Dear Dagen: The Impact of AOL Time Warner on Internet HOLDRs

With the pending merger of America Online (AOL Quote) and Time Warner (TWX Quote), what will become of the Merrill Lynch Internet HOLDRs (HHH Quote) security? From what I understand, they will not replace AOL? So will I get my approximately four shares of AOL delivered to me in the form of the new entity's shares?

-- Mike Keith

Mike,

Steve Case and Gerald Levin are probably still swamped with interview requests from CNN to Good Morning Saskatchewan.

Despite the hullabaloo, this deal isn't expected to close until the end of this year. And that's when it will directly impact the makeup of Internet HOLDRs.

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Investors in shares of Internet HOLDRs, an exchange-traded basket of 20 Internet stocks, are facing two possibilities.

The stock of the merged company could stay in the portfolio. Or it could get the boot.

Launched in September, the Internet HOLDRs security gives investors an ownership interest in 20 different Internet stocks through one investment. Merrill Lynch created the security, but investors can purchase it through any broker, just like a stock.

Internet HOLDRs Makeup
Company	Current weighting
Yahoo!(YHOO Quote)	31.7%
America Online (AOL Quote)	16.4
CMGI (CMGI Quote)	8.6
Amazon.com (AMZN Quote)	7.2
Exodus Communications (EXDS Quote)	5.2
eBay (EBAY Quote)	4.9
Excite@Home (ATHM Quote)	3.9
Inktomi (INKT Quote)	3.5
RealNetworks (RNWK Quote)	3.4
DoubleClick (DCLK Quote)	2.9
Priceline.com (PCLN Quote)	2.3
E*Trade (EGRP Quote)	1.9
Lycos (LCOS Quote)	1.8
CNet (CNET Quote)	1.4
PSINet (PSIX Quote)	1.3
Ameritrade (AMTD Quote)	1.2
Network Associates (NETA Quote)	1.0
EarthLink (ELNK Quote)	0.6
MindSpring (MSPG Quote)	0.5
Go2Net (GNET Quote)	0.5
Source: Bloomberg

AOL currently commands about 16.4% of the portfolio, behind Yahoo! (YHOO Quote) at 31.7%.

Internet HOLDRs shares trade like stocks but can only be bought in round lots of 100 shares, a trade that would total more than $15,000. Nevertheless, the underlying portfolio has attracted $1.25 billion from investors in about four months.

Generally, if a company that's part of the basket is acquired by another, then its stock would be removed from the portfolio. If Microsoft (MSFT Quote) was the one buying AOL, then the outcome would be obvious: AOL would disappear from the basket.

If a company in the Internet HOLDRs portfolio buys another company, then its stock typically would stay in the basket. Simply, the acquirer stays. The acquiree goes.

New stocks, however, will not be added to the underlying portfolio. Once one stock leaves, another doesn't move in to take its place. But Merrill Lynch can launch additional versions of this security with different components.

Portfolio holding EarthLink (ELNK Quote), for example, is merging with another, MindSpring (MSPG Quote). Once that merger is complete, the number of stocks in the basket will fall to 19.

However, the case of AOL isn't as clear as that example because Time Warner isn't a Net company.

With the merger of AOL and Time Warner, you've got the combination of two titans in two distinct businesses.

"We're waiting to see the AOL-Time Warner merger plan before determining the appropriate course of action," says a Merrill Lynch official.

The merging companies are required to file merger documents with the Securities and Exchange Commission within 10 days of the announcement of the merger, according to an AOL spokeswoman.

If the merger plan suggests that the stock doesn't qualify as an Internet security, the stock of the unified company would be deleted from the Internet HOLDRs basket. A vast media conglomerate arguably wouldn't belong in an Internet-only portfolio. If, however, only the form not the substance of the company changes, the company would stay.

However, it's a good guess that AOL will remain in the Internet HOLDRs portfolio.

Afterall, AOL is really the one buying Time Warner in the stock deal valued at more than $140 billion. (Of course, the AOL-Time Warner press release describes the deal as "a merger of equals.")

Although 80% of the proposed company's cash flow will initially come from Time Warner, AOL shareholders will end up owning 55% of the combined company.

That's definitely a signal that the combined entity could fundamentally remain AOL, with new distributions and content possibilities.

What If?

If the stock of the united AOL Time Warner is indeed removed from the Internet HOLDRs basket, investors would receive their share of whatever is paid to AOL shareholders. That will be one share of AOL Time Warner stock for each share of America Online stock they own through the portfolio.

That distribution would not trigger a taxable event. Taxes would only hit when the actual shares of stock are sold by an investor.

This event wouldn't take place until the deal actually closes, which is expected to happen by the end of the year.

Until then, you have another option (beyond just selling your shares in the open market), if you want to get out of AOL stock before the deal closes. Internet HOLDRs shares can be redeemed in kind. Redemption in kind means that investors can take their HOLDRs shares to the trustee, the Bank of New York, and receive the portfolio's underlying stocks in return. (This exercise costs $10 per 100 HOLDRs shares, the minimum redemption increment.)

If you did this, you would get your share of all 20 stocks in the portfolio. You could then go into the market and unload just your AOL if you like.

Why would you sell? Some critics are concerned that AOL's stock could be weighed down by Time Warner's slower-growth businesses. Some expect increased short-term volatility in AOL's stock as investors grapple with the new business model.

This week, AOL's stock was down 12% through Tuesday's close, and it followed that trend Wednesday morning.

If that performance continues, you may not want to wait to see if the stock stays in this basket.

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