May 28 (Bloomberg) -- Time Warner Inc. will spin off the entire AOL Internet unit by the end of the year, reversing a failed $124 billion merger that triggered record losses.

AOL’s online advertising and Internet-access businesses will be separated into an independent, publicly traded company, New York-based Time Warner said today in a statement.

“A separation will be the best outcome for both Time Warner and AOL,” Chief Executive Officer Jeffrey Bewkes said in the statement. “The separation will also provide both companies with greater operational and strategic flexibility.”

Bewkes is getting rid of AOL, which has confronted falling ad sales during the recession, to focus Time Warner on its film and cable-television businesses. AOL has dealt Time Warner a series of setbacks since the 2001 deal: shareholder lawsuits, a regulatory probe and declining sales. The parent company wasn’t able to sell or find a partner for the unit after talks last year with Google Inc., Yahoo! Inc. and Microsoft Corp.

“The obvious implication of spinning out all of AOL in one entity is that Time Warner’s efforts to sell AOL failed,” Fred Moran, a Boca Raton, Florida-based analyst at Benchmark Co., said in an interview. “Now, as a last resort, Time Warner is looking towards spinning the whole company out.”

Time Warner prepared AOL for a spinoff in the past three months, hiring a new CEO for the division and amending debt agreements. The board’s approval, announced today, sealed the deal a month after the company said a spinoff was likely.

Time Warner, based in New York, fell 1 cent to $22.99 at 10:01 a.m. in New York Stock Exchange composite trading. The stock had gained 3.2 percent this year before today.

Tim Armstrong

AOL will be spun off to shareholders, giving the unit’s new CEO Tim Armstrong a public company to run after he joined from Google two months ago. The transaction will be tax-free for Time Warner shareholders, and needs regulatory approval and the board’s final consent of the terms.

Finalizing AOL’s structure will allow Time Warner to resume share buybacks, Bewkes said on the company’s April 29 conference call. Time Warner finished the first quarter with $7.1 billion in cash after shedding its cable-systems unit.

Plunging Value

Time Warner’s 95 percent stake in AOL is worth about $6.3 billion, including about $3.4 billion for the advertising business and $2.8 billion for the access division, David Joyce, an analyst with Miller Tabak & Co., estimated in a report yesterday.

When Google bought a 5 percent stake in AOL for $1 billion in 2005, it valued the unit at about $20 billion. Time Warner said last month it was in talks to buy back the stake. Google wrote down $726 million of the investment last year.

Armstrong has shuffled AOL executives as he tried to salvage a business in decline. The unit’s ad sales dropped 20 percent in the first quarter, after falling 18 percent in the fourth.

AOL’s access business is also shrinking, finishing 2008 with 6.9 million paying access subscribers in the U.S., a quarter of the subscribers it had when the 2001 combination closed. It may lose another 550,000 customers this quarter, estimates Joyce, who recommends buying the shares.

In 2006, Time Warner’s former CEO Richard Parsons fought off an effort by investor Carl Icahn to split off AOL as part of a larger plan to break up the company. Parsons said at the time that AOL could be worth as much as $26 billion in the following few years.

America Online Inc. bought Time Warner for $124 billion in 2001, leading to a record loss the following year.

Internet Bubble

“The merger of Time Warner and AOL represented the peak of the Internet bubble literally months before the Internet bubble popped,” said Moran, who recommends holding Time Warner shares. “AOL ended up not only having a completely over-inflated valuation but also an over-inflated, inaccurate subscriber count.”

AOL Time Warner, as the company was named after the combination, left a series of executive departures and investigations in its wake. Former CEO Gerald Levin, an architect of the purchase with Steve Case, announced his retirement less than a year after the deal closed as growth slowed. The company dropped AOL from its name in 2003.

Case, the co-founder of AOL, resigned as chairman in 2003 amid shareholder lawsuits and a Securities and Exchange Commission probe into whether AOL improperly booked ad revenue to help close the deal. The company paid $510 million to settle the government probes and $2.4 billion to end the lawsuit.

To contact the reporter on this story: Sarah Rabil in New York at srabil@bloomberg.net

Last Updated: May 28, 2009 10:16 EDT