The Washington Post has a piece today about AOL's sliding stock price, which follows up on a Business Week story last week on the same subject. Both are useful on facts, short on analysis. What follows is a column I wrote a year ago for Inside Magazine on the AOL-TWX merger and what is required to make it work.
Journalists, like the rich, protect their own. So it's not surprising that the now federally approved AOL acquisition of Time Warner has received largely favorable treatment in the news media. Investors haven't been nearly as generous, and with good reason. AOL Time Warner's stock has "short" written all over it.
It's not just the stratospheric valuation, though anything that sells at a multiple of 99 times earnings these days is certain to fall. And it's not just that the advertising market has softened, making it harder for AOL Time Warner to meet its projected top- and bottom-line numbers. Nor is it the fact that most such oversized deals don't deliver their promised synergies - a recent KPMG study suggests that 83 percent of big deals don't. These things are all true, but they aren't the core problem. No, the core issue is how AOL Time Warner manages information or, more specifically, whether it can integrate its internal and external information-technology systems and software.
To appreciate the scope of the problem, we need to back up a bit. In the '80s, Wall Street arrived at a fairly standard formula for valuing cable TV systems: Each cable subscriber was worth $1,000. Thus if Black Hawk Cable in Southern California had 1 million subscribers, its market value was roughly $1 billion. As the Internet juggernaut gathered steam in the late '90s and the possibilities of broadband access via cable television became apparent, the value assigned to subscribers escalated, culminating in ATT's purchase of MediaOne in 1999 for an astonishing $5,000 per subscriber.
Extrapolating from the '80s formula, AOL Time Warner looks OK on paper. The company says it has 130 million subscribers to its various offerings, from AOL to Time Warner Cable to TBS, HBO and Time's magazines. Apply the $1,000 multiplier, and you get a valuation of $130 billion, which is $100 billion short of the company's current market capitalization. Apply a $5,000 multiplier and you've got the most-valuable corporation in the world. Even if you assume that many AOL subscribers also are customers of Time Warner magazines and other properties (and are therefore being counted two or three times), the subscriber base is impressive. AOL Time Warner sits atop potentially explosive value.
The trick is unlocking that value. A large part of that task has fallen to AOL Time Warner co-COO Robert Pittman, whose skills are not in question. Pittman has promised that AOL will meet its revenue and earnings targets despite a softening ad market, as long as it follows his three rules: "execute, execute and execute."
And Pittman has - in concert with a couple of AOL Time Warner division heads - already produced results. Time Warner's magazines are signing up 100,000 new subscribers per month (thanks to those ubiquitous popup screens on AOL), at a fraction of the direct-mail cost. Subscribers to Time Warner magazines have been shipped a disk containing the "all-new" AOL 6.0, which has helped increase AOL's subscriber base to 27 million.
The catch, of course, is that these steps show diminishing returns: They post big numbers at the outset but less and less as time goes on. To truly unlock the value inherent in all those AOL Time Warner subscribers requires collaborative-filtering technology, which sifts through all the preferences and purchases of each subscriber and, based on that, generates suggestions as to what else that subscriber might be interested in seeing or buying. The better the collaborative-filtering technology is, the higher the click-through/sell-through success rate.
Just think about how many books or CDs you've considered buying because Amazon put them in front of you. AOL Time Warner can only realize the underlying value imbedded in its customer base if it has the very best collaborative-filtering technology. And for that technology to work - to connect its vast array of products with its vast pool of customers - all of its information-technology systems (in every division) must be integrated into one interoperable information-technology system.
This is the challenge that Pittman and his colleagues now face, since the IT systems of the various AOL Time Warner divisions were designed and built independently of one other and, as a result, are incompatible. In some cases, they're even internally incompatible (meaning that, say, a single division's marketing software programs aren't integrated with the same division's accounting software programs). In other cases, there's been no reason to integrate them. The various business units (cable television and the magazines, for instance) have been run independently. To make all the IT systems interoperable requires an investment of hundreds of millions of dollars. And no one at AOL Time Warner is interested in adding hundreds of millions of dollars to the cost side of the ledger. They'll do the best they can for the time being with "patch" software (which bridges incompatible systems) and hope that Oracle or some other code company comes up with a magic solution.
AOL Time Warner is not the only company that suffers from this problem. Indeed, interoperability is the major technology challenge facing most large companies today. But it's particularly important to AOL because at its core, it's a marketing machine; a business of "bits" of information that gathers more information through the distribution of its various media products. If the information-technology systems are not fully integrated, then the true value of those "bits" lies, to a substantial degree, dormant.
Not being competitive technologically (in terms of its IT system) puts AOL Time Warner at considerable risk, because there are technological forces lurking out there that can lay waste to some of the company's most established brands. These external challenges have been well-documented over the course of the last 12 months, as the AOL-Time Warner deal wended its way toward FTC and FCC approval. And they are, if anything, even more menacing to AOL's value chain than they were a year ago.
Take peer-to-peer computing. It is now possible, through the services of Aimster, Gnutella and Napster, to download virtually any piece of recorded music for free. That makes it hard for Warner Records to tap the potential value of an AOL music service. Apply the same peer-to-peer technology to TiVo (the digital video recording system) and you cut into the future revenue streams at TBS, TNT and Warner Bros. Films. Download Groove.net software and you have a friends-and-family communications platform that makes AOL's instant messaging look and feel like your kids' old Etch-A-Sketch. And this is just the first wave of peer-to-peer technology. As the trend accelerates, what follows could be even more threatening to AOL.
Pittman understands all this. In interviews with various media outlets to discuss the future of AOL Time Warner, he seems to be three to five steps ahead of the questions. The hardest part of his job will be to get everyone else at the company to understand all of this. The AOL Time Warner combination is often written about as a culture clash - "let's skip lunch versus let's do lunch," is how Business Week recently put it. But any culture clash masks the larger argument about where value lies. No one at Warner Records or Warner Bros. Films or at any of the magazines or television entities thinks that information technology is the key to their future success. Truth be told, they probably think IT systems are for geeks. But without the geeks, the value of AOL Time Warner will diminish over time. And the shorts won't just profit, they'll bring the company to its knees.
Monday, April 01, 2002
Posted by John at 4/01/2002 01:30:00 PM