Motives & Benefits of Merging

The AOL and TW merger is described as the ideal merge: the best from the past in media and the best of
future in technology. However, the merger offers more than just strategic synergies . The AOL TW merger
represents the creation of a media network. The lasting impact of this merge heavily impacts advertising.
The new company has unprecedented control over the flow of information and entertainment , creating a
competitive advantage. AOL TW addresses more than 200 million magazine subscribers a week , and will
benefit from the ability able to better target subscribers on the Internet with AOL’s MovieFone , news from
CNN, and music clips from Warner’s Music Group. Each company had something the other wants. AOL
is a successful online service provider with core competencies in delivering Internet services and
innovative marketing. AOL's platform offers many opportunities, but the company needs content to offer
on its digital platform. This content must be acquired rather than developed in-house, as AOL’s core
competencies are not in content development.

TW is a media content company involved in almost every level of media . With other media companies
increasing their online presence like Disney's acquisition of Infoseek , it is becoming imperative for TW to
digitize its businesses and keep up with the evolving industry , but its attempts to establish a dominant
presence on the Internet have been unsuccessful . TW could attempt to internally develop its online
networks, but AOL would expedite this process. AOL offers TW an online platform for music and other
content, as well as online legitimacy from a connection with the world’s premier Internet brand . For AOL,
competing directly against Yahoo! and other emerging portals , it sought content to increase and sustain
traffic. With regard to revenue streams, the opportunity to use TW’s cable-TV wires to carry high-speed
broadband would increase its resources and capabilities . Additionally, AOL values TW specifically for
their hard assets, from which AOL TW would be able to gain a steady cash flow. TW’s unique
combination of content, strong brands and cable assets address AOL's interests and the benefits are
consistent with their strategic goals. TW would gain from merging with AOL because trading assets for
stock would increase market value.

The Issue of Overpaying

From a stock ratio perspective, AOL is underpaying for TW. Based on Baker's original FMV estimates,
each TW share would be redeemed for approximately $171 in AOL TW Stock around 1 .5 shares (Table
3). If we use the correct FMV, TW shareholders received only $96 per share. In order for each share to be
redeemed for $171, each stock should be exchanged for 2.68 shares of AOL TW. Thus, AOL shareholders
only pay $96 for $171 worth of TW stock. However, considering the merge holistically, AOL is
overpaying for TW. During this period, the merge is unprecedented and the Internet industry is relatively
new. As a result, analyst assumptions are not grounded in historical data , but heavily impacted by the halo
effect of the Internet boom. Projections are subsequently extremely optimistic .

Post-Merge Integration
Merging a young tech company and a well-established media company brings forth organizational issues .
AOL is a tech company with an entrepreneurial culture . The company's leadership is centralized and has
an environment promoting innovation, even using novel marketing tactics with its direct mail free trial
software. Commitment level among AOL's 15,000 employees is also high, as the company's generous
stock options have transformed thousands of their employees into millionaires . TW exhibits stark
differences. The media company's 70,000 employees work in a bottom-line-driven environment . Their
chief, Gerald Levin, is the TW visionary. He is the ultimate decision-maker, even refraining from sharing
information regarding the merge with those who reported directly to him . Nonetheless, Levin operates the
businesses with a decentralized approach, which has not been conducive to their attempts at integrated
digital businesses. The biggest challenge will be adjusting operational styles to leverage synergies
between businesses. TW's businesses will need to increase its level of centralization in order to streamline
integration with AOL. AOL-TW will also experience the challenge of clashing cultures when pursuing
integration. AOL employees are accustomed to detailed information sharing and an entrepreneurial
environment where interdivisional projects are common . TW has acquired different businesses and
experienced success with each individual business, but has little and unsuccessful experience in inter-
business activities. Thus, it is likely that these individuals who have had poor experiences in inter-
business activities will be hesitant and perhaps antagonistic to the AOL employees .

Expected Synergies
AOL-TW can leverage online/offline distribution and sales infrastructure , and result in increased reach
and ad revenue. However, the assumption that the company will experience an 80% margin is extremely
far-fetched. Thus, the projected $290 million to $360 million in additional EBITDA is unrealistic . The
chart detailing advertising spending by top advertisers demonstrates that of the top advertisers, AOL TW,
had the highest advertising spending percentage. During the first two quarters of 2001, the Internet bubble
began to deflate, and subsequently companies reduced advertising spending. AOL TW would presumably
follow suit and perhaps outperform its comparables by leveraging advertising synergies, but clearly, their
advertising spending percentage is still extremely high.

In addition, the hope to grow subscription revenues is heavily dependent upon the assumption that TW
customers will switch to AOL and vice versa. Furthermore, it is anticipated that AOL TW would grow its
broadband cable subscriber base. Once again, the projected increased revenue is misleading. It does not
take into account the lost revenues from AOL's Internet subscription base that will result from
cannibalization, which would only be further fueled by AOL's increase in US subscription price .

With regard to cost saving synergies, the anticipation of AOL leveraging TW distribution channels to
promote its online service and TW shifting its marketing to AOL online channels , have the most potential.
The merger will allow for additional channels and redistribution of marketing efforts to reduce costs . In
addition, shutting down AOL TW's digital media unit offers a onetime cost saving , but no synergistic
value to the merged entity. AOL's ability operate its Web properties at a cost 20% lower than Yahoo! and
Lycos as emphasized as an additional benefit , but misleading. AOL's Web operations do not rely on the
servers required by portals and search engines like its comparables . As a result, there is no cost saving
synergy in this regard, only a cost difference due to differing operations. Furthermore, the elimination of
redundancies in corporate overhead services and business operations suggested as another cost saving
synergy is an additional benefit, but cannot be anticipated having a substantial financial impact .

All these potential synergies would be dependent upon effective management. Given the integration
issues AOL TW will be facing, the potential synergies may be difficult to realize.

Valuation Analysis
In Smith Barney's 2000 Valuation, there are many problems with its assumptions. They inappropriately
used: Cash Flows, WACC, and EBITDA Terminal Value Multiple. As you can see from our AOL-TW
valuation, these problems led to the overvaluation of AOL-TW's stock by $46 .88 or 73% (Table 1 &2).

There were two main problems with the 2000 Valuation Cash Flows: they used the wrong equation to
calculate Unlevered Free Cash Flow, they overestimated the EBITDA growth rates, and they understated
the changes in CapEX and NWC. From the footnotes to the 2000 valuation, we found that Smith Barney
used NI +(D+A) - (CapEx - Change in NWC) to calculate FCFF . You can see that they added the Change
in NWC, instead of subtracting it. This error alone caused around a 4% increase in the valuation of the
Equity Value per Share. But there were more problems, from (Table 5), you can see that AOL TW
averaged only a 20% growth in EBITDA per year. But the valuation used 25% as its growth rate, again
increasing the Equity Value. Finally, their changes in CapEX and NWC did not match their revenue
growth. To sustain growth in a company's Revenue and EBITDA, they typically need to invest in more
assets, thus raising their CapEX and NWC. Again, this valuation erroneously decreases AOL TW's CapEX
and NWC, while maintaining growth in their Revenues. These errors led to severely altered Cash Flows
and led to the overvaluation of their Equity.
Unfortunately, there are additional problems with the 2000 Valuation. They calculated WACC incorrectly
and used a really high EBITDA TV Multiple. In their WACC calculation, their after-tax cost of debt was
the same as their pre-tax, which implies that AOL TW would not have to pay any taxes. Assuming that
AOL TW pays a tax rate of 40%, the valuation should have used a WACC of 14.52% (Table 4). Lastly,
they overstated their EBITDA Multiple. Their TV consisted of over 90% of their PV. If we removed or
even lowered the TV slightly, there would not be any way for the deal to go through. The 35x multiple
implies that the company would be able to sustain a growth rate of 11 .81% forever. By using their restated
2001 Valuation multiple of 25x, Smith Barney would have decreased the PV of their TV by 42% and
lowering the grow10.58%.
By comparing our valuation with the more realistic numbers compared to the 2000 Smith Barney
number, you can see that there was a significant difference between the two Equity Values per Share . The
2000 Valuation overstated theirs by $46.88 or almost 73% of our final numbers. This clearly shows that
Baker's assumptions were an inappropriate attempt to lead on AOL and TW's shareholders .

Terms of the Valuation

Reasons for the difficult valuation agreement include the following:
1. 2 large companies merging.
2. CapEX increased in TW prior to the acquisition with new technology .
3. Growth rate of 10% is too high.
4. FV/Rev range is huge due to volatility in the market .
Having two mammoth companies such as AOL and TW merge makes the valuation a tedious process as
this is the first time two large companies have merged , making it difficult to tell who's buying
who. Further, the valuation of this merger is difficult due to the additional assets that AOL receives at the
time of merger. Since TW has recently bought new equipment, CapEX has increased during that year,
which would retroactively decrease the amount of debt to finance for CapEX after the two companies
merge. In addition, the D/E ratio would decrease, which would increase the credit rate, making the
decreasing the cost of debt. In turn, this would affect the valuation of the WACC of AOL TW by
decreasing it. Also, an implied growth rate of 10% cannot constantly occur seeing as Exhibit 7 displays
how there are only three quarters where AOL TW had grown over 10% . The FV/Rev range is huge due to
the volatility in the market. Seeing as the spread between the high and lows are enormous , it is clear that
analysts were having difficulty predicting where the industry was going . Thus it cannot have a fair
valuation of AOL TW.

The impact of the merger will result in an accretive effect for AOL and a dilutive effect for TW . Since
AOL is only giving up 55% of its ownership for an 80% increase in profits , its EPS will increase.
Consequently, this merger will have a dillutive effect on TW, because it is gaining more equity than
earnings. They are decreasing their current EPS in hopes that the conglomerate company will eventually
achieve higher Earnings than those possible for TW alone .TW, on the other hand, does not gain as much
as AOL considering they do not have anything that will affect their income statement directly . However,
AOL's market value exceeds that of TW, which should help AOL TW's shares to grow.

The deal is not worth it from TW's perspective because they are getting underpaid for the merger .
However, given intangible assets, the ratios may seem more attractive because it is hard to price Levin ,
Turner, and Case. Also, during this time, the internet market was relatively new, and the prices were
heavily inflated. Because the industry is young, comparables were not reliable. Hence, the merger between
a media conglomerate TW and a technology colossal AOL , it is extremely difficult to value.