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Exam 1: Introduction to Mergers, Acquisitions, and Other Restructuring Activities

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Question 21

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Operating synergy consists of economies of scale and scope. Economies of scale refer to the spreading of variable costs over increasing production levels, while economies of scope refer to the use of a specific asset to produce multiple related products or services.

A) True
B) False

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Question 22

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Pfizer Acquires Pharmacia to Solidify Its Top Position In 1990, the European and U.S. markets were about the same size; by 2000, the U.S. market had grown to twice that of the European market. This rapid growth in the U.S. market propelled American companies to ever increasing market share positions. In particular, Pfizer moved from 14th in terms of market share in 1990 to the top spot in 2000. With the acquisition of Pharmacia in 2002, Pfizer’s global market share increased by three percentage points to 11%. The top ten drug firms controlled more than 50 percent of the global market, up from 22 percent in 1990. Pfizer is betting that size is what matters in the new millennium. As the market leader, Pfizer was finding it increasingly difficult to sustain the double-digit earnings growth demanded by investors. Such growth meant the firm needed to grow revenue by $3-$5 billion annually while maintaining or improving profit margins. This became more difficult due to the skyrocketing costs of developing and commercializing new drugs. Expiring patents on a number of so-called blockbuster drugs (i.e., those with potential annual sales of more than $1 billion) intensified pressure to bring new drugs to market. Pfizer and Pharmacia knew each other well. They had been in a partnership since 1998 to market the world’s leading arthritis medicine and the 7th largest selling drug globally in terms of annual sales in Celebrex. The companies were continuing the partnership with 2nd generation drugs such as Bextra launched in the spring of 2002. For Pharmacia’s management, the potential for combining with Pfizer represented a way for Pharmacia and its shareholders to participate in the biggest and fastest growing company in the industry, a firm more capable of bringing more products to market than any other. The deal offered substantial cost savings, immediate access to new products and markets, and access to a number of potentially new blockbuster drugs. Projected cost savings are $1.4 billion in 2003, $2.2 billion in 2004, and $2.5 billion in 2005 and thereafter. Moreover, Pfizer gained access to four more drug lines with annual revenue of more than $1 billion each, whose patents extend through 2010. That gives Pfizer, a portfolio, including its own, of 12 blockbuster drugs. The deal also enabled Pfizer to enter three new markets, cancer treatment, ophthalmology, and endocrinology. Pfizer expects to spend $5.3 billion on R&D in 2002. Adding Pharmacia’s $2.2 billion brings combined company spending to $7.5 billion annually. With an enlarged research and development budget Pfizer hopes to discover and develop more new drugs faster than its competitors. On July 15, 2002, the two firms jointly announced they had agreed that Pfizer would exchange 1.4 shares of its stock for each outstanding share of Pharmacia stock or $45 a share based on the announcement date closing price of Pfizer stock. The total value of the transaction on the announcement was $60 billion. The offer price represented a 38% premium over Pharmacia’s closing stock price of $32.59 on the announcement date. Pfizer’s shareholders would own 77% of the combined firms and Pharmcia’s shareholders 23%. The market punished Pfizer, sending its shares down $3.42 or 11% to $28.78 on the announcement date. Meanwhile, Pharmacia’s shares climbed $6.66 or 20% to $39.25. -Would you anticipate continued consolidation in the global pharmaceutical industry? Why or why not?

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With the industry focused on growth in E...

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Question 23

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Which of the following is an example of economies of scope?

Which of the following is true only of a consolidation?

Google Acquires Motorola Mobility in a Growth-Oriented as well as Defensive Move Key Points The acquisition of Motorola Mobility positions Google as a vertically integrated competitor in the fast-growing wireless devices market. The acquisition also reduces their exposure to intellectual property litigation. ______________________________________________________________________________ By most measures, Google’s financial performance has been breathtaking. The Silicon Valley–based firm’s revenue in 2011 totaled $37.9 billion, up 29% from the prior year, reflecting the ongoing shift from offline to online advertising. While the firm’s profit growth has slowed in recent years, the firm’s 26% net margin remains impressive. About 95% of the firm’s 2011 revenue came from advertising sold through its websites and those of its members and partners. Google is channeling more resources into “feeder technologies” to penetrate newer and faster-growing digital markets and to increase the use of Google’s own and its members’ websites. These technologies include the Android operating system, designed to power wireless devices, and the Chrome operating system, intended to attract Windows- and Mac-based computer users. Faced with a need to fuel growth to sustain its market value, Google’s announcement on August 15, 2011, that it would acquire Motorola Mobility Holdings Inc. (Motorola) underscores the importance it places on the explosive growth in wireless devices. The all-cash $12.5 billion purchase price represented a 63% premium to Motorola’s closing price on the previous trading day. Chicago-based, Motorola makes cellphones, smartphones, tablets, and set-top boxes; its status as one of the earliest firms to develop cellphones and one of the leading mobile firms for the past few decades meant that it had accumulated approximately 17,000 patents, with another 7,500 pending. With less than 3% market share, the firm had been struggling to increase handset shipments and was embroiled in multiple patent-related lawsuits with Microsoft. As Google’s largest-ever deal, the acquisition may be intended to transform Google into a fully integrated mobile phone company, to insulate itself and its handset-manufacturing partners from patent infringement lawsuits, and to gain clout with wireless carriers, which control cellphone pricing and distribution. Revenue growth could come from license fees paid on the Motorola patent portfolio and sales of its handsets and by increasing the use of its own websites and those of its members to generate additional advertising revenue. Google was under pressure from its handset partners, including HTC and Samsung, to protect them from patent infringement suits based on their use of Google’s Android software. Microsoft has already persuaded HTC to pay a fee for every Android phone manufactured, and it is seeking to extract similar royalties from Samsung. If this continues, such payments could make creating new devices for Android prohibitively expensive for manufacturers, forcing them to turn to alternative platforms like Windows Phone 7. With a limited patent portfolio, Google also was vulnerable to lawsuits against its Android licenses. Innovation in information technology usually relies on small, incremental improvements in software and hardware, which makes it difficult to determine those changes covered by patents. Firms have an incentive to build up their patent portfolios, which strengthens their negotiating positions with firms threatening to file lawsuits or demanding royalty payments. Historically, firms have simply cross-licensed each other’s technologies; today, however, patent infringement lawsuits create entry barriers to potential competitors, as the threat of lawsuits may discourage new entrants. It now pays competitors to sue routinely over alleged patent infringements. Risks associated with the deal include the potential to drive Android partners such as Samsung and HTC to consider using Microsoft’s smartphone operating system, with Google losing license fees currently paid to use the Android operating system. The deal offers few cost savings opportunities due the lack of overlap between Google, an Internet search engine that also produces Android phone software, and handset manufacturer Motorola. Google is essentially becoming a vertically integrated cellphone maker. Furthermore, when the deal was announced, some regulators expressed concern about Google’s growing influence in its served markets. Finally, Google’s and Motorola’s growth and profitability differ significantly, with Motorola’s revenue growth rate less than one-third of Google’s and its operating profit margin near zero. Samsung, HTC, Sony Ericsson, and LG are now both partners and competitors of Google. It is difficult for a firm such as Google to both license its products (Android operating system software) and compete with those licensees by selling Motorola handsets at the same time. Nokia has already aligned with Microsoft and abandoned its own mobile operating system. Others may try to create their own operating systems rather than become dependent on Google. Samsung released phones in 2011 that run on a system called Bada; HTC has a team of engineers dedicated to customizing the version of Android that it uses on its phones, called HTC Sense. Motorola Mobility’s shares soared by almost 57% on the day of the announcement. Led by Nokia, shares of other phone makers also surged. In contrast, Google’s share price fell by 1.2%, despite an almost 2% rise in the S&P 500 stock index that same day. -Speculate as to why the shares of other handset manufacturers jumped on the announcement that Google was buying Motorola Mobility. Be specific.

In a statutory merger, both the acquiring and target firms survive.

The empirical evidence shows that unrelated diversification is an effective means of smoothing out the business cycle.

Financial considerations, such as an acquirer believing the target is undervalued, a booming stock market or falling interest rates, frequently drive surges in the number of acquisitions.

Dell Moves into Information Technology Services Dell Computer’s growing dependence on the sale of personal computers and peripherals left it vulnerable to economic downturns. Profits had dropped more than 22 percent since the start of the global recession in early 2008 as business spending on information technology was cut sharply. Dell dropped from number 1 to number 3 in terms of market share, as measured by personal computer unit sales, behind lower-cost rivals Hewlett-Packard and Acer. Major competitors such as IBM and Hewlett-Packard were less vulnerable to economic downturns because they derived a larger percentage of their sales from delivering services. Historically, Dell has grown “organically” by reinvesting in its own operations and through partnerships targeting specific products or market segments. However, in recent years, Dell attempted to “supercharge” its lagging growth through targeted acquisitions of new technologies. Since 2007, Dell has made ten comparatively small acquisitions (eight in the United States), purchased stakes in four firms, and divested two companies. The largest previous acquisition for Dell was the purchase of EqualLogic for $1.4 billion in 2007. The recession underscored what Dell had known for some time. The firm had long considered diversifying its revenue base from the more cyclical PC and peripherals business into the more stable and less commodity-like computer services business. In 2007, Dell was in discussions about a merger with Perot Systems, a leading provider of information technology (IT) services, but an agreement could not be reached. Dell’s global commercial customer base spans large corporations, government agencies, healthcare providers, educational institutions, and small and medium firms. The firm’s current capabilities include expertise in infrastructure consulting and software services, providing network-based services, and data storage hardware; nevertheless, it was still largely a manufacturer of PCs and peripheral products. In contrast, Perot Systems offers applications development, systems integration, and strategic consulting services through its operations in the United States and ten other countries. In addition, it provides a variety of business process outsourcing services, including claims processing and call center operations. Perot’s primary markets are healthcare, government, and other commercial segments. About one-half of Perot’s revenue comes from the healthcare market, which is expected to benefit from the $30 billion the U.S. government has committed to spending on information technology (IT) upgrades over the next five years. In 2008, Hewlett-Packard (HP) paid $13.9 billion for computer services behemoth, EDS, in an attempt to become a “total IT solutions” provider for its customers. This event, coupled with a very attractive offer price, revived merger discussions with Perot Systems. On September 21, 2009, Dell announced that an agreement had been reached to acquire Perot Systems in an all-cash offer for $30 a share in a deal valued at $3.9 billion. The tender offer (i.e., takeover bid) for all of Perot Systems’ outstanding shares of Class A common stock was initiated in early November and completed on November 19, 2009, with Dell receiving more than 90 percent of Perot’s outstanding shares. Mars Buys Wrigley in One Sweet Deal Under considerable profit pressure from escalating commodity prices and eroding market share, Wrigley Corporation, a U.S. based leader in gum and confectionery products, faced increasing competition from Cadbury Schweppes in the U.S. gum market. Wrigley had been losing market share to Cadbury since 2006. Mars Corporation, a privately owned candy company with annual global sales of $22 billion, sensed an opportunity to achieve sales, marketing, and distribution synergies by acquiring Wrigley Corporation. On April 28, 2008, Mars announced that it had reached an agreement to merge with Wrigley Corporation for $23 billion in cash. Under the terms of the agreement, unanimously approved by the boards of the two firms, shareholders of Wrigley would receive $80 in cash for each share of common stock outstanding. The purchase price represented a 28 percent premium to Wrigley's closing share price of $62.45 on the announcement date. The merged firms in 2008 would have a 14.4 percent share of the global confectionary market, annual revenue of $27 billion, and 64,000 employees worldwide. The merger of the two family-controlled firms represents a strategic blow to competitor Cadbury Schweppes's efforts to continue as the market leader in the global confectionary market with its gum and chocolate business. Prior to the announcement, Cadbury had a 10 percent worldwide market share. Wrigley would become a separate stand-alone subsidiary of Mars, with $5.4 billion in sales. The deal would help Wrigley augment its sales, marketing, and distribution capabilities. To provide more focus to Mars' brands in an effort to stimulate growth, Mars would transfer its global nonchocolate confectionery sugar brands to Wrigley. Bill Wrigley, Jr., who controls 37 percent of the firm's outstanding shares, would remain executive chairman of Wrigley. The Wrigley management team also would remain in place after closing. The combined companies would have substantial brand recognition and product diversity in six growth categories: chocolate, nonchocolate confectionary, gum, food, drinks, and pet-care products. The resulting confectionary powerhouse also would expect to achieve significant cost savings by combining manufacturing operations and have a substantial presence in emerging markets. While mergers among competitors are not unusual, the deal's highly leveraged financial structure is atypical of transactions of this type. Almost 90 percent of the purchase price would be financed through borrowed funds, with the remainder financed largely by a third party equity investor. Mars's upfront costs would consist of paying for closing costs from its cash balances in excess of its operating needs. The debt financing for the transaction would consist of $11 billion and $5.5 billion provided by J.P. Morgan Chase and Goldman Sachs, respectively. An additional $4.4 billion in subordinated debt would come from Warren Buffet's investment company, Berkshire Hathaway, a nontraditional source of high-yield financing. Historically, such financing would have been provided by investment banks or hedge funds and subsequently repackaged into securities and sold to long-term investors, such as pension funds, insurance companies, and foreign investors. However, the meltdown in the global credit markets in 2008 forced investment banks and hedge funds to withdraw from the high-yield market in an effort to strengthen their balance sheets. Berkshire Hathaway completed the financing of the purchase price by providing $2.1 billion in equity financing for a 9.1 percent ownership stake in Wrigley. -It what way did the acquisition of Wrigley's represent a strategic blow to Cadbury?

Lam Research Buys Novellus Systems to Consolidate Industry Industry consolidation is a common response to sharply escalating costs, waning demand, and increasing demands of new technologies. Customer consolidation often drives consolidation among suppliers. ______________________________________________________________________________________________ Highly complex electronic devices such as smartphones and digital cameras have become ubiquitous in our everyday lives. These devices are powered by sets of instructions encoded on wafers of silicon called semiconductor chips (semiconductors). Consumer and business demands for increasingly sophisticated functionality for smartphones and cloud computing technologies require the ongoing improvement of both the speed and the capability of semiconductors. This in turn places huge demands on the makers of equipment used in the chip-manufacturing process. To stay competitive, makers of equipment used to manufacture semiconductor chips were compelled to increase R&D spending sharply. Chip manufacturers resisted paying higher prices for equipment because their customers, such as PC and cellphone handset makers, were facing declining selling prices for their products. Chip equipment manufacturers were unable to recover the higher R&D spending through increasing selling prices. The resulting erosion in profitability due to increasing R&D spending was compounded by the onset of the 2008–2009 global recession. The industry responded with increased consolidation in an attempt to cut costs, firm product pricing, and gain access to new technologies. Industry consolidation began among chip manufacturers and later spurred suppliers to combine. In February 2011, chipmaker Texas Instruments bought competitor National Semiconductor for $6.5 billion. Three months later, Applied Materials, the largest semiconductor chip equipment manufacturer, bought Varian Semiconductor Equipment Associates for $4.9 billion to gain access to new technology. On December 21, 2011, Lam Research Corporation (Lam) agreed to buy rival Novellus Systems Inc. (Novellus) for $3.3 billion. Lam anticipates annual cost savings of $100 million by the end of 2013 due to the elimination of overlapping overhead. Under the terms of the deal, Lam agreed to acquire Novellus in a share exchange in which Novellus shareholders would receive 1.125 shares of Lam common stock for each Novellus share. The deal represented a 28% premium over the closing price of Novellus’s shares on the day prior to the deal’s public announcement. At closing, Lam shareholders owned about 51% of the combined firms, with Novellus shareholders controlling the rest. In comparison to earlier industry buyouts, the purchase seemed like a good deal for Lam’s shareholders. At 2.3 times Novellus’s annual revenue, the purchase price was almost one-half the 4.5 multiple paid by industry leader Applied Materials for Variant in May 2011. The purchase premium paid by Lam was one-half of that paid for comparable transactions between 2006 and 2010. Yet Lam shares closed down 4%, and Novellus’ shares closed up 28% on the announcement date. Lam and Novellus produce equipment that works at different stages of the semiconductor-manufacturing process, making their products complementary. After the merger, Lam’s product line would be considerably broader, covering more of the semiconductor-manufacturing process. Semiconductor-chip manufacturers are inclined to buy equipment from the same supplier due to the likelihood that the equipment will be compatible. Lam also is seeking access to cutting-edge technology and improved efficiency. Technology exchange between the two firms is expected to help the combined firms to develop the equipment necessary to support the next generation of advanced semiconductors. Customers of the two firms include such chip makers as Intel and Samsung. By selling complementary products, the firms have significant cross-selling opportunities as equipment suppliers to all 10 chip makers globally. Together, Lam and Novellus are able to gain revenue faster than they could individually by packaging their equipment and by developing their technologies in combination to ensure they work together. Lam has greater penetration with Samsung and Novellus with Intel. Lam also stated on the transaction announcement date that a $1.6 billion share repurchase program would be implemented within 12 months following closing. The buyback allows shareholders to sell some of their shares for cash such that, following completion of the buyback, the deal could resemble a half-stock, half-cash deal, depending on how many shareholders tender their shares during the buyback program. The share repurchase will be funded out of the firms’ combined cash balances and cash flow. Structuring the deal as an all-stock purchase at closing allows Novellus shareholders to have a tax-free deal. -What are the motives for the deal? Discuss the logic underlying each motive you identify.

A vertical merger is one in which the merger participants are usually competitors.

During periods of high inflation, the market value of assets is often less than their book value. This often creates an attractive M&A opportunity.

What is the role of the investment banker in the M&A process?

A steel maker acquired a coal mining company. Which of the following terms best describes this deal?

Buyers often prefer "friendly" takeovers to hostile ones because of all of the following except for:

America Online Acquires Time Warner: The Rise and Fall of an Internet and Media Giant Time Warner, itself the product of the world’s largest media merger in a $14.1 billion deal a decade ago, celebrated its 10th birthday by announcing on January 10, 2000, that it had agreed to be taken over by America Online (AOL) at a 71% premium to its share price on the announcement date. AOL had proposed the acquisition in October 1999. In less than 3 months, the deal, valued at $160 billion as of the announcement date ($178 billion including Time Warner debt assumed by AOL), became the largest on record up to that time. AOL had less than one-fifth of the revenue and workforce of Time Warner, but AOL had almost twice the market value. As if to confirm the move to the new electronic revolution in media and entertainment, the ticker symbol of the new company was changed to AOL. However, the meteoric rise of AOL and its wunderkind CEO, Steve Case, to stardom was to be short-lived. Time Warner is the world’s largest media and entertainment company, and it views its primary business as the creation and distribution of branded content throughout the world. Its major business segments include cable networks, magazine publishing, book publishing and direct marketing, recorded music and music publishing, and filmed entertainment consisting of TV production and broadcasting as well as interests in other film companies. The 1990 merger between Time and Warner Communications was supposed to create a seamless marriage of magazine publishing and film production, but the company never was able to put that vision into place. Time Warner’s stock underperformed the market through much of the 1990s until the company bought the Turner Broadcasting System in 1996. Founded in 1985, AOL viewed itself as the world leader in providing interactive services, Web brands, Internet technologies, and electronic commerce services. AOL operates two subscription-based Internet services and, at the time of the announcement, had 20 million subscribers plus another 2 million through CompuServe. Strategic Fit (A 1999 Perspective) On the surface, the two companies looked quite different. Time Warner was a media and entertainment content company dealing in movies, music, and magazines, whereas AOL was largely an Internet Service Provider offering access to content and commerce. There was very little overlap between the two businesses. AOL said it was buying access to rich and varied branded content, to a huge potential subscriber base, and to broadband technology to create the world’s largest vertically integrated media and entertainment company. At the time, Time Warner cable systems served 20% of the country, giving AOL a more direct path into broadband transmission than it had with its ongoing efforts to gain access to DSL technology and satellite TV. The cable connection would facilitate the introduction of AOL TV, a service introduced in 2000 and designed to deliver access to the Internet through TV transmission. Together, the two companies had relationships with almost 100 million consumers. At the time of the announcement, AOL had 23 million subscribers and Time Warner had 28 million magazine subscribers, 13 million cable subscribers, and 35 million HBO subscribers. The combined companies expected to profit from its huge customer database to assist in the cross promotion of each other’s products. Market Confusion Following the Announcement AOL’s stock was immediately hammered following the announcement, losing about 19% of its market value in 2 days. Despite a greater than 20% jump in Time Warner’s stock during the same period, the market value of the combined companies was actually $10 billion lower 2 days after the announcement than it had been immediately before making the deal public. Investors appeared to be confused about how to value the new company. The two companies’ shareholders represented investors with different motivations, risk tolerances, and expectations. AOL shareholders bought their company as a pure play in the Internet, whereas investors in Time Warner were interested in a media company. Before the announcement, AOL’s shares traded at 55 times earnings before interest, taxes, depreciation, and amortization have been deducted. Reflecting its much lower growth rate, Time Warner traded at 14 times the same measure of its earnings. Could the new company achieve growth rates comparable to the 70% annual growth that AOL had achieved before the announcement? In contrast, Time Warner had been growing at less than one-third of this rate. Integration Challenges Integrating two vastly different organizations is a daunting task. Internet company AOL tended to make decisions quickly and without a lot of bureaucracy. Media and entertainment giant Time Warner is a collection of separate fiefdoms, from magazine publishing to cable systems, each with its own subculture. During the 1990s, Time Warner executives did not demonstrate a sterling record in achieving their vision of leveraging the complementary elements of their vast empire of media properties. The diverse set of businesses never seemed to reach agreement on how to handle online strategies among the various businesses. Top management of the combined companies included icons such as Steve Case and Robert Pittman of the digital world and Gerald Levin and Ted Turner of the media and entertainment industry. Steve Case, former chair and CEO of AOL, was appointed chair of the new company, and Gerald Levin, former chair and CEO of Time Warner, remained as chair. Under the terms of the agreement, Levin could not be removed until at least 2003, unless at least three-quarters of the new board consisting of eight directors from each company agreed. Ted Turner was appointed as vice chair. The presidents of the two companies, Bob Pittman of AOL and Richard Parsons of Time Warner, were named co-chief operating officers (COOs) of the new company. Managers from AOL were put into many of the top management positions of the new company in order to “shake up” the bureaucratic Time Warner culture. None of the Time Warner division heads were in favor of the merger. They resented having been left out of the initial negotiations and the conspicuous wealth of Pittman and his subordinates. More profoundly, they did not share Levin’s and Case’s view of the digital future of the combined firms. To align the goals of each Time Warner division with the overarching goals of the new firm, cash bonuses based on the performance of the individual business unit were eliminated and replaced with stock options. The more the Time Warner division heads worked with the AOL managers to develop potential synergies, the less confident they were in the ability of the new company to achieve its financial projections (Munk: 2004, pp. 198-199). The speed with which the merger took place suggested to some insiders that neither party had spent much assessing the implications of the vastly different corporate cultures of the two organizations and the huge egos of key individual managers. Once Steve Case and Jerry Levin reached agreement on purchase price and who would fill key management positions, their subordinates were given one weekend to work out the “details.” These included drafting a merger agreement and accompanying documents such as employment agreements, deal termination contracts, breakup fees, share exchange processes, accounting methods, pension plans, press releases, capital structures, charters and bylaws, appraisal rights, etc. Investment bankers for both firms worked feverishly on their respective fairness opinions. While never a science, the opinions had to be sufficiently compelling to convince the boards and the shareholders of the two firms to vote for the merger and to minimize postmerger lawsuits against individual directors. The merger would ultimately generate $180 million in fees for the investment banks hired to support the transaction. (Munk: 2004, pp. 164-166). The Disparity Between Projected and Actual Performance Becomes Apparent Despite all the hype about the emergence of a vertically integrated new media company, AOL seems to be more like a traditional media company, similar to Bertelsmann in Germany, Vivendi in France, and Australia’s News Corp. A key part of the AOL Time Warner strategy was to position AOL as the preeminent provider of high-speed access in the world, just as it is in the current online dial-up world. Despite pronouncements to the contrary, AOL Time Warner seems to be backing away from its attempt to become the premier provider of broadband services. The firm has had considerable difficulty in convincing other cable companies, who compete directly with Time Warner Communications, to open up their networks to AOL. Cable companies are concerned that AOL could deliver video over the Internet and steal their core television customers. Moreover, cable companies are competing head-on with AOL’s dial-up and high-speed services by offering a tiered pricing system giving subscribers more options than AOL. At $23 billion at the end of 2001, concerns mounted about AOL’s leverage. Under a contract signed in March 2000, AOL gave German media giant Bertelsmann, an owner of one-half of AOL Europe, a put option to sell its half of AOL Europe to AOL for $6.75 billion. In early 2002, Bertelsmann gave notice of its intent to exercise the option. AOL had to borrow heavily to meet its obligation and was stuck with all of AOL Europe’s losses, which totaled $600 million in 2001. In late April 2002, AOL Time Warner rocked Wall Street with a first quarter loss of $54 billion. Although investors had been expecting bad news, the reported loss simply reinforced anxieties about the firm’s ability to even come close to its growth targets set immediately following closing. Rather than growing at a projected double-digit pace, earnings actually declined by more than 6% from the first quarter of 2001. Most of the sub-par performance stemmed from the Internet side of the business. What had been billed as the greatest media company of the twenty-first century appeared to be on the verge of a meltdown! Epilogue The AOL Time Warner story went from a fairy tale to a horror story in less than three years. On January 7, 2000, the merger announcement date, AOL and Time Warner had market values of $165 billion and $76 billion, respectively, for a combined value of $241 billion. By the end of 2004, the combined value of the two firms slumped to about $78 billion, only slightly more than Time Warner’s value on the merger announcement date. This dramatic deterioration in value reflected an ill-advised strategy, overpayment, poor integration planning, slow post-merger integration, and the confluence of a series of external events that could not have been predicted when the merger was put together. Who knew when the merger was conceived that the dot-com bubble would burst, that the longest economic boom in U.S. history would fizzle, and that terrorists would attach the World Trade Center towers? While these were largely uncontrollable and unforeseeable events, other factors were within the control of those who engineered the transaction. The architects of the deal were largely incompatible, as were their companies. Early on, Steve Case and Jerry Levin were locked in a power struggle. The companies’ cultural differences were apparent early on when their management teams battled over presenting rosy projections to Wall Street. It soon became apparent that the assumptions underlying the financial projections were unrealistic as new online subscribers and advertising revenue stalled. By mid 2002, the nearly $7 billion paid to buy out Bertelsmann’s interest in AOL Europe caused the firm’s total debt to balloon to $28 billion. The total net loss, including the write down of goodwill, for 2002 reached $100 billion, the largest corporate loss in U.S. history. Furthermore, The Washington Post uncovered accounting improprieties. The strategy of delivering Time Warner’s rich array of proprietary content online proved to be much more attractive in concept than in practice. Despite all the talk about culture of cooperation, business at Time Warner was continuing as it always had. Despite numerous cross-divisional meetings in which creative proposals were made, nothing happened (Munk: 2004, p. 219). AOL’s limited broadband capability and archaic email and instant messaging systems encouraged erosion in its customer base and converting the wealth of Time Warner content to an electronic format proved to be more daunting than it had appeared. Finally, Both the Securities and Exchange Commission and the Justice Department investigated AOL Time Warner due to accounting improprieties. The firm admitted having inflated revenue by $190 million during the 21 month period ending in fall of 2000. Scores of lawsuits have been filed against the firm. The resignation of Steve Case in January 2003 marked the restoration of Time Warner as the dominant partner in the merger, but with Richard Parsons at the new CEO. On October 16, 2003 the company was renamed Time Warner. Time Warner seemed appeared to be on the mend. Parson’s vowed to simplify the company by divesting non-core businesses, reduce debt, boost sagging morale, and to revitalize AOL. By late 2003, Parsons had reduced debt by more than $6 billion, about $2.6 billion coming from the sale of Warner Music and another $1.2 billion from the sale of its 50% stake in the Comedy Central cable network to the network’s other owner, Viacom Music. With their autonomy largely restored, Time Warner’s businesses were beginning to generate enviable amounts of cash flow with a resurgence in advertising revenues, but AOL continued to stumble having lost 2.6 million subscribers during 2003. In mid-2004, improving cash flow enabled the Time Warner to acquire Advertising.com for $435 million in cash. -What are some of the reasons AOL Time Warner may fail to satisfy investor expectations?

Around the announcement date of a merger, acquiring firm shareholders of large publicly traded firms normally earn

A horizontal merger occurs between two companies within the same industry.

America Online Acquires Time Warner: The Rise and Fall of an Internet and Media Giant Time Warner, itself the product of the world’s largest media merger in a $14.1 billion deal a decade ago, celebrated its 10th birthday by announcing on January 10, 2000, that it had agreed to be taken over by America Online (AOL) at a 71% premium to its share price on the announcement date. AOL had proposed the acquisition in October 1999. In less than 3 months, the deal, valued at $160 billion as of the announcement date ($178 billion including Time Warner debt assumed by AOL), became the largest on record up to that time. AOL had less than one-fifth of the revenue and workforce of Time Warner, but AOL had almost twice the market value. As if to confirm the move to the new electronic revolution in media and entertainment, the ticker symbol of the new company was changed to AOL. However, the meteoric rise of AOL and its wunderkind CEO, Steve Case, to stardom was to be short-lived. Time Warner is the world’s largest media and entertainment company, and it views its primary business as the creation and distribution of branded content throughout the world. Its major business segments include cable networks, magazine publishing, book publishing and direct marketing, recorded music and music publishing, and filmed entertainment consisting of TV production and broadcasting as well as interests in other film companies. The 1990 merger between Time and Warner Communications was supposed to create a seamless marriage of magazine publishing and film production, but the company never was able to put that vision into place. Time Warner’s stock underperformed the market through much of the 1990s until the company bought the Turner Broadcasting System in 1996. Founded in 1985, AOL viewed itself as the world leader in providing interactive services, Web brands, Internet technologies, and electronic commerce services. AOL operates two subscription-based Internet services and, at the time of the announcement, had 20 million subscribers plus another 2 million through CompuServe. Strategic Fit (A 1999 Perspective) On the surface, the two companies looked quite different. Time Warner was a media and entertainment content company dealing in movies, music, and magazines, whereas AOL was largely an Internet Service Provider offering access to content and commerce. There was very little overlap between the two businesses. AOL said it was buying access to rich and varied branded content, to a huge potential subscriber base, and to broadband technology to create the world’s largest vertically integrated media and entertainment company. At the time, Time Warner cable systems served 20% of the country, giving AOL a more direct path into broadband transmission than it had with its ongoing efforts to gain access to DSL technology and satellite TV. The cable connection would facilitate the introduction of AOL TV, a service introduced in 2000 and designed to deliver access to the Internet through TV transmission. Together, the two companies had relationships with almost 100 million consumers. At the time of the announcement, AOL had 23 million subscribers and Time Warner had 28 million magazine subscribers, 13 million cable subscribers, and 35 million HBO subscribers. The combined companies expected to profit from its huge customer database to assist in the cross promotion of each other’s products. Market Confusion Following the Announcement AOL’s stock was immediately hammered following the announcement, losing about 19% of its market value in 2 days. Despite a greater than 20% jump in Time Warner’s stock during the same period, the market value of the combined companies was actually $10 billion lower 2 days after the announcement than it had been immediately before making the deal public. Investors appeared to be confused about how to value the new company. The two companies’ shareholders represented investors with different motivations, risk tolerances, and expectations. AOL shareholders bought their company as a pure play in the Internet, whereas investors in Time Warner were interested in a media company. Before the announcement, AOL’s shares traded at 55 times earnings before interest, taxes, depreciation, and amortization have been deducted. Reflecting its much lower growth rate, Time Warner traded at 14 times the same measure of its earnings. Could the new company achieve growth rates comparable to the 70% annual growth that AOL had achieved before the announcement? In contrast, Time Warner had been growing at less than one-third of this rate. Integration Challenges Integrating two vastly different organizations is a daunting task. Internet company AOL tended to make decisions quickly and without a lot of bureaucracy. Media and entertainment giant Time Warner is a collection of separate fiefdoms, from magazine publishing to cable systems, each with its own subculture. During the 1990s, Time Warner executives did not demonstrate a sterling record in achieving their vision of leveraging the complementary elements of their vast empire of media properties. The diverse set of businesses never seemed to reach agreement on how to handle online strategies among the various businesses. Top management of the combined companies included icons such as Steve Case and Robert Pittman of the digital world and Gerald Levin and Ted Turner of the media and entertainment industry. Steve Case, former chair and CEO of AOL, was appointed chair of the new company, and Gerald Levin, former chair and CEO of Time Warner, remained as chair. Under the terms of the agreement, Levin could not be removed until at least 2003, unless at least three-quarters of the new board consisting of eight directors from each company agreed. Ted Turner was appointed as vice chair. The presidents of the two companies, Bob Pittman of AOL and Richard Parsons of Time Warner, were named co-chief operating officers (COOs) of the new company. Managers from AOL were put into many of the top management positions of the new company in order to “shake up” the bureaucratic Time Warner culture. None of the Time Warner division heads were in favor of the merger. They resented having been left out of the initial negotiations and the conspicuous wealth of Pittman and his subordinates. More profoundly, they did not share Levin’s and Case’s view of the digital future of the combined firms. To align the goals of each Time Warner division with the overarching goals of the new firm, cash bonuses based on the performance of the individual business unit were eliminated and replaced with stock options. The more the Time Warner division heads worked with the AOL managers to develop potential synergies, the less confident they were in the ability of the new company to achieve its financial projections (Munk: 2004, pp. 198-199). The speed with which the merger took place suggested to some insiders that neither party had spent much assessing the implications of the vastly different corporate cultures of the two organizations and the huge egos of key individual managers. Once Steve Case and Jerry Levin reached agreement on purchase price and who would fill key management positions, their subordinates were given one weekend to work out the “details.” These included drafting a merger agreement and accompanying documents such as employment agreements, deal termination contracts, breakup fees, share exchange processes, accounting methods, pension plans, press releases, capital structures, charters and bylaws, appraisal rights, etc. Investment bankers for both firms worked feverishly on their respective fairness opinions. While never a science, the opinions had to be sufficiently compelling to convince the boards and the shareholders of the two firms to vote for the merger and to minimize postmerger lawsuits against individual directors. The merger would ultimately generate $180 million in fees for the investment banks hired to support the transaction. (Munk: 2004, pp. 164-166). The Disparity Between Projected and Actual Performance Becomes Apparent Despite all the hype about the emergence of a vertically integrated new media company, AOL seems to be more like a traditional media company, similar to Bertelsmann in Germany, Vivendi in France, and Australia’s News Corp. A key part of the AOL Time Warner strategy was to position AOL as the preeminent provider of high-speed access in the world, just as it is in the current online dial-up world. Despite pronouncements to the contrary, AOL Time Warner seems to be backing away from its attempt to become the premier provider of broadband services. The firm has had considerable difficulty in convincing other cable companies, who compete directly with Time Warner Communications, to open up their networks to AOL. Cable companies are concerned that AOL could deliver video over the Internet and steal their core television customers. Moreover, cable companies are competing head-on with AOL’s dial-up and high-speed services by offering a tiered pricing system giving subscribers more options than AOL. At $23 billion at the end of 2001, concerns mounted about AOL’s leverage. Under a contract signed in March 2000, AOL gave German media giant Bertelsmann, an owner of one-half of AOL Europe, a put option to sell its half of AOL Europe to AOL for $6.75 billion. In early 2002, Bertelsmann gave notice of its intent to exercise the option. AOL had to borrow heavily to meet its obligation and was stuck with all of AOL Europe’s losses, which totaled $600 million in 2001. In late April 2002, AOL Time Warner rocked Wall Street with a first quarter loss of $54 billion. Although investors had been expecting bad news, the reported loss simply reinforced anxieties about the firm’s ability to even come close to its growth targets set immediately following closing. Rather than growing at a projected double-digit pace, earnings actually declined by more than 6% from the first quarter of 2001. Most of the sub-par performance stemmed from the Internet side of the business. What had been billed as the greatest media company of the twenty-first century appeared to be on the verge of a meltdown! Epilogue The AOL Time Warner story went from a fairy tale to a horror story in less than three years. On January 7, 2000, the merger announcement date, AOL and Time Warner had market values of $165 billion and $76 billion, respectively, for a combined value of $241 billion. By the end of 2004, the combined value of the two firms slumped to about $78 billion, only slightly more than Time Warner’s value on the merger announcement date. This dramatic deterioration in value reflected an ill-advised strategy, overpayment, poor integration planning, slow post-merger integration, and the confluence of a series of external events that could not have been predicted when the merger was put together. Who knew when the merger was conceived that the dot-com bubble would burst, that the longest economic boom in U.S. history would fizzle, and that terrorists would attach the World Trade Center towers? While these were largely uncontrollable and unforeseeable events, other factors were within the control of those who engineered the transaction. The architects of the deal were largely incompatible, as were their companies. Early on, Steve Case and Jerry Levin were locked in a power struggle. The companies’ cultural differences were apparent early on when their management teams battled over presenting rosy projections to Wall Street. It soon became apparent that the assumptions underlying the financial projections were unrealistic as new online subscribers and advertising revenue stalled. By mid 2002, the nearly $7 billion paid to buy out Bertelsmann’s interest in AOL Europe caused the firm’s total debt to balloon to $28 billion. The total net loss, including the write down of goodwill, for 2002 reached $100 billion, the largest corporate loss in U.S. history. Furthermore, The Washington Post uncovered accounting improprieties. The strategy of delivering Time Warner’s rich array of proprietary content online proved to be much more attractive in concept than in practice. Despite all the talk about culture of cooperation, business at Time Warner was continuing as it always had. Despite numerous cross-divisional meetings in which creative proposals were made, nothing happened (Munk: 2004, p. 219). AOL’s limited broadband capability and archaic email and instant messaging systems encouraged erosion in its customer base and converting the wealth of Time Warner content to an electronic format proved to be more daunting than it had appeared. Finally, Both the Securities and Exchange Commission and the Justice Department investigated AOL Time Warner due to accounting improprieties. The firm admitted having inflated revenue by $190 million during the 21 month period ending in fall of 2000. Scores of lawsuits have been filed against the firm. The resignation of Steve Case in January 2003 marked the restoration of Time Warner as the dominant partner in the merger, but with Richard Parsons at the new CEO. On October 16, 2003 the company was renamed Time Warner. Time Warner seemed appeared to be on the mend. Parson’s vowed to simplify the company by divesting non-core businesses, reduce debt, boost sagging morale, and to revitalize AOL. By late 2003, Parsons had reduced debt by more than $6 billion, about $2.6 billion coming from the sale of Warner Music and another $1.2 billion from the sale of its 50% stake in the Comedy Central cable network to the network’s other owner, Viacom Music. With their autonomy largely restored, Time Warner’s businesses were beginning to generate enviable amounts of cash flow with a resurgence in advertising revenues, but AOL continued to stumble having lost 2.6 million subscribers during 2003. In mid-2004, improving cash flow enabled the Time Warner to acquire Advertising.com for $435 million in cash. -Although the AOL-Time Warner deal is referred to as an acquisition in the case, why is it technically more correct to refer to it as a consolidation? Explain your answer.

What are the critical assumptions that Microsoft is making in buying Nokia? Do you believe these assumptions are realistic? Explain your answer.