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. Last Updated: 07/27/2016

Investors Fear Pair Will Be Odd Couple

NEW YORK -- Pickup trucks can be great vehicles. So can sports cars. But their virtues are very different, and fans of one may not love the other.

That may help explain why the second day of the America Online-Time Warner deal sent stock prices of both companies tumbling, with each down $5 or more a share. The value of the stock that America Online is offering for Time Warner, at $165 billion when the deal was announced, leaped to $180 billion in early trading Monday but was down to $145.1 billion by the end of trading Tuesday.

That difference - $34.9 billion - is itself a huge number. A quarter-century ago, no company in the United States was worth that much. The most valuable company in 1975, IBM, sported a valuation of $33.3 billion.

If the proposed merger is completed, shareholders of both companies are going to get something very different from what they bought. In a real sense, Time Warner and America Online have inhabited parallel stock market worlds when it comes to valuations.

"The big question for shareholders is whether the market will accord the new entity a traditional valuation or an 'Internet valuation,'" Henry Blodget, an analyst at Merrill Lynch & Co., said in a report to clients. "Our answer to this is not surprising: probably somewhere in between."

The problem, in the short term at least, is that not a lot of stocks now fall "somewhere in between." Nor has there been much demand for such stocks. A share in AOL Time Warner, as the company is to be called, will have no hope for the growth rate that was expected for the old America Online. Nor will it sport the current cash flow that was represented by an old Time Warner share.

Moreover, many shareholders of each type of company have been contemptuous of the other. America Online and other Internet stocks were derided as bubbles waiting to burst; Time Warner was viewed as an old-economy company that was stumbling in its efforts to get with the new economy.

Stock prices are set by markets, of course, based on what investors are willing to pay. And in recent months, investors have been willing to pay far more for America Online's growth prospects than for Time Warner's cash flow.

That is reflected in a few ratios. Time Warner shareholders will provide operations that produced 82 percent of the revenue, and 70 percent of the operating cash flow, for the 12 months ending last September. But they will get only 45 percent of the stock in the new company.

Look at the numbers that way, and it appears that Time Warner shareholders are getting a bum deal. But a different set of numbers produces the opposite conclusion.

Based on stock prices Friday, before the deal was announced, Time Warner shareholders are getting a 71 percent premium for their shares. Had this been a "merger of equals," with the exchange ratio set by current market prices, Time Warner shareholders would have wound up with only 32 percent of the merged company, not 45 percent.

One risk to this deal is that shareholders will abandon the companies, some seeking purer plays in explosive net growth and some looking for better current valuations.

Another is that, in the year this deal may take to close, the stock market itself could radically alter the valuations on these two types of stocks. A year ago, the market thought Time Warner shares were worth 1.7 America Online shares; two years ago that number was 5.6.

The short-term winners in this deal are clearly Time Warner shareholders.

But in the longer term, it is probably a better deal for America Online. Its stock price has fluctuated greatly, tied to two factors: its success in the rapidly changing Internet market and investor infatuation with such stocks.

If and when Internet-mania fades, America Online will have substantial businesses, ranging from Warner Brothers movies to Cable News Network, to support its stock price, assuming this deal is completed. But getting to that point will require the company to convince its shareholders - who presumably were quite happy without the Time Warner safety net - that the new, slower-growing America Online is something they want to own.