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May 28, 2009

Time Warner Officially Jettisons AOL

I have been strongly in favor of a separation of AOL from Time Warner (TWX) for several years. I am not convinced there is much hidden value in AOL but getting rid of a management distraction and significant negative talking point for investors should be helpful to TWX's stock valuation. In addition, AOL is has been and probably remains a drag on long-term growth of TWX, which is now being driven by the company's cable networks.

Despite my enthusiasm for a split and the formal announcement on Thursday, I do not think this is a catalyst for a higher TWX stock price in the near-term. The move was widely anticipated and telegraphed, right down to the timing. In fact, when speculation about the split reached its peak in early May, coinciding with improved sentiment toward advertising trends, I sold all Northlake positions in TWX 10% above the current price. Even if you accept the possibility that AOL's valuation will be a few billion higher than most analysts assume, the incremental value would only get TWX shares back to their recent high.

Analyst estimates assume AOL will produce about $1 billion in EBITDA in 2009, down 30% plus vs. 2008 and well under half the level of just a few years ago. According on UBS analyst Michael Morris, if you put Yahoo's (YHOO) multiple on the display business, United Online's (UNTD) multiple of the access business, and ValueClick's (VCLK) multiple on the ad network business, AOL would be worth about $6 billion. This is as much as $1-2 billion, or $1-2, more than investors could be imputing into the current TWX share price.

The official announcement lacked a few key details that should be determinative for AOL's valuation and any TWX benefit. First, TWX will be buying back Google's 5% stake in AOL. Google just wrote this down to $274 million, implying a $5.5 billion value for AOL. The price of the buyout will go a long way toward establishing AOL's initial trading value. Second, TWX did not announce AOL's capital structure. AOL produces significant free cash flow as capital spending is minimal so only taxes come off the EBITDA line. On $700 million in free cash flow AOL could support $3-4 billion in debt but given the uncertainty surrounding AOL's future cash generating capabilities, TWX may not be able to pass off anywhere near that much debt.

This discussion also raises the issue that TWX will be giving up 20-30% of its free cash flow when it jettisons AOL. The remaining businesses are not capital intensive but they do require more working capital to operate. This gives TWX incentive to create more potential value for its post-AOL shareholders by transferring significant debt to AOL.

The bottom line is that the AOL spin-off is a long-term positive for TWX. However, it is not actionable in the short-term unless you want to make a bet on AOL's valuation and capital structure. Furthermore, even if you make the bet, TWX shares are not undervalued by more $1-2, just 4-9%.

Posted by Steve Birenberg at May 28, 2009 02:22 PM in TWX