Can the AOL-Netscape deal be made to work?

The Register picks it over, and concludes that it's going to be a tricky business

With the dust now settling on the AOL-Netscape-Sun deal and the details now filed with the Securities & Exchange Commission, it's time to step back for a moment and consider the implications. The fixers included John Doerr, a venture capitalist with Kleiner Perkins Caulfield & Byers who is on the boards of AOL and Netscape. Significantly, the deal allows his firm to liberate its investments. The deal also looks like an excellent exit strategy for Netscape shareholders. It is known that Steve Case, AOL's CEO, and Jim Barksdale, Netscape's CEO, both attended a Kleiner Perkins conference in Aspen in June. It would have been surprising if they had not arranged to meet again to work out a deal when Barksdale was in Washington giving evidence at the beginning of the Microsoft trial, since AOL's office is a taxi ride away. Miles Gilburne of AOL, who brokered the complex AOL acquisition of CompuServe, was the key AOL negotiator. Larry Sonsini, the ace industry fixer from Wilson, Sonsini, Goodrich & Rosati represented Netscape. The structure of the deal is complex, and was set up to minimise tax burdens. Apollo Acquisition Corp was set up by AOL for the transaction, which will be a reorganisation under Section 368 of the Internal Revenue Code, becoming effective as soon as a certificate of merger is filed in a few months. It requires the approval of Netscape's shareholders, who get 0.45 of an AOL share for each Netscape share. The deal is structured as a pooling of interests, which makes it possible to minimise how the acquisition affects the balance sheet. Netscape had 99,938,928 shares issued and outstanding. The deal is worth $4.2 billion. AOL had a capital stock of 1,800,000,000 shares of which 459,333,610 were issued and outstanding. Share options for Netscape staff will be maintained, since it is seen to be important to retain the staff. Netscape will cease to exist as a legal entity and become a division of AOL. As usual, not too much attention appears to have been played to the non-US aspects of the deal, and European partner Bertelsmann's role will need to be defined. The strategic development and marketing alliance with Sun is a three-year agreement designed to enhance e-commerce for the AOL and Netscape brands. Doing the deal as two separate transactions lessens the tax liability, which would otherwise have affected the bottom line of both AOL and Sun's accounts had Netscape been split between them. The cultural differences in the companies are very pronounced, so the decision to keep the separate geographical locations (Virginia and California) is probably a wise one. The companies have worked together in the past: Netscape had incorporated AOL's instant messenger service into its browser, and Netcenter incorporated AOL's digital cities product. But if their greatest common interest is in fact their opposition to Microsoft, it's a silly reason for the merger. So far as the effect on the Microsoft trial is concerned, there are factors that superficially favour both sides. AOL/Netscape is anxious that the deal is not presented as a fire sale, but the DoJ would prefer that interpretation. Microsoft wishes it to be seen as a ganging up by powerful industry forces against Microsoft, and with $4 billion involved, Netscape was far from being mortally wounded by anything that Microsoft did to Netscape. The remedy already proposed -- that Microsoft be obliged to distribute Navigator -- is less likely since the dynamics of the industry are changing far faster than the legal case is proceeding. For AOL to have two heavily-used Web sites does not spell success. So how does AOL expect to make money on the deal? Well, Case said he was impressed how Netscape had turned "away from browsers and platforms to high-growth portal and e-commerce opportunities" but that does not exactly equate at making a billion dollars a year to pay for the deal. The envisaged synergy with AOL, CompuServe, ICQ and Digital City has to translate into new revenue, and that is likely to be rather difficult to achieve. It amounts to AOL being successful at fulfilling its dreams for e-commerce, and we believe, an Internet terminal. We do not envisage Netscape making much money from Netcenter as a portal with the present business model. Users are fickle. Advertising budgets devoted to Web sites are likely to be moved quickly if the advertising is seen to be ineffective. Users will increasingly switch off graphics to achieve faster rendering, and the more sophisticated ones will use browsers like Opera that allow animation to be switched off. The real anomaly is that with AOL having 92 percent of its users on IE (at least since the Microsoft deal marketing deal), it cannot readily push them to Netcenter. Tools like Netscape TuneUp for IE have a very low market awareness and are unlikely be adopted on a large scale. Likewise, ICQ - AOL's appallingly named instant communications and chat portal - is hardly likely to "promote the downloading and registration of the Netscape client software" on a large scale. AOL users are at the dumb end of the spectrum, and are mostly not keen to get involved in installing software. Certainly the biggest unknown factor is how AOL can leverage Navigator sufficiently. Probably it can't, and is really relying on some as-yet undefined boost for its next generation of AOL software, possibly based on Internet terminals, so getting away from Microsoft dependency. It is uncertain whether Microsoft would be prepared to renew its deal with AOL if it became clear that AOL planned to introduce Windowless Internet terminals. Netscape has quietly developed a new, small browser called Raptor that might be used by AOL in an Internet device. Indeed, this is one area where the deal could make sense: a revival of the NC. It is by no means certain that the Microsoft-AOL deal will be renewed on the same terms, and AOL's inclusion in Windows is now less important, especially as Microsoft has been moving the folders down the hierarchy. In addition, one of the outcomes of the case against Microsoft may well be some ruling about how Microsoft deals with companies like AOL, to AOL's benefit. It is however most unlikely that any company that planned to stay in business would bet its future on the outcome of the present case against Microsoft. The future of Mozilla, the open-source Netscape browser code, seems safe, in view of what Case has been promising (and because it is not possible to take back what has been given away), but it is interesting that it has not been taken up by many large commercial organisations yet. So far as the Linux liaison is concerned, this was a pet project of Andreessen, but his future has not yet been defined. It is not likely that Sun would not be too enthusiastic about giving away Linux instead of selling Solaris. The value of Netscape's e-commerce software for Sun remains to be seen. It will depend on how keen Sun is to sell it. There is an opportunity there, but Sun's history is of being a conservative company that does not normally move unless it sees a profit. In the present deal, getting Netscape as a $500 million hardware customer was evidently sufficient. All the talk of "Sun's e-commerce hardware" is marketing hype: Sun has well-engineered hardware and well-oiled software, and so do several of its competitors, not least IBM, HP and Digital-as-was. A side-deal for Sun is that Kiva Software, a developer acquired by Netscape in 1997 (including what is now known as Netscape Application Server), have better products than those obtained from middleware company NetDynamics, which Sun bought for $160 million earlier in the year. Sun says it will sell products from both. Java is still an unknown factor for the deal. The Java opportunity is knocking on the door more loudly than ever before. Perhaps the right building consortium for Javaspace has now been found, since AOL has said that it would use Java in the next generation of Internet devices. We see the best prospect for the success of the deal as being for AOL to develop its own Internet devices (which Case has dubbed the "AOL Anywhere strategy"), with Raptor as the basis of a new browser. We would not be surprised to see Corel WordPerfect being part of the picture, and of course the servers would be by Sun, with Java playing a significant role. The deal does not have the solid product that the IBM Lotus acquisition had. Even the WordPerfect acquisition by Novell had a real product, although the dynamics were wrong at the time. It is now seen that mega deals must have product and a business model: the Lotus deal had both, but the WordPerfect deal had only product as a result of the failure of the DoJ to bring the right case against Microsoft in 1993. The Netscape deal seems to have products without much market potential and only a vague business model, which does not auger well. Some key questions remain. Can AOL really be worth 350 times its earnings? Can AOL earn at least a billion dollars a year to pay for the deal? We think not, and see the failure of this venture as more likely than its success. If that happens, the Internet sector would suddenly lose its glamour, and be starved of access to capital. Then, the one company with plenty of it could step in and buy any pieces it wanted. That's probably Microsoft's strategy, although it may not yet know it. ®

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