Managerial economics 08/07

Case Study: In January 2003, AOL Time Warner, Inc., announced that it would be posting a loss of $98.7 billion for the year ended December 31, 2002, the largest corporate loss in U.S. history. While company executives described the loss as a result of accounting changes rather than problems with ongoing operations, the media conglomerate clearly faced significant challenges. The stock price closed the month of January at $11.66, down from $71 in January 2000, when it announced its merger with America Online (AOL). The gravity of the events of the past few years hit TJ like a hammer. TJ was coming down from the high she felt when the CEO called last week to promote her to a new position within Time Warner—effective today, September 1, 2004. TJ set aside her morning coffee and The Wall Street Journal to review the company’s operations before replying to the first memo in her inbox. BACKGROUND Time Warner, Inc., was formed in 1990 by the merger of magazine publisher Time, Inc. and Warner Communications, primarily a producer of film and television programming. To reduce debt, Time Warner sold 25 percent of Time Warner Entertainment (which included HBO, Warner Bros., and part of Time Warner Cable) to Media One Group. In 1996, Time Warner acquired Turner Broadcasting Systems, expanding its cable programming networks significantly. By the end of 1999, Time Warner had revenues in excess of $27 billion and net income of almost $2 billion. In January 2000, AOL and Time Warner announced their intent to merge, and the merger was completed a year later. The merger was the largest in U.S. corporate history, with AOL’s preannouncement value at $163 billion, and Time Warner’s preannouncement value of $100 billion. However, by the time the merger was completed, the value of the combined firm had dropped to $165 billion. Both companies hoped that the combination of Time Warner’s content and AOL’s Internet base would provide increased opportunities for the merged company to grow. Many ideas were presented to show how AOL and Time Warner would be able to combine their Internet and media operations to enhance the value of the combined entity. By 2003, AOL Time Warner had achieved few successes in merging the products. Cooperation between the AOL and Time Warner divisions was nonexistent, and advertising deals were lost due to internal conflicts. The decline in the value of technology stocks and a sluggish economy forced AOL Time Warner to take a $98.7 billion loss in 2002, primarily due to the write-down of the value of AOL. Gerald Levin, the chairman and CEO of Time Warner prior to the merger, stepped down as the CEO of AOL Time Warner in 2002. Steve Case, former chairman and CEO of AOL, resigned as chairman of AOL Time Warner in early 2003. Richard Parsons was promoted from COO of the Time Warner side to the position of CEO of the firm. Parsons, who was also appointed chairman of the board when Case resigned, promoted several senior Time Warner executives and accepted the resignations of some of the top AOL management. Several commentators and numerous Time Warner investors considered the AOL merger a mistake, some even calling it the “worst deal in history.” Many believed that AOL misled Time Warner prior to the merger about the outlook in online advertising and overstated its revenues. In 2003, the Securities and Exchange Commission announced an investigation into allegations that AOL used aggressive and illegal methods for recognizing revenue leading up to the merger. By early 2003, the prospect of splitting AOL and Time Warner and undoing the largest merger in U.S. history was a real possibility. However, Parsons declined to shed AOL and instead focused on reducing the company’s debt and integrating the businesses. The company announced agreements to sell its music recording and publishing operations, Warner Music Group, for $2.6 billion and its CD and DVD manufacturing and distribution business, Warner Manufacturing, for $1.05 billion. It also reached agreements to sell Time Life operations, a direct-marketing business with 2003 net operating losses of $82 million, and its Turner winter sports teams (the NHL’s Atlanta Thrashers and NBA’s Atlanta Hawks), which posted operating losses of $37 million. In September 2003, the company dropped AOL from its corporate name and resumed operations as Time Warner, Inc. While 2003 saw improvement in operations and a return to profitability (see Exhibits 1a and 1b in the Appendix), Time Warner executives still face numerous challenges in managing the largest media company in the world. America Online is facing declining revenues, Time Warner Cable is seeing saturated markets and increased competition, and the publishing industry is soft due to low advertising levels. Success in its filmed entertainment and cable programming networks has provided the only encouragement. OVERVIEW OF THE INDUSTRY AND TIME WARNER’S OPERATIONS Subsequent to the AOL merger, Time Warner, Inc., is the largest media company in the world, with revenues in excess of $38 billion. However, Disney, Viacom, News Corp., and Sony are all huge media competitors, with various assets in the television, publishing, music, Internet, and film markets. (See Exhibit 2 for an overview of selected competitors in the media industry.) In 2004, General Electric agreed to merge its NBC property with Universal, owned by French firm Vivendi, to create NBC Universal. The new entity is 80 percent owned by GE and 20 percent owned by Vivendi. Currently there is speculation that Sony is attempting to acquire MGM. Media consolidation is expected to continue due to recent revisions of media ownership restrictions by the Federal Communications Commission (FCC). In 2003, the FCC relaxed several regulations that restricted the number of media outlets a company could own in any local market and increased the national audience that any one company can reach. Media ownership regulations are designed to prevent any one company from controlling too much of the media; they represent an effort to ensure some level of diversity in the media. Proponents of the stricter media regulations fear that increased concentration will lead to greater homogeneity in media content and will be a disservice to consumers. Those favoring relaxing the guidelines argue that the fast pace of technological change makes it impossible for any company to control the flow of information to consumers. The status of regulatory changes is still uncertain, as Congress is considering legislation that would affect ownership rules. Time Warner, Inc., operations include five principle business areas: AOL, filmed entertainment, publishing, programming networks, and cable systems. Figure 15–1 provides a snapshot of how these business areas contributed to Time Warner, Inc.’s 2003 net income and sales.