Date created:21 March 2000

Last modified: 21 March 2000

Maintained by: John Quiggin

John Quiggin

It seems anything's possible, virtually

Australian Financial Review

13 January 2000

The news that America Online is to acquire Time Warner in the biggest ($US 350 billion) merger in history is made even more interesting by its local echo, Telstra's proposed acquisition of Ozemail. But in anything concerning the Internet, it's hard to separate the virtual from the real.

Beginning with the real, both deals are part of the accelerating movement towards monopolisation of the economy, and especially the 'New Economy'. Telstra's acquisition of Ozemail is straightforward horizontal integration, cementing Telstra's dominant position in the Internet service provider (ISP) market. Of course, Telstra is already a vertically integrated firm, with market dominance at every stage of the chain from content provision to the copper and fibre local loops.

By contrast, the AOL-Time Warner merger is all about vertical integration. Time Warner has lots of content but has floundered in its attempts to exploit this content on the Web. More attractive for AOL is Time Warner's control of large sections of the US cable TV market. Cable connections are the broadband future for home Internet access, and AOL has been increasingly worried about its lack of control over this crucial link. The failure of the 1996 US Telecommunications Act, which was supposed to ensure third-party access to local telephone lines, has heightened this concern.

A crucial asset in both mergers is the subscriber base of the ISPs. Until recently, it was generally supposed that this was a market with very low barriers to entry. However, there is an increasing view that, as Internet access goes from being a luxury to necessity, the cost of changing service providers, and therefore email addresses, is rising. Australia has just gone through the introduction of telephone number portability. It looks as though we will soon have to do something similar for email addresses.

Turning to the virtual side of the story, the notion that a struggling media conglomerate and an ISP with gross revenues of $4 billion a year have a combined value equal to Australia's annual GDP (admittedly, a flow compared to a stock) is reminiscent of the calculations that used to be made showing that the land under the Imperial Palace in Tokyo was worth more than the state of California.

Dot.coms with limited revenue and nonexistent profits have used their inflated valuations to acquire firms producing real goods and real profits. On the face of it, this is not one of those deals. Not only is AOL one of the few profitable firms in the Internet sector, but its 1999 net profit of $762 million was about four times that of Time Warner. Since Time Warner will get 45 per cent of the merged company, its profits have been accorded a higher value than those of AOL. Moreover, AOL's profits are on a sharp upward trend from a loss of $485 million in in 1997. The deal looks a little fairer to AOL when revenues are taken into account - Time Warner's 1999 revenues of $25 billion dwarfed AOL's $4 billion. Still, the accounting numbers suggest that the deal is more than fair to Time Warner.

Digging a little deeper, however, the AOL picture does not look quite so rosy. Half of the 1999 profit was accounted for by capital gains on the sale of stock in another Internet company. Moreover, the prospects for revenue growth in the ISP market are limited. Although AOL is still adding users, partly through market growth and partly through acquisitions, the US market is nearing saturation, and AOL has not been as successful in its overseas ventures as it might have hoped.

But the big imponderable relates to stock options. In 1999, AOL gave its employees options with an estimated market value of $1 billion, which would more than wipe out its profit for the year. Even using the conservative approach of the Federal Accounting Standards Board, and amortising options over the vesting period, AOL's operating profit, excluding capital gains, is less than $200 million per year.

If the accounting numbers are taken at face value, AOL Time Warner will have a price-earnings ratio of about 350 to 1, modest by Internet standards. When options are taken into account, the ratio is more like 1000 to 1. It is difficult to see how an economy in which investment decisions are based on numbers like these can avoid some sort of financial catastrophe.

So is AOL Time Warner a super-profitable monopolist in the making or a jerry-built piece of financial engineering ? It can scarcely be both. But in the miraculous world of the New Economy, anything is possible.

Professor John Quiggin is a Senior Research Fellow of the Australian Research Council, based at the Australian National University and Queensland University of Technology.

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