Time Warner: Still Searching for Answers

A victor may finally be emerging in the 11-month tussle over AOL that pitted Google (GOOG) against Microsoft (MSFT). Time Warner (TWX) has entered exclusive talks to sell a small part of AOL to Google. Under terms being weighed on Dec. 16, Google would cough up $1 billion for a 5% stake, according to people familiar with the matter.

For Google, the deal would bolster an existing alliance that lets it serve as the search engine of choice for AOL's 42 million users. Time Warner's decision is also a setback for Microsoft, which had been hoping to combine its MSN search and sales forces with those of AOL. And the prospect of a Google deal creates a huge challenge for Microsoft, which had been considered a front-runner and must now find a way to help its MSN network catch up with rivals such as Google and Yahoo! (YHOO).

But most important for Time Warner CEO Dick Parsons, bolstering AOL is the centerpiece of efforts to keep the Time Warner media empire intact. With pressure mounting from billionaire investor Carl Icahn for a breakup, Parsons has a tall order on his hands.

HIGH HOPES. Just five years ago, Time Warner investors viewed the company as a likely winner in the new era of the Internet. Its assets -- which ranged from the Warner film studio to CNN, HBO, Time magazine, and Bugs Bunny -- had a mass following that commanded high advertising rates. Time Warner owned one of the largest digital-cable TV systems in the nation, providing an infrastructure for TV distribution and high-speed Internet access. Its shares, which traded at less than $10 in the mid-90s, soared to $100 in 2000.

Management incorrectly asserted that its $156 billion merger with Internet pioneer AOL cleared a pathway to an even greater future of digital convergence. Of course, that wasn't to be. The deal coincided with the collapse of the Nasdaq stock market and the ensuing recession. Time Warner has yet to recover. Its shares are trading at $17.93, stuck in a dreary range since the slide was stabilized three years ago. It's worth $83 billion.

That's frustrating for investors, especially at a time when new rivals are making money at a furious pace. Google, the world's largest Internet search engine, is worth $126 billion and has increased its value more than fourfold since going public just 15 months ago (see BW Online, 11/18/05, "Is Google Flying Too High?").

BREAKING UP. Now shareholders led by Icahn are agitating for change. Icahn and allies, who control about 3% of Time Warner shares, want the company broken up. They have hired investment bank Lazard Freres to analyze the options for the assets, which include AOL, the cable systems, and book, magazine, TV, and film properties. The work, which began around Thanksgiving, is expected to last until January. While previous press reports have suggested that Icahn wants to splinter Time Warner into four pieces, any number of options are still under consideration.

Once a plan is in place, Icahn will begin soliciting support from other investors. That could lead to a proxy battle later next year, with the future of Time Warner and Parsons' job at stake. Icahn has already recruited the support of AOL founder Steve Case.

Time Warner management is digging in. Parsons has boosted the stock-buyback program in an effort to appease investors by raising the stock's value as a result of limiting its supply. Parsons is also hoping to extend AOL's alliance with Google. Some analysts considered Microsoft the favorite to win (see BW Online, 12/12/05, "AOL: Time Warner Keeps Talking"). "But it seems that Time Warner was just using Microsoft as a wedge to get better financial terms from Google," says one analyst, who declined to be identified.

STATUS QUO. What's more, the deal will cement an alliance with a formidable, swiftly growing partner and may give AOL justification for charging advertisers higher rates. Whatever the rationale for siding with Google over Microsoft, it's not clear the move will help Time Warner keep Icahn at bay.

Microsoft and Time Warner had been discussing a joint venture that would have tethered the companies' fortunes more deeply. Had that deal gone through, it would have been harder to peel AOL away from its parent. Icahn was pushing Time Warner in the direction of Google, according to a person close to the discussions. By the morning of Dec. 16, Time Warner execs notified their Microsoft counterparts that they were entering exclusive talks with Google.

The deal has big implications for the Internet. It helps maintain the momentum of the Google juggernaut and places pressure on rivals such as MSN to raise the level of their game. It also may complicate the potential breakup of Time Warner, which Parsons seems intent on avoiding. Beyond a possible spin-off of the cable systems, management seems to have little appetite for a wholesale restructuring.

PUT ON THE SPOT. Microsoft wanted to strike a 50-50 joint-venture agreement with AOL and use the revamped organization to create a new way of selling online ads. But Time Warner was being pulled hard in the other direction by Icahn and execs at the AOL unit. Icahn urged the Google deal because it included cash and wouldn't encumber Time Warner with a new structure that had limited short-term benefit.

Icahn wants to see Time Warner broken up, and the Microsoft deal would have made that more difficult. The AOL side of the house was pushing for Google because it feared Microsoft would have left it less control over its destiny. By definition, AOL wouldn't have absolute control over the joint venture.

All of that put Parsons in a tough spot. He told Microsoft negotiators in early December that he favored their deal. But with pressure from Icahn and from the board members who came from AOL, not to mention a piece by Case in the Washington Post urging a breakup, Parsons eventually relented. "It's a question of picking his fights," an exec close to the negotiations says.

ULTIMATELY OVERRULED. So what was the Microsoft deal? Initially, it proposed combining AOL with MSN. But that proved too complicated. So, Microsoft proposed setting up a new venture that would sell all sorts of ads -- display and search. Currently, AOL gets money only from display ads.

Microsoft's deal would have made AOL a full partner in search-ad revenue. And considering the companies' combined scale, it likely would have been very lucrative. But there wasn't a short-term benefit. Microsoft wasn't offering an equity investment, either. That's why Icahn pushed hard for another deal. "At the end of the day, it was a question of who was making the decisions," an exec close to the talks explains.

Turns out the answer is Icahn and the AOL board members. Though he's CEO, Parsons was overruled. How did the players fare? For Microsoft it's only an opportunity cost, other than the investment advisory fees. So it plows ahead with MSN as it is. Google maintains a very important partner. And AOL gets buckets of cash and promotion.

STICKING TOGETHER. Parsons may win this battle, but only by convincing investors that he can build more value over the longer run by keeping Time Warner together. In an era of increased shareholder activism, he can't rely on investor inertia or apathy as a job security strategy. That just won't cut it in the post post-Enron, post-WorldCom era defined by New York State Attorney General Eliot Spitzer and other agents of CEO and director accountability. "Parsons has got some convincing to do if he's not going to split it up," says Daniel Bergstein, chair of the international telecommunications and media group at law firm Paul, Hastings, Janofsky & Walker.

Some shareholders believe a breakup would lift Time Warner's stock. Investors don't like conglomerates of any sort these days, which would make life difficult for Parsons even if the company wasn't facing huge challenges from the likes of Google, Yahoo, and News Corp. (NWS), which recently bought Internet powerhouse MySpace (see BW Online, 11/14/05, "MySpace Growing Even Faster Since Acquisition"). Each of the liberated pieces of Time Warner would be a takeover candidate, leading investors to believe that a premium in the neighborhood of 20% would be figured into the stock of each new company, Bergstein says.

Icahn sees several other advantages to a breakup, according to an investor who declined to be identified. Each of the units has a different growth profile, which attracts a different sort of investor. An independent publishing company could have a slower growth rate and a potentially different capital structure than an independent group of cable networks. Keeping the businesses together obscures their differences and makes them less attractive to different kinds of investors than rival pure-play companies.

MASTER PLAN. There's also a lack of fit between AOL and other parts of Time Warner, says the investor, adding that it wasn't clear Time Warner had a strategy, beyond the operating-unit level. And to a large extent, the company is defined by Time Warner's unique culture. Cultures can be changed, but that's difficult and usually requires an extremely forceful CEO. Time Warner declined to comment.

One media executive says a breakup would be a huge mistake. "If Time Warner is broken up to appease short-term hedge-fund money, no media CEO will ever feel secure again building long-term shareholder value," says Leo Hindery, former CEO of cable company TCI and AT&T Broadband, which now are part of Comcast. (CMCSA). Hindery says rivals such as News Corp. are getting larger, not smaller. "And Google is aggregating content and power every day. Either these rivals are wrong, or those who want to breakup Time Warner are wrong," says Hindery, who runs an investment fund called Intermedia and has written a new book, It Takes a CEO.

But Icahn believes that a breakup serves the longer-term interests of the businesses. The pieces might generate more value as part of another organization. The assets have plenty of potential buyers. Yahoo is believed to have submitted an offer to buy all of AOL, which was rejected. GE (GE) or Universal might make a good buyer for Warner Studios.

"VERY COMPLEX." Even if investors support Icahn, the outcome still could turn on practical considerations, such as taxes and the legal complexities of separating the businesses. "Speaking as a lawyer, it will be very complex and could determine the fate of the company," Bergstein says.

It won't be known until after the fact whether a breakup makes sense. But one thing is clear: The pressure for change is going to keep growing in early 2006.

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