A New Net Equation

One lesson of the AOL Time Warner deal: Profits matter after all

First came the explosion. After America Online Inc. and Time Warner Inc. announced plans to merge on Jan. 10, their combined market capitalization plunged by $10 billion in three days. AOL shareholders howled that they would be saddled with a slow-growing old media company, while Time Warner stalwarts questioned the value of shares in a brazen young company that not so long ago was derided as America Offline. The collision of Internet believers and skeptics was a little like the interaction of matter and antimatter: blammo.

But as the smoke clears, it's becoming apparent that the combination of online and offline companies makes perfect sense in terms of strategy--and may be just as smart on Wall Street, too. Bricks-and-mortar retailers need the reach of the Internet, while their online counterparts need showrooms where people can finger a pashmina shawl or settle into the bucket seat of a new sports car. America Online wants film libraries and high-speed connections via cable, while Time Warner covets the eyeballs of AOL's 20 million subscribers.

This scenario may not be as exciting as the story of an Internet startup with no revenue, heavy losses, and an initial public offering that produces billions overnight. But it could play longer. No, Net IPOS are not going away, and Net stock valuations are not going to fall in line with those of General Motors Corp. and General Electric Co. But, as the AOL/Time Warner deal makes clear, the way the markets will value companies will change as the Internet economy blends with the Old Economy. Profitless upstarts may not get such a break, and bricks-and-mortar companies that are investing in New Economy assets may be rewarded.

Some Wall Street pros are saying that the big story in the market this year could be more deals like the AOL-Time Warner combo. "This will be a groundbreaking year in terms of bricks-and-mortar companies forging relationships in a variety of capital structures with online companies," says James W. Breyer, managing partner at Accel Partners, a Palo Alto (Calif.) venture-capital firm. But the payoff in stock value will come only for those that can make this blending succeed. Says Breyer: "Only the best companies will operate very effectively at the intersection of offline and online."

BREAKING RANKS. AOL Chairman Stephen M. Case, by seizing this opportunity first, is the master of the new game. He snagged Time Warner at a time when AOL's shares were not far off their historic highs, easily paying a 71% premium for Time Warner shares. The next online rival who follows in Case's footsteps will most likely have to pay an even bigger premium. For Case, jumping early made a lot of sense. "AOL broke ranks," says Evan I. Schwartz, author of a new book called Digital Darwinism and a former BUSINESS WEEK software editor. "They distinguished themselves and put their competitors at risk."

The other lesson of the AOL-Time Warner merger is that profits matter. One reason AOL was able to use its shares as currency to acquire the world's largest media conglomerate is that it has real net income. On Jan. 19, it announced that earnings for its December quarter more than doubled from a year earlier, to $271 million. Black ink, a rarity for Internet companies, is so precious to investors that they gave AOL a pre-deal market capitalization of $173 billion, vs. just $97 billion for much larger Time Warner. That enabled AOL to bargain for 55% of the combined company. The net income also meant a lot to Time Warner Chairman Gerald Levin. He has said AOL was the only Internet company with which he would have considered merging.

That's a real reversal in thinking. Even in late 1999, it seemed big losses signaled big ambitions and profits were for wimps. "He who hesitates gets smoked. There's almost no incentive to be conservative," J. William Gurley, a partner at Benchmark Capital, lectured investors at a conference last September in Santa Fe, sponsored by Credit Suisse First Boston. Joy D. Covey, chief strategy officer of Amazon.com Inc., bragged to the Santa Fe crowd that the company could get away with years of losses because investors believed in its vision.

Covey may want to change that tune in 2000. Amazon shares dropped precipitously from a record of around $106 in early December to $66 a share on Jan. 19 on news that the company's losses weren't shrinking despite soaring revenue.

What changed? The Christmas selling season, for one thing. Investors lost their stomach for consumer-oriented Web sites that spent so much on advertising, promotion, and price-cutting that they lost huge amounts on every sale. Investors have also lost faith in Web media companies such as women's site iVillage Inc. that haven't figured out how to "monetize eyeballs"--that is, make money from the people looking at their pages.

Other Net stocks that have felt the swing: priceline.com Inc., a name-your-own-price Web site; E*Trade Group Inc., an online broker that was making money but started losing it after embarking on a costly advertising campaign.

MISSED MILEPOSTS. As investors search for value, most at risk are the companies with stock prices based primarily on a persuasive story. By convincing investors that a vision of market dominance is reasonable, a persuasive executive like priceline.com's Chairman Jay Walker can raise the money to make that dream come true. But if a company misses its mileposts and investors start to doubt the premise, the stock will slip. On Jan. 19, priceline.com was down 62% since its peak in April. The reason: slow improvements in its gross-profit margins.

Many disillusioned investors are casting around for somewhere else to put their money. Some are flocking to highly profitable tech companies like Microsoft Corp. and Cisco Systems Inc. Others are investing in small- and midcap Internet companies that are trading at more reasonable valuations than large-cap issues. Since the beginning of October, the Russell 2000, a small-cap stock index, has gained 22%--outpacing both the Dow Jones industrial average and the Standard & Poor's 500-stock index. "You've got a return to fundamentals, where there are parameters that finally start to make sense," says Laszlo Birinyi Jr., who runs his own research firm and serves as global strategist at Deutsche Bank Securities Inc. "It's the death of Internet `unvaluations,"' he says.

CONVERGENCE AHEAD. Investors who still want Internet stocks with big promise are moving into new areas, including business-to-business companies and makers of optical technology. Many of the hot new B2B stocks, such as Chemdex Corp., an online marketplace for life sciences, have been formed only in the last three to six months, notes Greg A. Kyle, president of Pegasus Research International LLC, a New York Internet research firm. But they are raising hundreds of millions in IPOS and seeing their shares soar. "Some of those companies could run up 1,000% before a shakeout occurs," he says.

The most interesting play may be a bet on the coming convergence of online and off-line. Some of the best performers lately are non-Net companies that are beginning to take on a Net persona, such as Charles Schwab Corp. Despite its origins as a conventional discount broker, Schwab has become the largest online broker, and its stock reflects that. On Jan. 13, Schwab agreed to acquire white-shoe asset management firm U.S. Trust Corp. In another twist, offline companies that are seen as potential takeover targets by online companies are seeing their shares rise. The day the AOL-Time Warner deal was announced, the stock of Walt Disney Co. jumped 16% on takeover talk.

As many older companies purchase or partner with Internet companies, their stocks should benefit. Wal-Mart Stores Inc. fell short in its homegrown Web efforts, but it's trying e-tailing again in a partnership with Accel Partners, which specializes in Internet properties. Wal-Mart's shareholders will own a majority of the venture, so they'll get most of any profits. Accel's Breyer, who will sit on the venture's board, says it will be located in Silicon Valley rather than Wal-Mart's hometown of Bentonville, Ark.--a signal that the giant retailer is deadly serious this time around. "The Old Economy is waking up. You can't think that the older economy is simply going to cede their business to upstarts," says Paul Cook, manager of the Munder NetNet Fund.

As the fireworks surrounding the AOL-Time Warner deal demonstrate, combinations of online and offline companies can be extremely difficult to carry off. For one thing, investors in fast-growing companies could continue to frown on the meldings. Last year, the stock of Lycos Inc. fell so precipitously after it announced plans to buy old-media company USA Networks Inc. that the deal was ultimately scrapped.

And investors who believe upstart Net companies can change the world have good reason to view the May-December pairings of old-line and Net companies with skepticism. A recent study by Sanford C. Bernstein & Co., a New York investment bank, showed that mergers represent the worst use of funds--with merged companies underperforming the S&P 500 by 15% after three years. More importantly, according to the study, large stock-merger deals by growth companies fare the worst because the degree of overpayment tends to be much larger. "The strategic impact of these deals may be ultimately positive. But at least short-term, the financial and valuation impact of the acquiring company will take a hit," says Munder's Cook.

Despite the risks, online-offline deals are sure to multiply in the coming months. Says Cook: "When we started the NetNet Fund three years ago, we said the total landscape will soon be the New Economy. Old Economy businesses would have to get there one way or another. The message to Old Economy companies: Buy it, build it, or be replaced by it." Prepare for more explosions.

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