A Yardstick for AOL Time Warner

Yes, it will churn out vats of cash, but AOL Time Warner's valuation is high compared with other money-spinners, such as Cisco and Walt Disney

Wouldn't it be terrific to be in a spot where, no matter how anxious your boss, business partners, or investors got about your performance, you couldn't be compared? That's the perch the newly merged AOL Time Warner (AOL ) now is claiming for itself. "You've got a global, large-cap growth stock here, and it's not a media company, and it's not an Internet company," CEO Gerald Levin recently told investors via CNBC. "This is a one-of-a-kind company."

Can that possibly be true? In one way, yes. AOL Time Warner is alone in having assembled such an assortment of media assets, New and Old, on such a vast scale. Adopting the jargon of Internet investors, Levin calls it "a big monetization machine," which he promises eventually will turn out the sort of financial returns that in a simpler era built such baronies as William Randolph Hearst's San Simeon. But does that also mean investors can't compare AOL Time Warner to alternative investments? No.

To remember why, take a trip past such mumbo jumbo as "monetization"--the turning of eyeballs into profits--or "metrics" and go back to basics. Any company exists to make cash dollars on the cash that the owners invest. Good businesses return goodly amounts of cash, even after spending on capital projects and whatever else is needed to keep operations in trim. That's what such careful investors as Holland Balanced Fund manager Michael Holland call "free cash flow." What interests him above all is finding a company to buy into that has a good "cash-on-cash" return. "It's fungible," he says, and to get it, "I don't care whether I invest in GE vs. AOL Time Warner vs. International Paper."

As it happened, Holland was CNBC's guest host the morning of Jan. 31, when Levin appeared. He asked Levin to pit his company's prospects against Viacom's (VIA ), which he noted Merrill Lynch also recommends. In fact, while targeting a rise in AOL Time Warner, from $47 a share now to $65 in the next year, Merrill sees Viacom surging over twice as far, to $100. Yet citing AOL's strong growth in online advertising and commerce, Levin told Holland: "There is no comparison."

Unless, perhaps, you look at that great equalizer, free cash flow and the list of giant-cap stocks AOL Time Warner finds itself among. It's telling Wall Street that it expects free cash flow this year to triple, from $920 million last year (figured as though the two companies were actually merged, which did not happen until this January).

MULTIPLES. That forecast sounded impressive until I also saw in the company's financials that the merged company's free cash flow would have been $2.4 billion in 1999. So the company's truest bottom line actually plunged in 2000, as it spent heavily to hook up digital cable and high-speed modem subscribers. That may pay off handsomely one day. But even if free cash flow does triple this year, it will wind up just 15% higher than in 1999.

Over the next several years, AOL Time Warner expects free cash flow to grow at a 50% annual rate. That would be an astounding accomplishment, bringing free cash flow in, say, four years to about $5 billion. In the past year, by Morningstar's measure, just eight companies spun out as much free cash, the least of them Johnson & Johnson (JNJ ). How does J&J compare? Its market capitalization is $135 billion, one-third less than AOL Time Warner's $201 billion, despite having generated last year the cash that AOL Time Warner only hopes to produce in 2004. Can Levin's "big monetization machine" meet its production goal? "We have a history of setting aggressive goals and achieving them," Mike Kelly, AOL's chief financial officer and CFO of the new company, told me. Perhaps they will again.

Yet careful investors will compare prices. Just a hair ahead of AOL Time Warner by market value is Cisco Systems (CSCO ). You could buy Cisco for 45 times its most recent 12 months' worth of free cash flow. AOL Time Warner? 220 times. Or look at a rival name dismissed by Levin on CNBC, Walt Disney (DIS ). The comparison is not flattering. A veritable Mississippi of free cash flow, Disney in its fiscal year ended Sept. 30 generated $1.7 billion. With a $68 billion market cap, it's going for 39 times free cash flow. So call AOL Time Warner incomparable. Just not incomparably cheap.

Questions? Comments? Send an e-mail to barkerportfolio@businessweek.com or fax (321) 728-1711

By Robert Barker

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