Dear Valued Clients and Friends,
This year commemorates the 25-year anniversary of a lot of things, as a lot happened in the year 2000. Many of you will remember that the whole world shut down and there was economic chaos everywhere because of the Y2K computer bug … oh wait, sorry … that was what people were talking about in 1999. No, the year 2000 was not known for the Y2K computer bug bringing down Western civilization, though I do know a few people who in 2000 got to count the money they made by scaring the heck out of people in 1999. But while the Y2K thing turned out to be a laughingstock, the year 2000 certainly teed up a lot of significant events in global markets. One of them is the subject of today’s Dividend Cafe.
On January 10, 2000, exactly two months to the day before the Nasdaq would hit its famous top and begin a crash that lasted fifteen years before a new high was made, the largest acquisition in corporate America history was announced: The utterly shocking acquisition of Time Warner by AOL for $182 billion (which is $332 billion in inflation-adjusted dollars today). And while many of you may have forgotten about this story, never cared about it, or think you don’t need to care about it today, I will suggest that it contains some lessons for investors that everyone needs to care about.
The AOL-Time Warner merger, which turns 25 years old this year, is a powerful tale not just of hubris, adventurism, stupidity, and the delusions that happen when corporate managers play their own game of FOMO (fear of missing out), but also provides several (as in, more than a couple) powerful investment lessons that ought to be remembered by every one of us.
So today we do a little history lesson in the largest wealth-destructive event in human history and come back to some basic lessons that ought to serve as evergreen reminders for investors seeking to do the right thing. Those right things are the ends to which we work, and learning from the history of AOL-Time Warner is the subject of today’s Dividend Cafe.
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Trip Down Memory Lane
The history of how this came to be is interesting, especially for business history nerds like me (obsessive is a fair description here). The AOL side of the story is pretty simple, and it is interesting in its own right. The predecessor companies to America Online (Control Video then Quantum Computer Services) are actually more interesting to me than the heyday of AOL in the late 1990’s, but that is almost always the case (I suspect many of you who are business owners or entrepreneurs relate to being more interested in the down and dirty days of a company’s fight to survive than the headline moments of when it was flying high). But without pinning down Dividend Cafe to a 1983-1991 story in the weeds of various gritty tech endeavors, let’s just say that AOL had a substantial fight to stay alive, went through a couple key executives who led those fights, and in the end, it emerged under then CEO, Steve Case, as the leading online service brand in the country. As the internet bubble was bubbling in the late 1990s, AOL was bubbling with it. The market cap at AOL’s IPO in 1992 was $61.8 million; at its peak in December 1999, the market cap was $222 billion. We’ll come back to AOL in a moment.
Time Warner’s side of the equation is much more interesting to me, primarily because Time Warner shareholders were the ones sliced into pieces by this disastrous AOL merger (the logic there being in the rather unremarkable observation that had AOL not acquired Time Warner, it’s stock was still going to plummet, since the internet bubble burst was a natural fact that happened, and was always going to happen, whether Time Warner had gotten sucked in or not). The Time side of things starts with Henry Luce starting Time Magazine in 1922, and then launching Life magazine in 1936. He would also start Fortune magazine and eventually, in 1954, Sports Illustrated. To say that this media empire was iconic to American life in the 20th century is a massive understatement. These media properties transformed American society, and they were profitable in a manner no other media had ever seen.
In the 1970s, Time-Life would launch HBO, which was not a big deal for quite a while (actually, it was a big money loser), but in the 1980s, it would take off as the cable TV world (and premium paid cable world) took off.
In 1989, Time Inc. (owner of Time, Life, and HBO) merged with Warner Communications. Led by Steve Ross, Warner was a media powerhouse that owned the Warner Music Group, Warner Bros. movie studio, DC Comics, Mad Magazine, and at one point, MTV, Nickelodeon, and The Movie Channel. The 1989 merger created a Time Warner entity that was among the top in media content in the world across all media (movies, television, magazines, etc.). This leadership position was substantially enhanced in 1996 when it acquired Turner Broadcasting System, owner of CNN, TBS, TNT, a good portion of the MGM library, and other movie studios that Ted Turner had started.
So to review, by the late 1990’s there were two companies: (1) America Online, a web and email provider that had come out of a few busted 1980’s video game start-ups, and (2) Time Warner that was the combined sum of Time, Life, Warner Brothers, HBO, Turner, and more.
Naturally, Company 1 would buy Company 2. Ay yi yi.
M&A is not Intrinsically Problematic, but …
The failure of the AOL Time Warner merger was not caused by the mere existence of mergers and acquisitions. Corporate America’s history is filled with success stories of M&A, some that create unbelievable value for the shareholders of both the acquired and the acquiree. Successful M&A generally requires some strategic and synergistic benefits that go beyond the basic numbers. One company’s chocolate mixes with another company’s peanut butter to make something better than stand-alone chocolate or stand-alone peanut butter (this analogy gives me an idea). Two companies with different products and services that can make sense being merged together is not sufficient to make a deal successful, but it is necessary. Company culture, post-transaction leadership, the economics involved in the deal, and a host of other circumstances all matter. Sometimes a deal has an embedded advantage because company A is buying its competitor, company B, and the removal of a key competitor gives company A pricing power, as well as market share. Those things are rather obvious.
But even then, the price paid matters, and certainly the talent of executive management matters. Business is human action, and while it does not exist separate from spreadsheets and numbers, it also must be more than spreadsheets and numbers – numbers that themselves merely reflect some measurement of human activity. The inescapable fact of commercial life is that dehumanizing the process is not only counterproductive, it is also futile. Leadership, decision-making, morale, strategy, team-building, and so forth are all uniquely human endeavors. M&A requires financial logic and human implementation, and one without the other leads to failure.
So What Made This the Worst Deal in History?
Did AOL-Time Warner fail because it was poorly managed, lacked strategy, didn’t create synergies, and failed to deliver in terms of genuine value creation in its delivery of goods and services?
Or, did it fail because the deal terms were absurd, the financials unsustainable, and the bubble price of AOL used as the currency of the deal guaranteed failure from the outset?
The answer is yes.
This was a deal that never had a chance of making sense, on either front.
Human Nature is Immutable
I’ve written a lot in recent weeks about the reality of human nature when it comes to investing. One of the most important revelations I have had in the last 25 years was the realization that corporate executives are human beings, and not immune to the universal realities of human nature. That “fear of missing out” drives many investment decisions is true for too many on a Robinhood app, but it is also true for far too many in the C-suite of a Fortune 500 company. The AOL-Time Warner merger was not the first, nor the last, deal to be deeply rooted in basic CEO ego and narcissism, but it was perhaps the worst example of such I have ever professionally studied.
Warner Bros. was brought public by Steve Ross in 1966. The market value was $12.5 million. Before it merged with Time Inc. in 1989, the value was $5.6 billion. It had compounded 32% per year for 22 years, off of earnings that compounded dramatically. Time Inc. paid $2.5 million in dividends for every $100 million of equity in 1967. The founder/CEO, Henry Luce, owned 15% of the common stock and largely lived off of dividends, as did many of the Time Inc. shareholders.
Gerald Levin, the CEO of the far more compelling company, Time Warner, initially resisted AOL’s overtures. His company was worth (in terms of stock market capitalization) much less than AOL, but its earnings were far higher, the revenue far higher, the history far more robust, and the assets more compelling. It was a real company, but AOL was a promise, a dream, a glimpse of an undefined internet future that many felt was irresistible. Levin had every reason to believe he had the better company. AOL had the 1990s tech bubble going for it. Time Warner had cable assets, cash flows, grown-up executives, and media content. Levin was going to hold his ground and not sell Time Warner to this little internet start-up that was in the midst of a brand new, somewhat incoherent, internet hype phase.
But then AOL hit the right notes …
“Offering Levin the position of CEO was the deciding factor in the creation of AOL Time Warner. Case had called [Levin’s] bluff. Having made one painless concession to Levin’s ego, Case would now take him to the cleaners. Armed with months and months of meticulous research, Case and his advisors knew how to build the perfect trap.”
*Stealing Time, Alex Klein, Simon Schuster, 2003
They needed to give Levin a toothless CEO role, and they needed him to perceive it as a merger of equals. Having successfully manipulated that outcome by consciously and deliberately appealing to the weakest of CEO vulnerabilities—namely, insecurity and ego—a fluff dot-com with a completely bogus currency (called a bubble stock price) proceeded to acquire an iconic American company, all with the complete cooperation of the company’s leaders. The pathologies at play here don’t cooperate nicely with the narrative that greed is the defining driver of corporate America: For those studying deals like this one, it would appear childish insecurity and self-aggrandizement are.
FOMO
By the time Levin and Time Warner had said they would turn down the AOL overtures, AOL’s stock climbed another 50% (late 1999 blow-off top), and Warner hadn’t gone up much at all. AOL was double the value of Berkshire Hathaway (dear Lord), it was triple the value of Disney (LOL), and it was worth more than McDonald’s, Philip Morris, and Pepsi COMBINED.
The AOL stock appreciation meant the deal was LESS attractive to Warner (AOL was buying Warner with AOL stock, so the higher the stock was, the fewer shares they had to give to equal the financial consideration being offered). But Levin relented nonetheless. Sometimes, the pain of watching your neighbor get richer than you is too much to bear.
Sometimes that mentality allows both to get poor together.
A Sucker Born Every Minute, and Someone There to Bank It
The investment banking fees on the deal: $60 million to Salomon Smith Barney and $60 million to Morgan Stanley. The thought was that AOL agreed to these outlandish fees because they were a small price to pay in a $165 billion deal. By the time the companies had been right-sized in value, those fees as a percentage of the remaining value would look like a pretty high percentage (to say the least). But at the time, $120 million was the price of doing the deal. And bankers do not see deals they do not like for a reason.
Should a good investment banker have said, “Ummm, you want to take the stock of AOL as currency for your multi-decade company?” Yes. Was there an investment banker on the planet who would have said that?
Incentives matter.
Buying an Iconic Company with Fake Money
AOL Time Warner presented a pro forma value of their company of $290 billion after doing the $165 billion merger. Understand, the one thing no one cared about here was earnings. AOL had $762 million of them in their last fiscal year before this deal (though, in fairness, the calendar year earnings were about $1 billion, so it was only trading around 200 times earnings). Ay yi yi. Time Warner had $1.3bn of earnings, but was the minority part of the deal. And the COMBINED earnings of the company equated to a pro forma earnings multiple of over 100x. (I should point out, further analysis revealed that there were substantial nonrecurring gains even in the paltry $2.3bn of earnings; normalized pro forma earnings meant the deal multiple was really around 300x.)
And something else I did not know: AOL used EBITDA, the very conventional number everyone uses now to report earnings (while deducting all kinds of things like interest, debt, taxes, depreciation, and amortization). But Time Warner used EBITA – not EBITDA – because Time Warner, annually recognizing the very meaningful cost of their depreciating capital equipment as a major cable systems player, knew that it was highly disingenuous to pretend such depreciation of real-life capital expenditures was not material. But lo and behold, guess which system was used for the combined entity? You guessed it: EBITDA, a convenient use of the highest possible number for the pro forma earnings of the combined company, but an apple compared to an orange in terms of what the pre-deal earnings were.
Why do I bring this up? Was it illegal? Nope. Was it disclosed? Sure, it was. But does it speak to the outrageous disingenuity that a determined company can rationalize within the bounds of modern accounting? Yep. If only there were a way to skip through all the noise and get something that can’t hide behind complex accounting, you know, like actual money they put in investors’ accounts every quarter?
To hit the projections they targeted in the merger, it would have meant growing profits by 15% for 15 years. That would have meant $50 billion in pre-tax profits and $34 billion post-tax. At the time, General Electric, which had a market cap more than double that of the combined AOL-Time Warner, had $12.5 billion in annual after-tax profits. (To be clear, GE had double the market cap, but more than 12x the earnings, then, what I am referring to is that AOL-Time Warner’s projections, rosier than Pasadena on New Year’s Day, were to be less than 3x where GE was, IN FIFTEEN YEARS). But more importantly, what was the company going to be worth if it were doing $34bn in after-tax profits (growing earnings 15% per year for fifteen years in a row) … Well, IF they hit those absurd projections, and IF the market was willing to give them a 20x multiple, AFTER fifteen years of growth, that would have meant a market cap of $680 billion. At the time that Fortune magazine did all of this work in the year 2000, the market cap was already $290 billion.
A Deal Gone Bust
Their 2002 write-down of $99 billion was the largest write-down in corporate history. That record holds today. Why does this matter? It was not an operating loss – i.e., spending $150 billion on expenses but only bringing in $50 billion of revenue, so a loss of $100 billion – it was a “goodwill impairment.” Sounds fancy, right? It’s actually vitally important. AOL bought Time Warner, and Time Warner had X amount of value on its balance sheet in assets – properties, intellectual property, business units (valued based on earnings), etc. AOL was buying it for more than the value of those assets, so that “intangible” value is referred to in accounting jargon as goodwill. There are all sorts of legitimate reasons one may pay more than the value of tangible assets. Some strategic factors or an optimistic view about the future could provoke a company to “pay up” – and almost always does (otherwise, why would a deal happen?). But the issue here is not what AOL paid for Time Warner, but how they paid for it – with AOL stock that was in a monumental and unsustainable bubble.
Some would say the amount of the write-down at the point of write-down was meaningless. No new cash had been lost. No operating earnings deteriorated. To some, this was just accounting jargon a couple years after a transaction to “level the books.” This is true in a sense. The 2002 write-down was not a problem for the company. The 2000 deal was. The 2002 write-down was nothing more than the finance nerds admitting it. The bad news happened the second the merger was announced. The 2002 recording of “goodwill impairment” was the suits saying, “hey, remember that deal two years ago? Well, turns out, we set $100 billion on fire.” And as we would eventually find out, the real value destruction was far more than $100 billion.
The fire was in 2000. The press release about the fire was in 2002.
Who Could Have Seen It Coming?
Here is the part that should have been driving this story all along. They projected 15% earnings growth for fifteen years and $50 billion of pre-tax profits, but stated they would do all of this:
With. No. Dividends.
The combined company claimed to have $2 billion of profits (it didn’t). It projected to grow those by 15% per year up to $50 billion pre-tax (it wouldn’t, to put it mildly). And yet it said from the outset, “we will not be paying any dividends.”
You know who didn’t believe their own projections very much? AOL Time Warner.
A Governor on Risk, and Reality
Henry Luce never sold a share of Time Inc. and left over 1 million shares (15% of the company) to his estate, collecting $2.5 million per year in dividends on his $100 million ownership. Why did founder-oriented companies like Time with Luce or Wal-Mart with the Waltons never sell shares? They received dividends from the company every year and paid dividends to the other owners, who were minority shareholders and could not impact the day-to-day operations of the company. However, they de-risked their investment quarter by quarter with real cash profits received.
What did these recurring, growing dividends signify? High confidence in the sustainability of the business, and strong alignment between management and shareholders.
The alternative can often mean vanity M&A that is far more problematic than merely being ego-driven for the C-suite; it can be value-destructive in a way never thought possible. AOL Time Warner just happens to be the most painful example of all time.
Conclusions
Bad mergers happen. Bad deals happen. Companies sometimes fall off the leaderboard. Not every company that pays a dividend stays on top. Not every company that doesn’t pay a dividend fails.
But.
The AOL Time Warner deal should be the poster child for the rest of history of all the things that investors ought to look for.
- Is this deal driven by a path to shareholder value creation, or was this deal incubated in the egos of the executives behind it?
- Is this deal taking place because the buyer has a stock price that is, itself, left to its own devices, a time bomb?
- Is one party in this deal trading in a good asset for a less good asset, and being told they should be happy about it in the end because “the future …”?
- If a deal is based on the promise of significant free cash flow growth in the future, is a generous dividend payment accompanying that? In other words, are they putting their money where their mouth is?
- To that last point, most M&A is actually heavily levered, so dividend payments can’t happen because the lenders have to be paid first if everything goes well. AOL Time Warner did not do a debt-fueled levered deal; they did a stock deal. Sometimes, you have to pick your poison – excessive leverage that prevents a dividend, or a bubble stock price, and a game of hot potato.
As for us, we will stick with none of the above. To that end, we work.
Chart of the Week
And to this end, we don’t:
Quote of the Week
“Conventional beliefs only ever come to appear arbitrary and wrong in retrospect; whenever one collapses, we call the old belief a bubble.”
~Peter Thiel
* * *
Enjoy your weekends, don’t ever say the words, “this time it’s different,” and learn from the lessons of the past.
With regards,
David L. Bahnsen
Chief Investment Officer, Managing Partner
The Bahnsen Group
thebahnsengroup.com
This week’s Dividend Cafe features research from S&P, Baird, Barclays, Goldman Sachs, and the IRN research platform of FactSet
