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The merger of AOL and Time Warner: A case study

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Volume 16, Number 7 Printed ISSN: 1078-4950
PDF ISSN: 1532-5822

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 103

THE MERGER OF AOL AND TIME WARNER:

A CASE STUDY

David Malone, Weber State University

James Turner, Weber State University

CASE DESCRIPTION

The purposes of this case are several, and the potential uses fairly rich. From an accounting
perspective, the assignment of a value to the transaction will directly affect the goodwill assigned to the
merged firm’s financial statements. From that, students can be given the opportunity to discuss such
topics as measurement, earnings management, and efficiency with respect to analysts’ capacity to filter
through non-cash flow effects.
Interesting questions arise with respect to the adequacy of information about the probability of
merger completion. Evidence suggests that analysts assigned a fairly high probability to the chance that
the merger would not be completed. The fairness of this probability allows for speculation as to whether
or not information available in the market, including that disseminated by the firm, was adequate to the
task of assigning that probability.
Finally, because the case involved two very widely held firms, there are rich opportunities for
students to research the wealth of information that exists on this merger.
At its highest level, the case is rich enough to be used for Masters of Accounting students and
MBA students who have taken an MBA-level corporate finance class. Upper division accounting and
finance students who are familiar with analysis of mergers and with theories of asymmetric information
could also benefit from analyzing the case.

CASE SYNOPSIS

When AOL and Time Warner announced their proposed merger in January 2000, the securities
of both firms experienced significant price adjustments. Initially, prices of both securities rose on the
news. When details of the proposal became clear, the security price of Time Warner fell back somewhat,
but remained approximately 30% above its pre-announcement selling price. AOL shares, however,
retreated to a price about 15% below its pre-announcement price. Both of these prices were significantly
below consensus price targets set by analysts.
Of special interest is the relative price level at which the two securities settled soon after the
announcement. The merger proposal called for the issuance of a new security representing common

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 104
ownership in the new firm. One share of the new security would be issued for each share of AOL, while
each share of Time Warner would be exchanged for one and one-half shares of the new security. As
weeks passed beyond the announcement date, the ratio of the Time Warner shares to the AOL shares
ranged from just less than 1.4:1 to 1.5:1 (rather than settling at and sustaining the 1.5:1 ratio one would
expect from the agreement.)
This case presents the circumstances surrounding the merger of AOL and Time Warner,
including their respective business strategies, markets, financial structures, and price movements during
the period leading up to the merger.

INTRODUCTION

Very early on Monday, January 10, 2000 news began to appear on wire services suggesting that
an announcement was forthcoming of the merger between America Online (AOL) and Time Warner
(TWX). At that time, the capitalized market values of AOL and TWX were $164 billion and $97 billion
respectively. Value of the combined company was estimated at $361 billion (based on the $110/share
value assigned to TWX in the merger agreement), making it one of the ten largest firms in the world as
measured by capitalized market value. The $190 billion in stock AOL agreed to issue to acquire Time
Warner made it the largest merger in U.S. history at that point in time. Together, AOL and TWX offer
significant brand recognition including AOL, Warner Bros., HBO, NetScape, Time, CNN, TNT,
CompuServe, Warner Music Group, Sports Illustrated, Fortune, People, and numerous others. TWX also
brought with it a broadband distribution platform from which to expand significantly AOL’s interactive
market. As was later mentioned in the combined firm’s annual report for fiscal 2000, executives felt the
merger had the potential to “combine the power of the Internet with the world’s most trusted information
and entertainment brands.”

A BRIEF COMPARATIVE ANALYSIS OF AOL AND TIME WARNER

AOL was founded in 1985 as Quantum Computer Services. After a name change in 1991, AOL
underwent its initial public offering in 1992. As mentioned before, AOL was and continues to be the
world’s largest internet service provider, with in excess of 20 million customers. At a P/E ratio of 245
in early January, 2000, an investment in AOL stock prior to the merger was one reliant on persistent
growth in cash flows. During the period between 1996 and 2000, AOL realized an 86% compound
annual growth rate in revenues and 106% in stock price.
By comparison, Time Warner was more established and far more complex. During the same four
years referred to above, TWX realized compound revenue and stock price growth of 18% and 36%
respectively. As a result of the combination of Time Inc. and Warner Bros., TWX not only had an
established history of operations, but had diversified into media industries including published, broadcast
and other entertainment media. The company listed in its 1999 annual report five businesses as its
principal sources of revenues: cable networks, publishing, music, filmed entertainment, and cable

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 105
systems. Selected statistical and financial data prior to the merger announcement are provided in
Appendix A.
A telling comparison between the two firms comes from an examination of their respective cash
flows. From its previous year-end cash flow statement, AOL had cash flows from operations of $1.1
billion, compared to $1.8 billion for TWX. AOL, however, used $1.8 billion in cash for investing
activities compared to $353 million listed as sources of cash from investing activities for TWX (i.e.,
TWX was actually realizing a net disinvestment from its holdings. In years before the most recent one,
TWX did have cash outflows from investing, but those were negligible.) As one might deduce, AOL
supplemented its investing activities through additional financing, with a source of cash of $886 million
by financing activities. TWX, in contrast, was using its operating cash flows to pay down its substantial
debt and to pay dividends. Cash used by financing activities for the year amounted to $2.4 billion.

FINANCIAL EFFECTS OF THE MERGER ANNOUNCEMENT

The merger agreement between AOL and TWX called for the issuance of a new stock, to be
named AOL Time Warner. For each share held of AOL, shareholders were to receive one share of AOL
Time Warner. For each share held of TWX, investors in that stock would receive 1.5 shares of the new
security. On the day of the announcement, although it opened with an initial surge, AOL closed at 72
5/8. The following day, the price fell to 64. TWX surged in pre-market trading and never looked back,
gaining 27.5 points to close at 92 1/4. The ratio of prices of the two securities at the end of that first day
following the announcement was 1.27:1, far short of the ratio of 1.5:1 established by the merger
agreement.
Over the next few days, as the market digested the implications of the merger, arbitrageurs began
seizing on what appeared to be a profit opportunity, effecting a January 11 closing price for AOL of 64,
down 8 5/8, with TWX closing at 86, off 6 1/4, leaving the ratio at 1.34:1. Two weeks after the initial
announcement, shares of AOL were trading at 62, with TWX at 87 5/8, a ratio of 1.41:1. Two weeks
later AOL was at 57 13/16 while TWX was at 84 5/8 (closing prices, Friday, February 4) for a ratio of
1.46:1. Appendix B shows the ratio of prices as they emerged in weeks following the merger
announcement. The mean value of the ratio in the two months following the announcement was 1.42:1,
with a standard deviation of 0.05.
Following the announcement date, several key news reports by both company and government
officials were issued that would serve to mollify concerns over potential antitrust conflicts or other
reasons the merger might not be completed. SEC Chairman Arthur Levitt in a January 11 interview with
Reuters news service, labeled the combination of AOL and TWX as “smart.” On January 12, Jon
Friedman of CBS MarketWatch reported that several large shareholders of AOL had endorsed the
concept of the merger. AOL, in past years, had petitioned the FCC to require cable companies to open
their broadband networks to competitors in order to enhance competition. On January 19, FCC
Chairman William Kennard pointed to the merger of AOL TWX as an example where the market could
solve its own problems with threats to competition. Shortly thereafter, AOL TWX announced that they

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 106
would open their cable systems to competitors (offering additional evidence that competitiveness in the
cable media markets would be enhanced rather than inhibited). On February 3, Joe Wilcox of CNET
News concluded, from interviews with several legal experts, the merger between AOL and TWX would
very likely pass through antitrust scrutiny without difficulty. Senator Orrin Hatch (R-Utah), however,
offered a cautionary note. Hatch, in a public statement reported by Bloomberg News on January 12,
pointed out that internet combinations such as that represented by the AOL TWX merger could pose the
same antitrust threats as those encountered in both railroad and oil industry combinations at the end of
the 19th century.

EPILOGUE

Problems arose almost as soon as the merger was completed. The merger was finalized on
January 11, 2001; shortly after, in 2002, the internet bubble burst, taking down share prices of internet
companies generally, even those with positive earnings like AOL. The share price of the merged firm,
which closed at $47.23 the day the merger was completed, fell to a low of $9.64 on July 25, 2002.
Time Warner shareholders initially seemed to be receiving a huge premium for their shares in
the merger. (Under the terms of the merger, AOL’s shareholders would take ownership of only 55% of
the new firm, even though AOL’s share of the combined market capitalization of the two firms was 65%
at the time the merger was announced.) After the merger, former Time Warner shareholders saw the
value of their investment fall precipitously, with share prices of the combined firm dropping 90% from
their peak value. (Economist AOL Time Warner: A Steal? Oct 24th 2002) Several shareholders filed
lawsuits claiming that AOL executives deliberately and fraudulently inflated the value of AOL shares
prior to the merger, partly by covering up steep declines in advertising revenue. At about the same time,
news came out that 14 AOL Time Warner executives had sold hundreds of millions of dollars worth of
shares shortly after the announcement of the merger. AOL eventually paid $2.4 billion to settle these
claims.
In the intervening years, several business publications analyzed the merger, with several calling
it the “worst deal in history.” Most writers faulted the execution of the merger or its timing however,
rather than the logic behind the merger itself. The two companies had very different corporate cultures
and there was serious friction after the merger between AOL executives and employees and Time Warner
executives and employees. Very few executives from either company had been in on the merger
negotiations and Time Warner executives in particular (other than the very few who worked on the
merger) were reluctant to work with AOL. In fact, the original idea behind the merger, pairing Time
Warner’s content with AOL’s delivery capabilities was turned on its head – the AOL website was the
one place that Time Warner content could not be found.
When the internet bubble burst, it took down nearly any and all companies that had participated
in the earlier internet craze; AOL Time Warner was no exception. Because of this it is difficult to
untangle the effect of the merger alone on company value from the effect of the general market downturn.

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 107
As much as five years later, Steve Case continued to defend the logic behind the merger, noting that
“AOL needed Time Warner for its cable division,” while accepting blame for the failure of execution.
On May 28, 2009 Time Warner Inc. announced that it would spin off AOL; the news came as
no surprise. At least one publication again defended the concept of the merger, noting that while the
merger may have been the worst deal in history, it didn’t have to be. The day Time Warner announced
the AOL spinoff, Steve Case, no longer with Time Warner, posted a Twitter entry that said, “Thomas
Edison: ‘Vision without execution is hallucination’ - pretty much sums up AOL/TW - failure of
leadership (myself included).”

REFERENCES

Case, Steve. (May 28, 2009). Twitter entry retrieved May 31, 2009 from Web site http:// [Link]/SteveCase

Kramer, Larry. (May 4, 2009). Why the AOL-Time Warner Merger Was a Good Idea. Retrieved May 30, 2009 from The Daily
Beast Web site: [Link]

Munk, Nina. (2004). Fools Rush In: Steve Case, Jerry Levin, and the Unmaking of AOL Time Warner. New York:
HarperBusiness.

Strukhoff, Roger. (August 3, 2005). Time Warner to Pay $2.4 Billion to Settle AOL-Related Suit: Is the Megamerger Misery
Nearing a Close? Retrieved May 30, 2009 from Sys-con Media Web site: [Link]
[Link]/node/114262

Time Warner. (February 2, 2000). Time Warner CEO Reaffirms Confidence In Exceptional Growth Potential of AOL Time
Warner. Retrieved May 24, 2009 from Time Warner Web site
[Link]

Questions

1. What synergies exist in the combination of AOL/TWX?

2. What evidence of capital market efficiencies or lack thereof existed in the circumstances
surrounding the AOL/TWX merger announcement and subsequent price fluctuations?

3. Discuss the difficulties of initially estimating the negotiated exchange value in the merger of a
volatile, highly growth oriented firm with a stable, moderate growth firm?

4. In this merger only stock was exchanged. Under the purchase method of accounting for business
combinations, goodwill must be recognized and amortized. What are the implications for
earnings of the merger?

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 108
5. Referring to Appendix B, one observes that the ratio of TWX:AOL prices ranged from just
below 1.4:1 (allowing for an initial settling period) to above 1.5:1. What implications for
accounting are there in the seeming persistent lack of stability of that ratio?

6. Which firm is left better off? Is there a “winner” and/or a “loser”?

APPENDIX A

Selected Statistical and Financial Information

AOL Time Warner
Friday, January 7, 2000 Closing Stock Price 73 3/4 64 3/4
Shares Outstanding, January 10, 2000 2,278 Million 1,375 Million
Market Capitalization January 7, 2000 $164 Billion $97 Billion
Market Capitalization February 11, 2000 $129 Billion $108 Billion
4-year Compound Annual Growth Rate:
Revenues 86% 18%
Stock Price 106% 36%
Total Revenue (FYE 1999) $4.8 Billion $27.3 Billion
Net Earnings (FYE 1999) $762 Million $1.95 Billion
Earnings per Share (FYE 1999) $0.298 $1.42
Total Assets (FYE 1999) $10.3 Billion $48.4 Billion
Total Liabilities (FYE 1999) $4.1 Billion $39.6 Billion
Annual Dividend $0 $0.18

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 109
APPENDIX B
Price Ratio Following Announcement

TWX:AOL Price Ratio

1.55
1.5
1.45
o 1.4
it 1.35
a
R 1.3
1.25
1.2
1.15
1.1
1 7 13 19 25 31 37 43 49 55
Days After Announcement

APPENDIX C
Share Prices Following Announcement

T W X a n d A O L S h a r e P ri c e s
120

100

80
e
ic
r
P 60 TW X
e
r AO L
a
h
S 40

20

0
1 7 13 19 25 31 37 43 49 55
D a y s A f te r A n n o u n c e m e n t

Journal of the International Academy for Case Studies, Volume 16, Number 7, 2010
 110

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