Breaking Up Is Hard To Due... Diligence

Time Warner and Yahoo may represent different ends of media's diverse spectrum, but a similar faltering and folly has brought them to the same place--determining whether their assets and shareholders are better served by a breakup.

Wall Street appears to be increasingly resigned to that exercise.

At the start of the new millennium, both companies were touted for their foresight and boldness. Time Warner took a giant step into the Internet Age by buying AOL, while Yahoo was at the top of the cyberspace charts, with more than 412 million unique users and 3.4 billion average page views to its global network of Web sites. It is interesting that a relative newcomer such as Yahoo and a media world anchor such as Time Warner could misstep enough to arrive at the same place, to be more valuable in pieces than as a whole. It can be instructive to examine why that is, and where each company's asset valuations stand.

Yahoo's breakup value exceeds the company's combined value as long as its current strategy prevails, according to Bernstein Research analyst Jeffrey Lindsay. Another option is to sell Yahoo to a third party that would be prepared to undertake a major restructuring.



Yahoo's sum-of-the-parts value is about $39 a share, based on average estimated values for its three core businesses (drawn from recent similar property sales), Lindsay said. By comparison, Yahoo's current strategy is valued at only about $25 a share. More than half of Yahoo's $42 billion enterprise value for operations is comprised of its display advertising business, followed by paid search and subscriptions (for the likes of music and personals). Yahoo's stakes in Yahoo Japan and Alibaba, and other factors, gives the company an overall equity value of $54 billion, Lindsay says. On a more reasonable discounted cash flow basis (given the company's anticipated profit declines), Yahoo's equity value is closer to $35.5 billion, Lindsay said.

But no matter how you cut it, Yahoo will not realize its value without more radical actions and strategies--which, short of selling off the company or its pieces, could only be achieved one other way. Lindsay recommends Yahoo could outsource its paid search business to Google in exchange for an 85+% traffic acquisition cost (considering that Google's overall monetization of search is 50% to 75% higher than Yahoo's). Management also would have to reduce its overall head count by 25%, and restructure its display ad business. The three moves combined would increase net revenues by 16% and operating income by 205%. This series of radical changes "to unlock its intrinsic value, reestablishing growth and liberating sufficient cash for the next round or strategic acquisition" could lift Yahoo's share price to $45 a share, Lindsay said.

Either way, founding CEO Jerry Yang and President Susan Decker will have to make far more dramatic moves (through sales or restructuring) than Lindsay said he expects them to in order to recapture its place as a hot company and hot stock. Maintaining Yahoo's incremental strategy "locks up almost half of its value potential," Lindsay said. "If Microsoft was to buy Yahoo (as speculated), the post-merger integration plan would amount to little more... than what Yahoo management could do for themselves."

However, the same would not be true if News Corp. were to trade its MySpace for about a 30% ownership stake in Yahoo along with the ability to jointly manage and monetize the popular social network. That additive move would put a stand-alone Yahoo in a better place than it is now.

The erosion in email users, unique visitors and search that has plagued Yahoo also has troubled Time Warner's AOL, whose value also may be better served under the break-up looking glass. Yahoo's email users and unique visitors have stagnated over the past year under duress of Google's Gmail, as well as New Corp.'s MySpace and the independent Facebook. Its continuing loss of search share is undermining the benefits of having the new Project Panama effort. AOL has likewise suffered losses in paid search and display advertising as it transitions from a subscriber business (at 11 million today from a peak of 26 million in 2002) to an audiences and advertising-based business, although it is growing page views and earnings.

Like Yahoo, Time Warner and its AOL unit are responding to challenge with change to avoid what Lindsay refers to as "the inevitable slide into irrelevance." But the most dramatic uptick in their overall value will come only from transaction-related rather than operational measures, most analysts agree.

The valuation for Time Warner is so strained, shareholders are practically getting AOL for free, according to Morgan Stanley analyst Benjamin Swinburne. In an August report, Swinburne noted that at just under $19 a share (where Time Warner continues trading), the market is giving the company a $112 billion enterprise value of all of its cable, network, film and publishing assets and other investments--nearly the same as the analyst's estimated $114 billion enterprise value for Time Warner without including AOL. Shareholders are getting AOL for free, he insists. In a worst-case scenario, returns from AOL could reduce Time Warner's value by as much as $1.25 a share, especially if revenue growth continues to decline, Swinburne said.

However, Time Warner's total estimated asset value is $143 billion (with consolidated operations including cable and its unconsolidated investments) based on 2008 earnings estimates, the analyst said. Sum-of-parts evaluations of Time Warner assets estimate AOL's equity value at between $13 billion and $15 billion, and Time Inc. publishing at about $9 billion--the two other assets that analysts have speculated that the company may opt to spin off when COO Jeff Bewkes takes over for Richard Parsons as Time Warner CEO by some time next year. Time Warner Cable--of which Time Warner still is controlling shareholder, with an estimated intrinsic enterprise value as high as $54 billion--remains the company's most significant growth contributor.

Some analysts estimate Time Warner's enterprise value without Time Warner Cable is about $68 billion.

Bernstein Research analyst Michael Nathanson recently made the point that Time Warner's remaining content assets (driven mostly by its cable networks and filmed entertainment), have the second-highest earnings per share of media conglomerates (at 13.4%) behind only News Corp.--and its long-term growth is less than half that of News Corp., Viacom and Disney. That means that even as a stand-along pure-play media company, Time Warner Content would remain the cheapest stock among its peers.

No matter how analysts drill down into the company's valuation and numbers (and there is some disagreement about it on Wall Street), any positive thesis for Time Warner will rely on the potential of a transaction like the sale of one or more assets "rather than on its core business development," as pointed out by UBS analyst Michael Morris. "By expecting a transaction premium for these businesses, the investor already has priced in unknown synergies or assumes that a suitor will overpay," Morris said.

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