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In announcing the deal, the two companies called it a “strategic merger of equals.” Time Warner’s chairman, Gerald M. Levin, declared that “the opportunities are limitless for everyone connected to AOL Time Warner”—above all, he added, for its shareholders.

Ecstatic that their stock might finally get the cachet of an Internet darling, Time Warner shareholders overwhelmingly approved the deal. But they overlooked a few things:

This “merger of equals” was designed to give America Online’s shareholders 55% of the combined company—even though Time Warner was five times bigger.

For the second time in three years, the U.S. Securities and Exchange Commission was investigating whether America Online had improperly accounted for marketing costs.

Nearly half of America Online’s total assets—$4.9 billion worth—was made up of “available-for-sale equity securities.” If the prices of publicly-traded technology stocks fell, that could wipe out much of the company’s asset base.

CONCLUSION: On January 11, 2001, the two firms finalized their merger. AOL Time Warner Inc. lost $4.9 billion in 2001 and—in the most gargantuan loss ever recorded by a corporation—another $98.7 billion in 2002. Most of the losses came from writing down the value of America Online. By year-end 2002, the shareholders for whom Levin predicted “unlimited” opportunities had nothing to show but a roughly 80% loss in the value of their shares since the deal was first announced.5

Can You Flunk Investing Kindergarten?

On May 20, 1999, eToys Inc. sold 8% of its stock to the public. Four of Wall Street’s most prestigious investment banks—Goldman, Sachs & Co.; BancBoston Robertson Stephens; Donaldson, Lufkin & Jenrette; and Merrill Lynch & Co.—underwrote 8,320,000 shares at $20 apiece, raising $166.4 million. The stock roared up, closing at $76.5625, a 282.8% gain in its first day of trading. At that price, eToys (with its 102 million shares) had a market value of $7.8 billion.1

What kind of business did buyers get for that price? eToys’ sales had risen 4,261% in the previous year, and it had added 75,000 customers in the last quarter alone. But, in its 20 months in business, eToys had produced total sales of $30.6 million, on which it had run a net loss of $30.8 million—meaning that eToys was spending $2 to sell every dollar’s worth of toys.

The IPO prospectus also disclosed that eToys would use some proceeds of the offering to acquire another online operation, Baby-Center, Inc., which had lost $4.5 million on $4.8 million in sales over the previous year. (To land this prize, eToys would pay a mere $205 million.) And eToys would “reserve” 40.6 million shares of common stock for future issuance to its management. So, if eToys ever made money, its net income would have to be divided not among 102 million shares, but among 143 million—diluting any future earnings per share by nearly one-third.

A comparison of eToys with Toys “R” Us, Inc.—its biggest rival—is shocking. In the preceding three months, Toys “R” Us had earned $27 million in net income and had sold over 70 times more goods than eToys had sold in an entire year. And yet as Figure 17-3 shows, the stock market valued eToys at nearly $2 billion more than Toys “R” Us.

CONCLUSION: On March 7, 2001, eToys filed for bankruptcy protection after racking up net losses of more than $398 million in its brief life as a public company. The stock, which peaked at $86 per share in October 1999, last traded for a penny.

FIGURE 17-3 A Toy Story

All amounts in millions of dollars.

Sources: The companies’ SEC filings.

Chapter 18

A Comparison of Eight Pairs of Companies

In this chapter we shall attempt a novel form of exposition. By selecting eight pairs of companies which appear next to each other, or nearly so, on the stock-exchange list we hope to bring home in a concrete and vivid manner some of the many varieties of character, financial structure, policies, performance, and vicissitudes of corporate enterprises, and of the investment and speculative attitudes found