AOL-Time Warner Merger: Happily Ever After?

How big was it? In Northern Virginia on Friday night, Jimmy Lynn, an AOL marketing executive, got an inkling that something was happening. “I usually go to the Redskins games with a guy from the mergers and acquisitions group,” Lynn explained. When the friend canceled–for the Redskins’ first playoff game in seven years–Lynn knew it was not just something, but really something. In downtown Manhattan early Monday, the 7:30 a.m. daily research call emanating from the fifth-floor conference room of Merrill Lynch headquarters was handled by analysts Henry Blodget and Jessica Reif Cohen. Traders who had nearly run off the road when they had heard the news on their car radios crammed the room; 1,000 more around the world were connected by telephone. Like everyone else on Wall Street, Blodget and Reif Cohen had been taken totally by surprise. They used words like brilliant and huge–but they were at a loss to explain to their colleagues what it actually meant.

It was on Tuesday afternoon, the day after the deal was announced, that the influential Silicon Valley venture capitalist Roger McNamee summed up the object of all this attention: “Let’s be clear,” he said. “This is the single most transformational event I’ve seen in my career.”

Just what exactly was transformed? America Online, the newbie-friendly smiley face of the Web that just three years ago was an operational mess, had engineered the largest merger in American corporate history. Time Warner, the immense media conglomerate that had sprung from the loins of the magazine you are now reading–having failed to beat the Internet upstarts with its own efforts–had decided to surrender to them for the best price it could get, about $162 billion in AOL stock. The companies valued the combination at $350 billion.

For Time Warner chief executive Gerald Levin and AOL boss Steve Case, the common experience of groping through a rapidly mutating economy made this deal in some ways inevitable. In AOL, Case had built a brand, a customer base and (by Internet standards) healthy profits. But he faced a future that may see Internet access become a commodity, and he lacked access to the leading source of broadband–the fat, fast pipes of cable television that could carry vast amounts of Internet content. And Case didn’t have much in the way of content either. Time Warner’s cable-television system, the country’s second largest, owned plumbing aplenty to distribute AOL’s services. The company also had the proprietary content–magazines, books, movies, music, programming–to send down the pipes.

Yet Levin’s company had remained inextricably mired in its own past, a dinosaur lurching its way through a world that would soon belong to swifter creatures, almost pathetically unable–like all the major media companies–to make the Great Leap Forward into the new Internet economy. The company’s stock price had plateaued in a year in which Net stocks soared, and there was little excitement about the plans being developed in its recently hatched digital division, despite projected outlays this year of $500 million. “We had a big uphill job as a corporation” to catch up with the established Internet players, notes Time Warner vice chairman Ted Turner. Levin was even contemplating “an internal takeover” of CNN to make it the company’s digital division, separate from the rest of the Turner networks.

When Time Inc. announced its betrothal to Warner Communications in 1989, the men in the front of the room were an odd match of Hollywood glitz and suburban Connecticut golf club. In 1995, when Levin and Turner proclaimed their deal, it was Earth meets Mars. But last week the two dealmakers actually seemed to speak the same language and perceive the same future.

Both Case and Levin were faced with what corporate strategists call a “make or buy” dilemma. Case must have contemplated that at some point Wall Street would come to its senses and that AOL’s helium-supported Internet valuation would be punctured and deflate. Better spend those Net-flated dollars now–buy. Levin, with his stock price sputtering, didn’t have the currency to pay the price of admission on the Internet. The company, in fact, could neither “make” nor “buy,” which left it with but one option–sell.

Case and Levin began their mating dance at a meeting of the Global Business Dialogue in Paris last September. Two weeks later they continued their global flirtation at a lavish FORTUNE magazine event (FORTUNE is also owned by Time Warner) in Shanghai–one of those blurred events, part journalism, part meet-greet-and-deal, that make press critics howl. But the active courtship didn’t begin until early October, when Case called Levin, proposed merger outright and–significantly–said he wanted Levin to be CEO of the combined company.

The gritty details of negotiating corporate marriage, in particular who gets the top jobs, began in mid-November, when AOL vice chairman Ken Novack, a Boston lawyer who is Case’s closest professional confidant, traveled to New York City with senior vice president Miles Gilburne to meet with Richard Bressler, the former Time Warner CFO who had recently been placed in charge of the corporation’s digital efforts. How do you puzzle out a high-tech-meets-media merger? On large sheets of paper. The three men scrawled out a crude vision of a combined company and posted the pages all over the muted gray walls of Bressler’s imposing Rockefeller Center office. Gilburne took the rolled-up sheets back to AOL’s Dulles, Va., headquarters, where senior executives examined them the way archaeologists examine the runic traces of an early civilization.

That it somehow remained secret was remarkable. The only clue was so outrageously bold that it went unnoticed. When AOL board member Thomas Middelhoff, CEO of the Bertelsmann publishing empire, visited with Time Inc. editors in early December, he was asked if he thought AOL should buy Disney. “No,” Middelhoff replied with the sort of smile that announces a joke is coming, “I think [AOL] should buy Time Warner.”

Levin had also come to that conclusion. He then had to come up with a price. Ten years ago, when Time Inc. “acquired” Warner Communications, he was harshly criticized for agreeing to a share-exchange ratio that allowed Warner’s stockholders to become majority owners. Over the millennial weekend–“watching 100 hours of CNN,” he says–Levin mulled the numbers. Conventional valuation methods, which look at a stock’s price history as well as its potential, wouldn’t work. In December 1998, for instance, Time Warner was worth more than AOL. By December 1999, AOL was worth 2.5 times more than Time Warner.

Levin reasoned that Time Warner without an Internet connection was still valuable, but its value to an Internet buyer was greater. So he arrived at 1.5 AOL shares to be exchanged for each TWX share. In real money, that was 70% more than Time Warner’s $65 price the Friday before the deal was announced, but it would still give AOL shareholders 55% of the company. Conversely, Time Warner was providing 80% of the cash flow. Says Levin: “If some people think that AOL has been sold at too much of a discount or Time Warner has been sold at not a high enough premium–if we get those disparate reactions–then we’ve probably done the right thing.” Although both companies have done handsprings to portray the combination as a merger of equals, Wall Street has since made it clear that it considers AOL more equal than Time Warner.

The deal finally became real on the night of Jan. 6 at a dinner for Case, Levin, Novack and Bressler at Case’s northern Virginia house. What began with a bottle of 1990 Chateau Leoville-Las Cases (“dazzling concentration, as well as fine acidity”–wine critic Robert Parker) in the living room and ended with chocolate mousse at the table became semiofficial when Case and Levin broadly agreed to a merger. They also agreed to sleep on it, and after midnight Bressler and Levin flew back to New York on a Time Warner jet. Novack and Bressler spoke at 9 the following morning, checked in with their respective bosses and had a deal at 9:15. As one of the supporting actors put it, “At a certain point they had to swallow hard and jump off the cliff together.”

Whether they’ll land on their feet depends on whether the two companies can mesh their organizations, persuade Wall Street that the deal makes sense and endure the federal regulatory reviews and potential legal challenges of the next several months.

The first task will probably be the hardest. In many ways, the pre-deal Time Warner was less an operating company than it was a stock price, the financial expression of a series of disconnected assets. Unlike other media megaliths like Disney or News Corp., where a nearly totemic central figure–Michael Eisner and Rupert Murdoch, respectively–conceives the strategy and orders it into place, Time Warner under Levin has been an extremely successful dysfunctional family. Six powerful executives, ranging from Roger Ames of the music group to Terry McGuirk of the Turner networks, run six huge businesses, and their rivalry with external competitors often consumes less energy than their alpha-male, intramural head butting. When the cable division wanted to brand its high-speed cable-modem business Road Runner, the Warner Bros. marketers–with straight faces–tried to extract a billion-dollar licensing fee from their corporate brethren for use of the cartoon bird. If any one thing has made Levin a success, it is his long-range strategic vision. But his willingness to let his managers run their businesses as they see fit–as long as they deliver double-digit earnings growth–runs a close second.

It is precisely this combination of decentralized structure and a desperate hunger for Wall Street-pleasing growth–especially necessary for a company whose balance sheet includes $17.8 billion of indebtedness–that propelled the sale to AOL. Time Warner’s stuttering, stumbling, ill-managed attempts to score on the Internet (in which I and several of my Time Inc. bosses have participated) have foundered on the inability of the various divisions to work collaboratively and on the relentless bottom-line pressure that discouraged investment in the distant future when there was a quarterly target to meet.

AOL, of course, has had no such problem. Ever since Case fought off the awful negative publicity surrounding the late 1996 fiasco in which customers couldn’t access the overburdened servers, the company has been rocketing from one success to another. The number of AOL zillionaires has multiplied with each upward ratchet of the stock price, and the atmosphere in Dulles sometimes feels like it’s ready to combust. The unnamed Time Warner executive who told the New York Times that merging the cultures would be easy because the AOL people are laid-back “latte drinkers” would do well to re-examine what’s in those cups.

While Case plays the statesman and AOL president Robert Pittman deploys the substantial charm of a born salesman, the next few levels of management harbor a cadre of “killers and cutthroats,” says a former analyst intimately familiar with the company. AOL’s laid-back latte drinkers took early retirement (“I just didn’t want to sit in on any more screaming matches,” says one), while the real sharks, believing themselves invulnerable because of their vast wealth, continued to swim the halls in Dulles. The piped-in music may be the Eagles, and the furnishings may look as if the Ikea catalog had been redesigned by Antonio Gaudi, but deep down, AOL is about as New Age touchy-feely as a hammerlock. Sure, it used to be “ponytails, tattoos and surfboards,” recalls Mark Walsh, a former senior vice president of AOL who now runs the business-to-business e-commerce site VerticalNet, but “AOL became the most aggressive company in the Internet business–and, as a result, the most successful.”

The typical Time Warner manager, especially in its entertainment divisions, would never be mistaken for St. Francis of Assisi. But the deal-a-minute, scream-until-you-win culture of AOL is not likely to tolerate the stately pace of a company whose decision-making arteries are often clogged with consultants and task forces. California venture capitalist Jennifer Fonstad anticipates that the slightest whiff of old-economy culture in the halls of Dulles will create “a huge opportunity for headhunting. I can’t underscore how excited many of us are at the prospect of getting good AOL executives and engineers out here.”

Winning over Wall Street will require a prolonged process of–pick your noun–either education or spin. Music-business executive Danny Goldberg, a former head of Warner Bros. records, says the merger both “validates the Internet and validates the value of content.” But it also forces the invention of a new currency to reflect it; as the AOL and TWX stock prices yo-yoed up and down last week, it was clear that investors had no idea how to put a price tag on something that was neither an Internet highflyer nor an old-economy cash-flow locomotive. AOL lost about 20% of its value before recovering to $63. Time Warner leaped 58% on the news, then settled at $82, up 26% for the week. In the nobody-knows-anything world of Wall Street, one analyst was predicting a 50% increase in AOL’s stock price between now and next fall when the deal is expected to close, another was predicting a continuing slump, a third meaninglessly narrowed the medium-term price target to “between $55 and $90,” and the last little analyst cried all the way home. “The Street has no historical reference,” says one of the dealmakers.

Finally, there will inevitably be personnel and turf issues to unravel some nerves, as already seems to be happening to some Time Warner executives suspicious of the sudden omnipresence in the media of Case’s agile No. 2, the 45-year-old Pittman. Himself a former Time Warner executive, Pittman is the highest-ranking manager in either company who made his bones in both the entertainment business and the digital world. Within hours of the deal’s announcement, the corporate handicappers had tabbed him as Levin’s successor. He had better be patient. According to an investment banker who knows both men, recalling the 1992 blitzkrieg with which Levin deposed his predecessor, N.J. Nicholas Jr., “betting against Jerry Levin in a boardroom struggle would be a big mistake.” Especially when, as in this case, it would take a 75% vote of the board–to consist, initially, of equal numbers of Time Warner directors and AOL directors–to dump the CEO.

Along the way, there’s business to be done. New media buccaneers refer to their easiest challenges as “low-hanging fruit,” and in the merger announcement the two companies listed a series of efforts that would launch immediately: CNN.com programming featured on AOL services; AOL discs stuffed into Time Warner product shipments; cross-promotion of Warner Bros. movies on AOL-owned MovieFone. If none of these seems especially delicious, that’s because low-hanging fruit rarely is.

Within a year expect major initiatives in broadband, where AOL visionaries see their eventual future, and in recorded music, an area that has been less gold mine than minefield for Time Warner in the past few years. “We can change the way people interact with music, change the distribution medium,” says Jonathan Sacks, the senior vice president who supervises the main AOL service. Contemplate a music company that no longer has to bother manufacturing or shipping CDs, or sharing revenue with retailers–one that distributes its music directly from its hard drive to yours.

For consumers, the combination represents, in its barest terms, the potential for getting whatever they want–books, movies, magazines, music–whenever they want it, whatever way they choose, whether on a TV, a PC, a cell phone or any of the myriad wireless devices that are hurtling toward the marketplace. They can even get it on–drum roll–paper. Is there a compelling reason that one company has to provide all of this? No. It will be up to AOL Time Warner to prove its case to consumers.

That’s the tantalizing potential of the AOL-Time Warner merger, the notion that two very different companies can combine to create something unimaginable only yesterday. Ten years ago, a Time Warner manager went to one of the company’s senior executives with a proposition. This small but promising online business on whose board he sat, run by this terrific guy Steve Case, was in desperate need of cash. For $5 million, Time Warner could own 11% of it. “If we did that,” the boss replied, meaning if he conceded that the digital distribution of content was going to succeed, “then everything we have done here since 1923 could be thrown out the window.”

To see that, he may have been a wise man, though a horrible stock picker (that $5 million would be worth $15.6 billion at Friday’s market close). But that was then, and this is tomorrow.

–With reporting by Maryanne Murray Buechner, Adam Cohen and Emily Mitchell/New York, Michael Krantz/San Francisco and Chris Taylor/Dulles