How It All Fell Apart

Perhaps Mona Lisa, with her uncertain smile, knew something at the time that nobody else did. In the fall of 1999, an upstart group with the lofty title of the Global Business Dialogue on Electronic Commerce had chosen the Louvre for its first conference. The setting certainly matched its ambitions--to set worldwide standards for cyberspace and electronic commerce. Among the conference heavyweights: Gerald Levin, the CEO of Time Warner, the world's largest media company, and Steve Case, chairman of America Online, the Internet king. The two men wound up chatting about big ideas; the belief that companies should be values-driven, rather than mere slaves to profit targets. "We weren't talking about putting our companies together'' at the Louvre, Levin would later note in a NEWSWEEK interview. And despite the warm words, there was in fact unspoken tension between the two men. Earlier in 1999, Case had pushed regulators to force AT&T, Time Warner Cable and the rest of the industry to carry AOL's broadband service over their data pipes. Case's hubris stunned them. "I don't trust him," Levin said about Case, according to someone who overheard him at the conference.

Just three months later, though, on Jan. 10, 2000, Levin and Case were beaming before a mob scene of TV crews in Manhattan, making history with the announcement of their $350 billion blockbuster marriage. Combining AOL and Time Warner would create a behemoth that, they boasted, would touch the lives of people around the world an amazing 2.5 billion times each month through magazines, cable and movies. AOL would be the turbo-charged engine to bring Old Media into the "Internet century'' and deliver a dizzying 30 percent surge in profits on $40 billion in sales in the first year alone. "We've become a company of high-fives and hugs,'' Levin gushed. Ted Turner, the largest individual shareholder and vice chairman of the new company, said the deal felt like "the first time I made love some 42 years ago."

But this week, when AOL Time Warner holds a much-anticipated press conference, there won't be any backslapping. In fact, there won't be any Jerry Levin, who abruptly retired months ago. Case, the man who helped send his partner packing, will be there, though there likely will be a harsh spotlight on him. The man now running the show, Richard Parsons, will unveil a new AOL Time Warner strategy: to create a kind of "must-have AOL," in which consumers would pay extra for exclusive online offerings from Time Warner siblings. In effect, it turns the company's original model on its head, with Old Media re-energizing the New Economy division. The mantra from Parsons these days is to under promise and over deliver. After all, no one is in the mood to hear spin from a company that was never able to live up to its own hype. The combined company's stock, which peaked at $56.60 in May 2001, hit bottom in July 2002 at $8.70, and is now trading at about $16. That collapse has wiped out a stunning $280 billion in value for one of the market's most widely held stocks since the deal was announced. And its capitalization may take a further hit--the company faces its second investigation by the SEC and the Justice Department over its accounting.

The company's stock is so beaten down that, NEWSWEEK has learned, several Wall Street buyout firms have explored making a bid for the company's assets, particularly its online operations. Among them, according to executives privy to the talks: Henry Kravis's Kohlberg Kravis Roberts; the Blackstone Group, and JPMorgan Chase's deal making czar, James Lee. The firms declined to comment.

There are easy explanations for AOL Time Warner's sudden fall. Who knew when the deal was forged that the dot-com era and booming economy were about to come to a wrenching end? And not even the gloomiest of forecasters could have predicted the attacks of September 11. Certainly, those were among the causes that sent the company into a tailspin. Yet the real problem with AOL Time Warner can be traced to its roots. A detailed reconstruction of the merger, based on interviews with dozens of key executives close to the deal, offers a clear picture of what went wrong: Case and Levin, and their companies, were never right for each other. While the popular strategy at the time of marrying New and Old Media may have made sense in the abstract, there were troubling signs from the very start that this marriage wouldn't work. The architects of the deal were incompatible, and their companies inevitably were, too. But they forced them together anyway, in an effort to secure their place in history.

Case and Levin's relationship, in fact, was far more contentious early on than many people believed. Barely a day and a half before their big announcement, NEWSWEEK has learned, Case and Levin were locked in a fierce power struggle. Levin, who was to be CEO, was worried about ceding too much power to Case, the chairman-designate. Yet he knew that Case, whose company's soaring stock made the deal possible, couldn't be seen by investors as a figurehead. The showdown "went down to the wire," people involved in the matter say. Levin, they added, was even prepared to walk away from the deal at the last minute. But they struck a precarious solution, with Case to rule over public policy and technology matters, and Levin overseeing the core media and online businesses. For the TV cameras, though, the two executives painted a picture of harmony. "Jerry and I worked out very early our relative responsibilities," Case said at the press conference.

The companies' cultural differences also sprung up over a critical issue: the dazzling financial results AOL Time Warner promised to deliver. The companies clashed over these projections much earlier than previously believed. Joan Nicolais, who was Time Warner's chief contact with Wall Street analysts, fiercely opposed the aggressive projections of a quick 30 percent profit increase to win Wall Street's support, several colleagues say. She preferred to offer straight guidance to Wall Street. Nicolais criticized AOL's approach as "basically an elaborate spin machine," says one top executive. "She didn't think the numbers added up." Nicolais would eventually lose out to an AOL executive for the investor-relations post.

Why did Levin want this deal so badly? He won't say. "I'm yesterday's news," he told NEWSWEEK. But there are clear signs of what he might have seen in AOL. He had always yearned to be on technology's leading edge. In 1975, as an executive at Time Inc.'s fledgling HBO division, he switched the network's signal from microwave to satellites, a pioneering move that transformed the business. Levin made other good tech calls, playing a crucial support role in the early development of DVD. Through the 1990s, he launched many costly efforts to become a central player in the digital age, including Time Inc.'s Pathfinder portal and a cable Information Superhighway. Levin was worried that Time Warner's culture would prevent him from operating on "Internet time." AOL would help him get there.

Over the years Case had made fleeting appearances in Levin's life. They were both guests, for example, at the White House for a screening of "You've Got Mail," a Warner Bros. movie that took its title from AOL's e-mail greeting. In Levin and Time Warner, Case saw what his company was missing: real assets, particularly a media company, with big, steady revenues and profits. Case was also increasingly worried that customers would dump his snail's-pace dial-up service for faster connections offered by the cable companies. His hot stock was burning a hole in his pocket.

Case and Levin deluded themselves early on with talk of a marriage of equals, even though AOL shareholders would own 55 percent of the stock. The truth became obvious when they announced their management structure in May 2000. As co-COO with Parsons, Bob Pittman, AOL's No. 2 executive, managed to get the lion's share of the operations. AOL also swept out Time Warner executives from many senior staff positions. "That was basically the Case plan," says a Time Warner executive.

The AOL executives wasted little time behaving as if they were in charge. According to Time Warner officials, their AOL colleagues ridiculed Parsons behind his back, often saying that he was history. The AOL crowd wasn't keen on Levin, either. They whispered that he often drifted off-message, and they considered him too lax with his underlings. Tensions also rose after a widely publicized incident in which AOL's Michael Kelly, who became AOL Time Warner's finance chief, addressed executives of both companies in a planning session. Recalling AOL's 1998 purchase of Netscape, he said, "We fired everyone. We will do that here," recalls an attendee.

AOL's arrogance was fueled largely by its lofty stock price. But in a troubling sign for the merger, the value of its shares started to fall to new lows with the bursting of the dot-com bubble. Even with its price dropping, though, Time Warner shareholders would still get enough AOL stock to make it worth their while. In June 2000, the shareholders of each company voted to approve the deal. The regulators' final blessing was still months away. AOL's declining stock price inevitably led to questions, even within the management ranks of Time Warner, about whether the deal should be finalized. According to two senior officials, discussions were held about whether to pay an enormous breakup fee of $5 billion and walk away from the deal. Some executives in the operating divisions of the company were in favor of aborting the transaction.

AOL executives tried to brush off doubts about the prospects of its business, particularly for online advertising. They argued that, as the industry leader, AOL would avoid the falloff in ads that its competitors were suffering. Besides, the combined company, with its broad mix of businesses and strong base of subscriptions, would be more immune to fluctuations in the ad market than other media giants. This was the mantra when the deal was finalized on Jan. 11, 2001, with the blessing of the Federal Communications Commission. "AOL is in a totally different zone than a dot-com advertising vehicle," Levin said after the closing.

Financial results for the first full quarter of marriage, however, showed ominous signs. Advertising and e-commerce sales were both flat or down. The stock dropped almost 10 percent. Levin and Pittman tried to focus attention on a bump in subscriptions. "To me, this was proof positive that the merger is working," Levin said at the time. Added Pittman: "The story of this quarter is that our synergies are hitting, and they're hitting big." As some insiders saw it, Pittman and Levin seemed to be trying to one-up each other with bullish forecasts. Pittman appeared to be upstaging Levin, making little effort to douse rampant speculation that he was heir to the AOL Time Warner throne. Pittman popped up on the cover of BusinessWeek after the transaction closed. The headline: SHOWTIME--BOB PITTMAN'S JOB IS TO IMPLEMENT THE BIGGEST MERGER IN HISTORY.

Pressures mounted as the stock fell after hitting its postmerger peak of around $60. The power of the bullish forecasts was waning. Then terrorists attacked on 9-11. Thirteen days later, using the attacks as an explanation, Levin finally stated what Joan Nicolais knew from the beginning, and what many observers had come to suspect. AOL Time Warner would fall well short of its projected $11 billion in cash flow--off by $1 billion, to be exact. It wouldn't be the last time it would back off from its much-ballyhooed projections. Its credibility on Wall Street sank.

Levin seemed to change after 9-11, publicly resetting his priorities, with shareholders falling down the list. He told a gathering of investors that he intended to spend heavily on the "public trust," notwithstanding the impact on profits. "I'm the CEO, and this is what I'm going to do," he reportedly said. "I don't care what anyone else says." Levin and Case were apparently on a collision course. Levin was intent on acquiring AT&T's sprawling cable empire, a transaction that would have spread Time Warner Cable across about a quarter of the nation. It was the way he went about it, however, that led to a confrontation with Case and a crisis in the boardroom, according to senior officials. Levin simply pursued the transaction without consulting the board, according to these sources. "Steve made it an issue that he hadn't liked Jerry's approach" and that he wouldn't tolerate it, says one person close to the situation. On Dec. 5, 2001, Levin abruptly resigned. Their relationship had come full circle. Levin didn't trust Case from the start because of his tough stance on a cable issue. And now a new disagreement over cable was the final straw. As a parting victory for Levin, he helped get Parsons elevated as his successor over Pittman, the presumed heir.

The company rattled off bad news like a jackhammer. This past April it announced a massive $54 billion write-down, reflecting the company's deterioration since the merger. It was forced to pay an extraordinary $7 billion to purchase Bertelsmann's interest in AOL Europe, an obligation that came with the merger. Debt ballooned to $28 billion. In July, The Washington Post turned up alleged accounting improprieties at AOL during the months before the merger was completed. The article suggested that the funny accounting was done to prop up AOL's earnings to support the completion of the deal. Within days, the SEC and the Department of Justice launched investigations (still underway), sending AOL Time Warner shares to a low of $8.70. Pittman quit a few days later in the midst of the turmoil.

Perhaps no single shareholder has more right to be angry than AOL Time Warner's vice chairman, Ted Turner, whose stake in the combined company, once worth $7.2 billion, has plunged to about $2 billion. During a recent breakfast meeting with Parsons at the crowded Rainbow Room in Rockefeller Center, Turner, in a booming voice heard around the room, was calling Levin names that are unprintable here.

This week, only a couple blocks from the site of the original engagement almost three years ago, Parsons and a new lineup of top executives (notably, all from the Time Warner side of the family, except for Case) will announce a new set of vows for AOL. It's hard to say whether they'll pay off. After all, others have tried to charge for online media content, but consumers have been reluctant to start paying for things they've gotten for free. Parsons isn't making any huge promises. He just wants to start delivering results. The point, of course, is to focus everyone's attention on the company's potential and its future, rather than the soap opera of its relationship up to now.