that AOL Time Warner had been attempting.
Logsdon calculates that the Time Warner businesses could have a market value of more than $15 a share, after deducting corporate debt, minority ownership of some of its cable assets and factoring in intangibles of the market’s judgment.
If the AOL side alone could command $5 to $6 a share, the potential “breakup” price of AOL Time Warner could be $20 to $21 a share, Logsdon says. Such a breakup value, he suggests, might attract adventurous investors, such as cable mogul John Malone.
But other analysts don’t think the present favors adventures. Jordan Rohan of Soundview Technologies Inc., a research firm based in Stamford, Conn., sees investors as too unnerved by the stock market’s instability and uncertainty at AOL Time Warner to make any moves now.
In any event, the company selling at roughly half its breakup value testifies to the fact that highly paid but unimaginative executives have once again misunderstood a new medium. It also happened when many movie moguls misread television, and when phonograph executives misunderstood the promise of radio.
Yet lessons can be learned and mistakes corrected. The new policies of AOL Time Warner Chief Executive Richard D. Parsons, announced Thursday, dictate that each of the company’s many businesses work to succeed individually.
Synergy is out. Striving to be top of the class is in.
So it’s a good idea to see what the future is promising for entertainment and the Internet business.
For traditional entertainment companies, owning many lines of business, from movies to television and cable and other interests, remains the way to go, argues David Miller, a Los Angeles-based entertainment analyst for Sanders Morris Harris, an investment firm. He cites the relative success of Viacom, which manages CBS, Paramount Pictures, Infinity Broadcasting and cable channels MTV and Nickelodeon.
On the other hand, contact with the Internet has been poison for entertainment companies. Disney lost on its investment in Go.com before abandoning the effort. Vivendi Universal’s attempt to marry entertainment to Internet transmissions over cellular telephones also is in disarray amid reorganization of that firm.
So there is doubt and confusion in entertainment circles about the Internet.
But there is no doubt elsewhere about the enormous future of the Internet. After all, some 130 million Americans are hooked up to the Internet, and the linkage for all but a minor portion of consumers is through telephone lines. The delivery of broadband capabilities through two-way cable or digital subscriber phone lines is stalled by the heavy capital expense faced by cable and telephone providers.
If those companies could make a breakthrough on costs, or figure a different way to amortize the capital expenditure, broadband could spread faster--and with it an explosion of services.
The public likes to use the Internet. The amount of merchandise sold through Internet sites--from Wal-Mart Stores Inc. to the smallest specialized companies--has grown to more than $200 billion a year, about 6.5% of retail sales.
Online education services total more than $20 billion a year. And the opportunities for online medical services have scarcely been touched.
Internet companies, such as Amazon.com Inc. and Yahoo Inc., no longer are distracted by the boom and have settled down to serious business, trying to come up with services that customers can interact with and for which the Internet providers can charge. An example is the HotJobs.com employment search service that Yahoo owns.
Digital photography, with family pictures being sent across the country via the Internet, is doing for family heirlooms what George Eastman did with snapshots more than a century ago. And when broadband capability arrives, virtual family visiting will be a growth business.
The way to think about the Internet, in short, is as the biggest new consumer market that ever existed. AOL and others got sidetracked from that vision through a lack of imagination. But the correction process may have just begun.
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James Flanigan can be reached at [email protected].
(BEGIN TEXT OF INFOBOX) * Breakup Value?
On the heels of management turmoil at AOL Time Warner, some Wall Street analysts are hypothetically separating the parts of the company, calculating a value for the Time Warner and the AOL parts, and coming up with a total breakup stock price almost double the current market price. Here’s how one analyst figures the sum of the parts.
Time Warner (cable, films, America Online music, publishing) (Internet services)
Estimated 2002 pretax $8.5 billion $1.8 billion earnings
Price-to-earnings ratio* 13 times 13 times
Potential value $110 billion $23.4 billion
Share value** $15.22 a share $5.08 a share
Combined share value $20.30 Actual Friday close $11.58
*Based on comparisons with peer companies, Walt Disney, Viacom, EarthLink ** Total value minus debt and minority ownership divided by 4.6 billion shares outstanding.
Source: Jeffrey Logsdon, Gerard Klauer Mattison Inc.
