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A favorite Wall Street parlor game right now is to put a value on America Online, the

Time Warner


Internet unit that is reportedly up for sale.

The deal chatter intensified Tuesday with reports that Steve Case, the AOL founder and former chief, might be interested in grabbing the company. The notion that AOL is on the block is of course laden with irony: It was just three short years ago, at the height of the bubble, that indomitable-seeming AOL bought apparently ailing Time Warner.

Of course, the deal soon turned into a nightmare for everyone involved. Demand for AOL's subpar and irritating-to-use product sagged dramatically as Internet users became more discerning. In addition, Case's company was appallingly run and became the subject of federal investigations, still ongoing, into potential accounting irregularities. Time Warner managers reacted by wresting control from AOL honchos and even expunging AOL from the corporate name. Though the powers that be have put Jonathan Miller, a well-regarded manager, in charge of AOL, it would be no surprise if Time Warner sought to wash its hands entirely of the unit by selling it.

But at what price? While Time Warner obviously wants as much as it can get, first it must convince a buyer that AOL can resume growing and that it can keep reaping those rich cash flows. The price often bandied about is $10 billion -- which is far below the $170 billion market capitalization that AOL had when it announced its intention to buy Time Warner.

In this climate, where optimism about the tech sector is again riding high, it's all too possible that AOL could actually fetch $10 billion -- and perhaps a bit more. But in truth, the company may be worth no more than $6 billion. Even if we take the midpoint between $10 billion and $6 billion, we get $8 billion. There is no good reason for AOL to go for any more than that.

Cash-Flow Conflict

How do people arrive at the $10 billion figure? Though few reports have cited a rationale, there is a cash-flow-based calculation using AOL's much smaller rival



that gets surprisingly close to $10 billion. However, another type of EarthLink comparison also gets us to $6 billion.

First, the cash-flow approach. Since AOL isn't publicly traded, we need to use a valuation based on that for EarthLink. The first step is to calculate EarthLink's so-called free cash flow, which is the cash produced by the business after capital expenditures and operating cash costs that don't immediately go through the income statement. We then compare that to EarthLink's enterprise value, or market cap plus debt minus cash, to get a cash-flow multiple that we can apply to AOL.

In 2004, EarthLink expects to report earnings before interest, taxes, depreciation and amortization of around $145 million. Next we subtract expected capex of $35 million and cash customer acquisition costs of $15 million, and that gives us free cash flow of $95 million in 2004. To get the enterprise value, we take the market cap of $1.43 billion and add debt (nothing in this case) and subtract cash in hand, which was $439 million at the end of 2003. The result is $991 million, which is 10.4 times the projected free cash flow at EarthLink this year.

If we apply that multiple to AOL's forecast of $1 billion in free cash flow in 2004, we of course get to an implied enterprise value of around $10 billion. Now, a buyer may not pay all that in cash because AOL may want to have the acquirer assume some of the $9.1 billion in debt associated with AOL. It is doubtful that Time Warner would be able to offload all that debt -- but if a deal happens, the total debt included is likely to be substantial.

Caveat Emptor

What's wrong with that calculation? Well, it relies on the companies' own projections for cash flows. The pricing pressure and competition in the Internet service provider market could easily intensify and cause the companies' cash flows to fall short of expectations, if not this year then next.

Oddly, the bulls expect the shift to broadband by Internet users to help the likes of EarthLink and AOL. But AOL and EarthLink don't actually own the broadband infrastructure, in this case the cable or DSL lines. They are simply out there trying to persuade Internet users to go through them rather than the cable or phone providers that do own the broadband infrastructure. (The ISPs pay for the DSL or cable access and then use the lion's share of remaining subscriber payments to pay for their own marketing and customer service costs. Anything left after that is profit.)

Of course, the ISPs always have had to pay the phone companies for dial-up Internet access. But the sort of consumers paying up the high rates for broadband will likely be sophisticated enough to know that they don't need to go through AOL or EarthLink to get broadband access.

As a result, AOL and EarthLink have to compete on price. The only other way to get a real edge is through marketing, which means heavy costs. Clearly, there are enough reasons to worry about the achievability of the 2004 cash-flow forecasts.

As a result, it makes sense to use reported data. One metric is to calculate enterprise value per subscriber at EarthLink and then apply that number to AOL. EarthLink had 5.2 million subscribers at the end of 2003, and has an enterprise value of $991 million right now, which works out at $190 per subscriber. AOL had 32 million subscribers at the end of last year. If we multiply 32 million by $190, we get an implied enterprise value of $6.1 billion -- far below the rumored $10 billion price tag.

This approach also shows just how expensive a $10 billion deal could be. If AOL were to sell for $10 billion, the buyer would be valuing each subscriber at $313 -- which is 65% more than the level where the market is valuing EarthLink's subscribers right now.

Is AOL really 65% better than EarthLink? It seems very unlikely, even if Miller has wrought some improvements. If Case really wants his baby back, Time Warner should of course exploit any sentimental attachment he has to AOL and demand $15 billion or more, and try and dump as much debt as possible. But if it goes to Case, or anyone else, for $10 billion, it would still be a good price for the biggest flameout of the Internet era.

In keeping with TSC's editorial policy, Peter Eavis doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He welcomes your feedback and invites you to send any to