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July 13, 2006

One More Stab At AOL - Time Warner Heading Lower

Time Warner (TWX) shares fell for the 7th straight day yesterday, no doubt continuing the negative reaction since word spread that AOL might switch strategies again. The stock has dropped 5.1% in total, erasing about $3 billion in market value.

As I noted in a post last week, the shift away from a subscription model could have an immediate EBITDA hit of $200 million. Since investors were probably not valuing AOL at 15 times EBITDA, I think the reaction is reality settling in that AOL is worth a lot less than previously assumed and might not be salvageable.

Reading analyst research about the AOL situation, I was intrigued by a comment from Jessica Reif about AOL's declining page views. Remember that the idea behind giving free access to all the features at AOL.com to any user with a broadband connection is to keep subscribers that are deserting the dial-up business on the AOL site and maybe even attract some new users. The goal, of course, is to turn AOL.com into Yahoo and build an advertiser driven business that more than makes up the EBITDA loss from the dying dial-up subscription model.

Personally, I think it is a hopeless case because AOL is a weak and stale brand. To justify my harsh view, I asked Jessica for data on AOL's page views and unique visitors. I know that internet stock investors are probably very aware of this data but what I found was pathetic.....

First, based on May data, the Time Warner Network of sites (includes AOL, CNN, and others) had the worst growth rate of any of the top 12 sites. In fact, vs. year ago figures it grew just 1%, worse than total internet unique user growth of 4%. Even a "mature" site like Yahoo had 9% growth, while MSN, which is often compared to AOL for its futility in advertising growth, had 8% unique user growth. Second, turning to page views, the data is really startling. AOL, excluding instant messenger, is down 27% year-over year, and down 35% from April 2005 when AOL page views last had any meaningful sequential monthly growth.

This data clearly shows that the prior strategy to build AOL.com into a leading portal was failing. While I think that strategy was hopeless due to the weakness of the AOL brand in the online world, at a minimum, the steady loss of dial-up subscribers was too much to overcome. The data also shows that AOL doesn’t have a huge amount to lose with the new strategy. The prior approach to grow AOL.com against the dial-up tide rolling out was hopeless. And looking at the rate of loss for page views and loss of market share with internet users, it is pretty clear that the path to complete irrelevancy and massive EBITDA declines was etched in stone.

What's the worst case scenario for TWX? If I assume AOL is worth $0, adjust the capitalization for the huge share buybacks driven both internally and by Carl Icahn, and use comparable EBITDA multiples to TWX's divisions such as Comcast and Viacom, I get to a price of $14.41 based on 2007 estimates.

Of course, the reality is that AOL is not worth $0. Each $1 billion in EBITDA the division can produce is worth about 30 cents per TWX share at a multiple of just 1 times. I had been assuming that AOL would do around $1.6 billion in EBITDA next year. So even if that number is $500 million too high, there is some value to the asset. Anyone for a $1.50 per TWX share at 5 times EBITDA?

Consequently, I think the downside for TWX is a meaningful break to a new 52 week low, which would be below $16. I believe that is a realistic worst case scenario assuming current estimates hold at the other divisions. Of course, I don’t see much upside from that price unless a successful strategy to slow the demise of AOL is found and/or comparable multiples across cable, cable networks, publishing, and filmed entertainment expand.

Posted by Steve Birenberg at July 13, 2006 09:45 AM in TWX