AOL Time Warner's interest in merging its cable operations with AT&T's is based on an unusual principle. Not market dominance - though AT&T's 13.7 million cable television subscribers would more than double AOL's cable customer base. Not operating efficiencies - though Time Warner could easily improve AT&T Broadband's paltry 23.4 percent estimated operating margin. And not high-speed Internet access, though AOL would gladly add the 1.3 million high-speed subscribers of AT&T affiliate Excite@ Home.
Those are compelling reasons, but there's another motive, one that reveals the ways of the cable industry: The deal would keep AOL from making a profit. A merger of AOL's cable operations with AT&T Broadband, at a cost of more than $60 billion, would create years of losses from interest and depreciation. For AOL, nothing could be sweeter.
How's that? The business of publicly traded cable companies is like few others. The key to their financial leverage is that they never turn a profit, so they never have to pay taxes. The problem, an odd problem indeed, is that cable subscriptions generate loads of revenue - AOL Time Warner got $1.5 billion in cable revenue last quarter alone, 17 percent of the company's total revenue. With that kind of inflow, the only way cable companies can avoid profits is to spend huge sums.
The early days of cable made this easy. As cable rolled into new neighborhoods, firms had massive expenses. But when the system was turned on, it started generating cash. So the companies built new systems, avoiding profits - and taxes. And as the cable market matured, two new trends took hold: system upgrades and a wave of mergers, which saw big cable companies borrowing money to buy smaller competitors. The resulting debt created a new, tax-deductible expense.
Big debt, of course, isn't necessarily a bad thing, any more than a big home mortgage is - as long as you make the payments. So the health of a cable business depends on generating cash while generating losses. Cable investors aren't so worried about a net loss when a company is EBITDA positive (that is, before items like depreciation and income). And the EBITDA for AOL's cable business is higher than that for AT&T's, despite lower revenues. "The cable industry has been historically cash-flow-driven," says Raymond James analyst Phil Leigh. "It's in their interest to reduce their taxes. There is no industry more sensitive to reporting a profit."
In this light, with almost $20 billion in long-term debt and interest of $26.4 million a week, AOL Time Warner is a great success. If Bugs Bunny were around today, he'd probably say his parent company was in hock up to its armpits, bub.
Last week's $1.64 billion acquisition of British publisher IPC Group by AOL adds another cash-flow-rich business - and another big cost. Magazines are the perfect cash-flow business: Subscribers pay a year before the product is even made. According to influential Goldman Sachs analyst Anthony Noto, magazine subscriptions already account for 3.6 percent of AOL's revenues.
If AOL gets its way, the irony won't escape information-economy cognoscenti: AOL Time Warner, the mother of all Internet companies, goes to great lengths to generate costs and avoid profit, while other Internet companies are now forced to seek profit at all costs.
