Content is now key to value in media

The $300bn merger between America Online and Time Warner was initially met with euphoria, leading to surging stock prices for both companies. Since then, both stocks have come under pressure, with AOL's stock price dropping 15%.

The terms of the deal mean that Time Warner shareholders will own 43% of the combined company, will have 50% of the board seats and will have the chief executive officer position despite having a market value substantially lower than that of AOL at the time of the merger. AOL is therefore putting a substantial discount on the value of its own stock to achieve the merger.

The reasons for the merger are fairly clear. AOL gains vital access to Time Warner's cable customers, who make up 20% of US households, and will ultimately offer broadband (high speed) internet services over cable.

For Time Warner, AOL's internet services (which reach 20 million subscribers) offer huge opportunities for delivering proprietary content to online users. The company has unique properties in news and entertainment (including CNN, TNT, Cartoon Network and Warner Brothers), publications (Time, Fortune and Sports Illustrated) and music (where the company has a 25% share of the global market).

Some analysts have viewed AOL's move as a defensive action since its core subscription-based internet service is under competitive pressure. AOL still receives nearly 70% of its revenues through online subscription fees, but the introduction of totally 'free' internet access services, from companies such as NetZero in the US, mean that subscription fees are likely to fall, reducing AOL's future profit growth.

The migration of users to broadband internet access, through cable or high-speed telephone lines, was also a potential problem for AOL since nearly all of its users access AOL's services through narrow-band (slow-speed) technology. McKinsey & Co forecasts that in 2004, 42% of online households will have broadband access, up from the current 4%.

The merger is not expected to close for at least a year and other uncertainties lie ahead. Like any mega-merger there will be corporate culture clashes, management's attention will probably diverted by internal politics and employee retention could become an issue because some influential employees may leave to join other, higher growth internet companies.

For investors, there is uncertainty about how the merged company should be valued. Prior to the merger there was a huge gap between how investors valued Time Warner and AOL, reflecting the differences in future revenue and earnings growth. The merged company is expected to grow revenues annually by 18-20%, slower than AOL's 30% growth rate but higher than Time Warner's 8-10%. The current AOL stock price suggests investors are valuing the merged company mid-way between the two ends of the growth spectrum.

The AOL merger also has wider implications for other media and content providers, distributors and internet companies. For media and content providers the merger highlights the value that should be ascribed to proprietary 'content' assets. For cable companies and AT&T, the distributors of content, the merger clearly vindicates the future of cable as a means of providing broadband internet access.

For internet companies the implications are less clear. AOL is a unique company in the internet space and there are fairly strong synergies with Time Warner. For other internet companies it is much more difficult to see natural merger candidates in either the content or distribution segments.

However, given the high values currently ascribed to internet stocks, we would not be surprised to see other mergers, using internet stock as the currency, to acquire real world assets.

Sean Daykin is investment manager at Norwich Union Investment Management

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