In Anticipation of the Next “AOL-Time Warner”

This post was inspired by a @PlanMaestro who wrote: “Prediction: #PullingAnAOL will start trending soon.” I fully agree.

As “everyone” knows:

• Interest rates remain low (and in many cases, negative)
• Corporate cash balances remain high (at least in the United States, part of the reason there are inversion/tax related “controversies”)

As some know:

• Capital/wealth has really nowhere to go other than the private sector, as public sector returns are de minimis. Corporate bonds/equities, hard assets, venture capital and private equity are the only game in town. I believe US is (largely) the only game in town as well.
• Confidence in the corporate sector (C-level suites) is increasing.
• Mergers and acquisitions are “back”
• US Equity valuations are on the higher end historically, but can arguably go much higher given the prevailing low interest rate environment AND due to the pressure capital has to flee public sector and go SOMEWHERE.
• The relatively high equity valuations have some interesting effects: (1) C-level executives face greater pressure to justify their existence, and so will look for ways to prop/grow EPS. (2) high valuations mean cheap currency, so acquisitions may seem, and may occasionally even be “accretive” (3) High valuations may lead otherwise mediocre/poor managers into thinking they are actually competent, and deserving of their absurdly high compensation packages. This dangerous and misplaced rise in confidence may encourage people to take on risks via M&A they otherwise would not.

All the above conditions lead me to believe we are in ripe territory (said differently, in dangerous territory) for a few eventual AOL-Time Warner debacles… I mean, deals. I’m giving it 5-6 quarters. Personally speaking, I am less interested in identifying potential targets on the long side… I’m not “smart” enough to do that. I’ll leave that to other Long/Short and Event-driven folks (I may change my mind, as I somehow magically transform into a super talented long focused guy with the power to foresee acquisitions). I am much more interested in getting involved ex-post. This leaves me plenty of time to observe the frauds and follies that I believe will come to fruition in the near future. 

 

About AOL-Time Warner

“Every time it [AOL] got to a clean quarter, it would buy something so you never saw internal growth. Total scum.” - Lisa Thompson from http://twitter.com/LTommy256/status/508807681579425792

It is my understanding that the AOL Time Warner deal gloriously harmed quite a few short sellers. Kynikos Associates, Rocker Partners, etc. I believe the list of those who lost money shorting in that situation is a “who’s who” list. I believe losses on shorting AOL were in the order of 10x. Note that time actually vindicated the AOL shorts… but little comfort in being “right” and losing considerable amount of capital.

 

David Rocker, Rocker Partners on AOL:

“Ask what the bull case is, other than bull generally,” demands David Rocker, a New York hedge fund head who says AOL is still one of the market’s most overvalued stocks. 1996

source: http://articles.baltimoresun.com/1996-07-28/business/1996210078_1_aol-america-online-steve-case

In addition, the company used questionable accounting practices for new  subscribers and marketing revenue to improve its short-term financials. These practices  would lead to a $385 million write-off in 1996, and accusations that the company was
“morally bankrupt.” 

Former CEO Kimsey described the accounting issue
as “the big turd” that “sat in the middle of the company and smelled up the place.” Id. at 57. Short-seller Rocker
claimed that for AOL, “every revenue is ordinary, and every expense is extraordinary.

A well-known short seller of America Online, meaning he has bet that its stock price will decline, Mr. Rocker said that the company inflated its quarterly results by spreading its high marketing costs over two years. At the same time, it was reporting costs to the Government, reporting a loss to receive tax breaks.

”They have been telling the Government the truth, but they tell investors something else,” he said.

source: http://www.nytimes.com/1996/10/30/business/america-online-announces-a-newer-transformation.html

 

Jim Chanos, Kynikos Associates on AOL:

Q: what was your biggest mistake?
A (Jim Chanos): AOL. It was a short due to accounting, we thought they were masking higher churn then they reported. We thought the value of a subscriber would turn out less than they thought. We started shorting at $2-$4, covered as it went up, and covered the last at $80. We kept it to a 1%-1.5% position. We knew we were in the midst of a bubble, so we kept it small, but it still cost us 10% over 2 years.

source: http://myinvestingnotebook.blogspot.com/2010/05/jim-chanos-power-of-negative-thinking.html