Steven J. Ross knows all about D-Day. This past June 6, the chairman of Time Warner Inc. was set to spring his own big surprise: a highly unorthodox $3 billion rights offering. Ross should have had a premonition that things might go awry.
On another June 6, two years earlier, Ross's carefully fashioned merger of Warner Communications Inc. and Time Inc. was nearly unraveled by a phone call to Time Chairman J. Richard Munro. The caller: Martin S. Davis, chairman of Paramount Communications Inc. His message: Paramount would bid $175 a share in cash for Time, scuttling Ross's cozy deal.
Ross and Munro won that battle, of course. By restructuring the deal so that Time would bid for Warner, they pulled off a merger in January, 1990. But the price of victory was steep: Besides angering shareholders, Time was forced to come up with cash to buy Warner, and the combined company now lumbers under $11.2 billion in debt. It's that crushing burden that forced Ross to ask shareholders to ante up more cash for the rights offering.
By this June, Ross was already taking heat on the Street for his 1990 compensation package, a gargantuan $78.2 million. Shareholders' response to the rights issue was similarly unambiguous: They hated it. Within days, Time Warner's stock price tumbled from 117 to 88 1/8--a sickening slide that knocked $1.6 billion off the market value of its common stock. Investors still chafing from Time's rejection of the Paramount bid were now even angrier, branding the new offering coercive. "This is like Rape Two," says one major shareholder.
Beyond such bitter sentiments, some investors bear another lurking suspicion: that Steve Ross's ambitious vision of a vertically integrated media and entertainment conglomerate may be foundering on hard business realities. "We doubted the synergy. And we couldn't see the supposed benefits of the two companies in marketing and distribution capability," says Michael K. Arends, co-manager of Kemper Growth Fund, who sold off his shares after the merger.
No one is suggesting that Time Warner is starved for money: Its powerful cable television, music, and movie divisions generate more than $1.7 billion a year in cash flow. But the billions more that Ross promised would come from the merger haven't materialized. And a close look at Time Warner suggests that that's because Ross's and Munro's original rationale for fusing the companies is fundamentally flawed.
GLOBE-TROTTING. The premise was that as foreign markets open up to American media and entertainment products, a U. S.-based but truly global conglomerate such as Time Warner would stand to reap huge gains. The trick would be to forge massive alliances with partners in Europe and Asia who would help Time Warner crack these markets. Equally important, the partners would put up princely sums to get an equity stake in Time Warner's rich assets, which range from Warner Brothers to Time magazine to Home Box Office (table). That money would go to pay down the debt--specifically, a $4.3 billion term loan due by March, 1993.
For 18 months, Ross has been scouring the globe for potential partners. He has been joined in this quest by Munro's successor as co-chief executive, N. J. Nicholas Jr., and Vice-Chairman Gerald M. Levin. So far, they've clinched only a flurry of much smaller deals. These include a joint venture with cable operator United International Holdings to develop a cable TV system in Hungary, as well as an agreement with French, Dutch, and German companies to distribute movies in Europe and the U. S. But despite talking to virtually every major media conglomerate and some consumer-electronics companies, the billion-dollar alliance has eluded Ross.
And there's the rub. Without an infusion of cash from a big strategic partner, Time Warner can't make that $4.3 billion payment in 1993 (charts). While the company's operations are churning out plenty of cash, a combination of business trends and regulatory threats could soon cut into its margins. Since Ross desperately wants to avoid the draconian remedy of selling assets, he has little choice but to go to the market for more funds. "I think they need the money to repay the principal," says one unhappy shareholder. "They've tried to woo and win partners on a global basis, and they've come up short."
Ross has betrayed no hint of the strategy's weakness in discussions with money managers, analysts, and shareholders. Time Warner never intended to cover principal payments through cash flow. And the company insists that it won't back away from the rights offering. But Time Warner may ultimately modify the deal in response to investor concerns.
What don't they like about the offering? Under the current plan, Time Warner wants to raise $2.1 billion to $3.5 billion by offering shareholders rights to purchase 34.5 million shares. But the price isn't fixed: Each new share would cost $63 if only 60% of shareholders subscribe and up to $105 if they all participate. So shareholders must cough up cash to maintain the same stake in the company--without knowing the cost, since the price they pay depends on how many play the game. And because shareholders who don't subscribe would see their holdings diluted, the deal twists their arms to buy in. "This is an unprecedented sum of money to be raised in an unprecedented way," says one investment banker. "It was a deal designed by a technician who put all the right levers and buttons on it to give it the highest chance of coercing shareholders."
This time, shareholders aren't merely complaining. Fourteen suits have been filed challenging the plan, and some stockholders have protested to the Securities & Exchange Commission. They want the plan converted to a smaller, fixed-price rights issue. At the least, they want the price range lowered and narrowed. By July 10, Time Warner was beginning to show signs of relenting.
For now, Ross and Nicholas have plenty more to worry about. As both toured Europe recently to pitch the deal to investors, the burning question from shareholders was: Why haven't the strategic alliances happened?
Senior executives at Time Warner say prospective partners have been scared off by the debt, adding that they'll begin signing on once some of that weight has been lifted. But one investment banker familiar with Time Warner says that only two companies, Japan's Toshiba Corp. and France's Canal Plus, even got into serious discussions with the company. Canal Plus currently has a film distribution deal with Time Warner. But executives at the French pay-TV service say their company is too small to strike a meaningful strategic alliance with Time Warner. Toshiba says it passed on a proposal from Time Warner after it conducted a feasibility study. Neither company would discuss the outlines of the proposal.
Investment bankers in the U. S. say the Toshiba talks bogged down because Time Warner wouldn't relinquish any management control over the subsidiaries in which Toshiba was to acquire a stake. Time Warner insists it wants to install European-style management in its European ventures and Japanese-style management in Japan. Still, one Time Warner executive notes: "Depending on who our partner is, I don't think it's a good idea for them to come and tell us how the hell to make movies. We're too good at that."
Such unabashed confidence has led Time Warner to ask rich prices from prospective partners, according to bankers familiar with the talks. That reduces the number of would-be partners as well, since several oft-mentioned alliance candidates such as France's Hachette are struggling with their own finances. "Price will always be a matter of discussion," says the Time Warner executive, "but we are not arrogant." Exchange rates don't help, either: A weaker Japanese yen would make a deal tougher for Toshiba than Sony's 1989 buyout of Columbia Pictures or Matsushita's recent acquisition of MCA.
Even aside from economic vagaries or Time Warner's negotiating posture, few companies have the size and assets to make such an alliance truly worthwhile. Arthur R. Barron, a former Paramount executive whom Ross lured from retirement last February to spearhead Time Warner's joint-venture effort, figures that eight companies in Europe and Japan meet the requirements. He adds, however, that offering Japanese and European partners a variety of equity stakes would swell the number of candidates appreciably.
INSATIABLE. Time Warner's smaller deals generally take two forms. The most common is one in which the company supplies its entertainment software--movies, TV shows, rights to licensed characters such as Bugs Bunny--to foreign programmers such as Canal Plus. The other is where Time Warner uses its technological expertise to create new cable television markets: Witness the Hungarian cable venture and a new pay-TV service Time Warner recently launched with Svensk Filmindustri, Sweden's largest motion picture and TV producer.
Such deals work because government deregulation of European airwaves has generated an insatiable demand for programming. But the strategic alliances are tougher: A Toshiba deal, for example, would mean linking an electronic hardware manufacturer with a software supplier. Such linkups are attractive if the company wants to promote a new home-entertainment technology: Sony, for example, is putting movies from its RCA/Columbia Home Video unit on its eight-millimeter video system. Similarly, Pioneer Electronic Corp. has used an alliance with Carolco Pictures Inc. to promote its laser-disk technology. But Toshiba isn't a leader in such technology.
And some media experts contend that the appetite for these pairings is slackening. "I am not in the least bit convinced that there is a compelling reason for hardware-software alliances," says Robert Alexander, a consultant who has advised Time Warner and several other media companies. "I think it's a fad."
Such words don't daunt Barron. He says he has deals percolating in Greece and Britain, among other countries, and predicts he will close five or six more this year. He also insists that the Big Deal still looms. And he adds that the pressure to produce a flurry of deals has not increased because of the Sturm und Drang surrounding the rights offering: "I've never had anyone say to me, `Why aren't there more deals?' "
COURTROOM CAMERA. All of Time Warner's operating executives are quick to point out that the uproar hasn't led to pressure on them to jack up earnings. But make no mistake: The rights offering has turned a klieg light on the company's divisions. Simply put, investors are looking for signs of the synergies that Ross and Munro promised when they talked up the merger 18 months ago. The company points to several places where Time Warner's diversity has generated opportunities. But so far, the payoff is difficult to see.
Time Warner's huge cable system, for example, will certainly help Courtroom Television Network, a new channel backed by American Lawyer Media and Time Warner Enterprises. The channel, which airs 24-hour coverage of trials, premiered July 1 on Time Warner's all-important Manhattan cable networks.
On the other hand, synergies have provided scant comfort to executives at Time Warner's magazine division, who are coping with the worst advertising drought in two decades. Reginald K. Brack Jr., chairman of Time Warner Publishing, claims the merger has let him sell lucrative multimedia ad packages to clients such as Chrysler Corp. and General Motors Corp. But Brack admits that innovative ad packages only go so far: "There is very little we can do to radically improve the short term."
Indeed, cash flow at Time's publishing division plunged from $72 million in the first quarter of 1990 to $42 million in the same quarter of 1991. That was the primary culprit in the slight decline in Time Warner's overall first-quarter cash flow, from $536 million in 1990 to $530 million in 1991. More revealing is that 1990 gross revenue was off 1.8% at Fortune and 2.7% at Sports Illustrated, according to Publishers Information Bureau. Revenue at Time was flat, while it increased 5.5% at People. These results are markedly similar to those of competing titles, in spite of Time Warner's ability to package a number of its publications or offer deals with other of its media properties. Media buyers on Madison Avenue say Brack's frustration with the pace of package deals led him to realign his ad sales staff recently.
The maestro of Time Warner's huge music business is also waiting for an industry upturn. Robert J. Morgado, chairman of Warner Music Group, says weak demand for cassettes and compact disks contributed to a decline in first-quarter cash flow from $149 million in 1990 to $137 million. "We're going through a necessary readjustment to a slowdown in consumer spending," he says. Those results, however, weren't helped by the recent loss of distribution deals with Geffen Records and MCA, both of which were swallowed up by Matsushita Electric Industrial Co.
Music is an unpredictable business, dominated by hits. But Morgado says Warner has hedged its bets by nurturing a broad array of artists and styles. Last week, for example, Warner labels boasted 6 of the top 10 U. S. albums on the Billboard chart, with artists ranging from the heavy metal band Skid Row to pop crooner Natalie Cole.
HOODWINKED? Then there's Madonna, who is now demanding a multimedia deal with Warner to rival Michael Jackson's blockbuster pact with Sony Corp. Morgado won't comment, but Warner executives say privately that they doubt Madonna's appeal as a multimedia star. Still, Morgado had better hope the Material Girl keeps churning out hits: Madonna and other stars helped the music division kick in a hefty $558 million in 1990 cash flow, making it second only to the cable division in profitability.
Warner's filmed entertainment division, with one of Hollywood's strongest libraries, generates more than $370 million a year in cash flow as well. But it could do better, industry experts say. That's because to cut its risks, the company only produces about half the films it distributes. Its take from its summer hit, Robin Hood: Prince of Thieves, for example, would have been far greater if it had bankrolled the entire $52 million in production costs. Instead, it only paid about one-fourth of the costs. So it has to watch the film's producer, Morgan Creek Productions, take the lion's share of profits.
As happened at the music division, Warner faces the loss of a deal to dis
tribute Walt Disney Co. movies overseas. Yet Warner Brothers insiders put the loss of that business at less than $30 million a year. And Chairman Robert A. Daly says he is already talking to other studios about picking up their business. More troubling is a recent Federal Communications Commission ruling that changes regulations governing fees from syndication of TV programs. The Big Three networks would share in some of the overseas revenues from shows they aired first. That would eventually damage the bottom line at the Warner Brothers and Lorimar TV units.
The shadow of government regulation hangs over Time Warner's robust cable holdings, too. Lobbyists in Washington are predicting that some form of further cable reregulation will pass Congress this year. Now, broadcasters are pushing legislation that would force cable companies to pay a fee for the network feeds that they currently air on cable for free. Time Warner executives say the campaign will backfire on the networks: "It's so outrageous that it's hard to see it adopted as the law of the land," says Joseph J. Collins, chairman of Time Warner Cable Group.
FIRM FOCUS. Time Warner's weakest division is Home Box Office. While it's still the biggest and highest-rated pay cable service, HBO's growth has slowed from its heyday. It added 300,000 subscribers in 1990, a tiny fraction of its heady growth in the early 1980s, while sister channel Cinemax actually lost 100,000. So HBO Chairman Michael J. Fuchs is looking for new sources of revenue such as programming. HBO has begun distributing pay-per-view fare such as the recent Evander Holyfield-George Foreman heavyweight bout.
Rival media executives argue that Warner's already successful movie and music businesses have yet to benefit from the merger. Certainly, one result of the merger has been to introduce Time Warner executives to the financial jargon of a highly leveraged company. Asked about his EBITDA results (earnings before interest, taxes, depreciation, and amortization, a common measure of a company's ability to meet its debt service), Morgado recently snapped: "Forget EBITDA. Let's look at the business."
He has a point. Time Warner owns a dazzling array of properties that have been solidly managed. And Steve Ross's dogged focus on global markets is logical enough. "We never doubted the globalization theory," says Kemper's Arends. The trouble is that Ross bet shareholders' money on an overarching vision of how his businesses would fit into this global scheme. As Ross comes up short, Time Warner's shareholders must live with the fallout.
That above all has sparked the intense hostility toward Ross. A year and a half after denying investors Paramount's bid, which ultimately reached $200 a share, Time Warner again is asking its shareholders to suffer. "It's almost an oxymoron to say you're making money in Time Warner," says Dale M. Hanson, CEO of the California Public Employees' Retirement System, which owns more than $50 million in Time Warner stock.
Hanson is one of several shareholders who are taking action. He has hired Providence Capital Inc., an investment bank that represents shareholders, to plead his case with Time Warner management. Rumors that the company might bend sent Time Warner's stock up several times in early July.
BOXED IN. Most investment bankers still think the offering will fly in some form. Short of selling assets, it's unclear how else Time Warner would be able to pay off the $4.3 billion term loan. Refinancing the debt would subject the company to steeper rates, since Time Warner negotiated its bank loans prior to the adoption of banking regulations governing highly leveraged transactions. "They would have to pay enormous fees to get that kind of financing this time around," says Gerald Hassell, executive vice-president of Bank of New York, one of Time Warner's banks.
So Ross has boxed himself in. But he has a long history of wriggling out of tight corners: the devastating collapse of Warner's Atari subsidiary, his bitter feud with Chris-Craft Industries Inc. Chairman Herbert J. Siegel, Paramount's unexpected offer for Time. Shareholders may grumble and rivals may cluck, but few of them are betting that the ever-resourceful Ross won't extricate himself from this mess, too.
The bigger question has to do with Steve Ross's vaulting vision. Time Warner is in no imminent danger. But many shareholders of the world's largest communications company are starting to wonder: Is their money being mortgaged on a chimera?
TIME WARNER'S EMPIRE
Time's 1990 merger with Warner Communications created a media and entertainment powerhouse. Its publishing, music, and Home Box Office properties are the leaders in their businesses, while cable television and filmed entertainment are among the top three
1990 results; income figures reflect earnings before interest, taxes, depreciation, and amortization
22 major record labels, including Warner Bros., Atlantic, and Elektra; music publisher Warner/Chappell Music
STRENGTHS Broad array of superstars such as Madonna and Phil Collins; unparalleled global distribution system
WEAKNESSES Slack consumer demand; loss of lucrative distribution deals
REVENUES $2.93 billion
OPERATING INCOME $558 million
24 magazine titles, including Time, Sports Illustrated, People, Fortune, and Money; Book-of-the-Month Club; Little Brown & Co.
STRENGTH Three of the top five magazine titles in gross revenue
WEAKNESS Prolonged ad recession
REVENUES $2.93 billion
OPERATING INCOME $366 million
Warner Bros. studio; television programmers Warner Bros. and Lorimar Television; Warner Home Video
STRENGTHS Only filmed-entertainment company that controls 100% of its worldwide distribution; Robin Hood: Prince of Thieves is shaping up as a hit
WEAKNESSES Inherently unpredictable business; future loss of some foreign TV syndication revenues
REVENUES $2.90 billion
OPERATING INCOME $377 million
Warner Cable and 82%-owned American Television & Communications Corp.; basic-cable ventures such as Courtroom Television Network
STRENGTHS 6.5 million subscribers in key metropolitan areas such as New York City, and growing areas such as Florida
WEAKNESSES Big price hikes threaten consumer backlash, stricter government regulation; new technologies could open way to competitors
REVENUES $1.75 billion
OPERATING INCOME $769 million
HOME BOX OFFICE
HBO and Cinemax pay-cable channels; basic-cable channels such as CTV: The Comedy Network; pay-per-view cable ventures such as all-boxing TVKO
STRENGTH Largest and highest-rated pay-cable service
WEAKNESS Pay-cable growth is slowing because of rising rates
REVENUES $1.3 billion
OPERATING INCOME $182 million
DATA: COMPANY REPORTS, BW
WHY TIME WARNER NEEDS AN INFUSION OF EQUITY THE VISION
In July, 1989, Time walked away from Paramount's $200-a-share bid. Its rationale: A merger with Warner would generate synergies that would ultimately boost the value of the stock even more. Warner's Steve Ross sketched out a vertically integrated company that would use European and Japanese partners to expand into foreign markets. Cash to pay down debt would be raised by selling equity stakes to some of these partners
The synergies have been few. Businesses that thrived prior to the merger are still thriving. But there's little sign that they've benefited from the deal. What's more, Time Warner hasn't clinched a big strategic alliance. Few companies fit the profile for such a partnership. And Time Warner has had trouble agreeing with would-be partners on price and control for the deals. It's forging plenty of smaller deals, but these don't erase much of the $11.2 billion debt
Time Warner must pay off a $4.3 billion term loan in March, 1993. It can draw on a $1 billion credit line to pay off part of the loan. That still leaves it hunting for $3.3 billion. Cash flow won't cover it all. So Time Warner figures it must raise at least an additional $2 billion. That can come either from a rights offering or from asset sales. The company has opted for the former, but its proposal has infuriated shareholders and heightened scrutiny of the
original vision for the merger