(FORTUNE Magazine) – What's the old saying? Be careful what you wish for? If America Online and Time Warner think they've had an agonizing time getting their merger past Washington regulators--and yes, they have--just wait until they get the deal done, take on the mind-boggling task of turning the two companies into one, and then try to run it, as they say they will, as a world-changing, rule-breaking, speed-generating, synergy-creating, fast-growing, moneymaking media, entertainment, and Internet rocket ship that, we're assured, will be pro-competitive, consumer-friendly, and socially responsible too. Whew. Merely contemplating the scale and complexity of the task that the dealmaking duo of Steve Case and Jerry Levin have handed to their operating minions would exhaust lesser mortals. It's beyond daunting.

This isn't to say that what still stands as the new millennium's biggest, boldest deal won't pay off. Eventually, it may pay off big. The thinking behind the merger remains sound. The executives in charge are strong. There's a plan in place, which is mostly about remaking Time Warner (parent of FORTUNE's publisher), leveraging customer relationships, and creating big new ventures in arenas like music and TV. And together these companies will be able to deploy an unequaled array of assets--a TV and movie studio, cable and TV networks, cable systems, magazines, interactive properties like instant messaging, and at the center of it all, AOL's 26-million-member online service (29 million including CompuServe), the engine that will be asked to power much of the enterprise. Yes, in the long run, the potential is vast. But for now--meaning the next year or maybe two--the people trying to steer this contraption face pitfalls and obstacles at every turn. Lots can go wrong. Skeptics say lots will.

Start with the fact that most big mergers don't work as well as anticipated. Think AT&T-TCI or Disney-ABC, neither of which was as complicated as this deal. Knowing this in advance doesn't help. Just ask Jurgen Schrempp, who, when he merged Chrysler with Daimler-Benz, said that his challenge would be "to beat the statistics--70% of mergers have not brought results" for shareholders. That figure came from his own company's study of big, cross-border mergers--a category into which AOL Time Warner fits, in a sense, although their corporate headquarters are just a shuttle flight apart.

This deal also has steep financial hurdles to leap. Here are the numbers, as sketched out by J. Michael Kelly, who will be the new company's CFO: $40 billion in revenues in 2001, which should grow by 12% to 15%; $11 billion in Ebitda (earnings before interest, taxes, depreciation, and amortization), which is projected to grow 25% annually. Some analysts say the company will generate as much as $5 billion in free cash flow this year--real money you can spend or put in the bank--and while AOL won't confirm that figure, Kelly says cash flow will grow an eye-popping 50% annually. "It's a big number," he admits. Wall Street is perplexed about how to value the stock and who will analyze it, and estimates about the company are all over the lot.

Speaking of which, let's pause for a word from our sponsors, who will be paying some of the bills: The advertising market is softening, and we're not just talking about dot-coms. Entertainment industry analysts have downgraded Disney, News Corp., and Viacom, because, as Morgan Stanley's Rich Bilotti writes, "most advertisers will cut their advertising budgets, if they have not already," to boost profitability in the year ahead. The new AOL Time Warner will generate about 25% to 30% of its revenues in 2001 from advertising--less than other media giants but still a lot--and it's projecting enormous growth in AOL's ad revenues without any slowdown in Time Warner's. Does it really make sense to believe that Internet advertising will explode without damaging old media?

Then there are the people issues, notably the crowding at the top. The senior corporate structure looks like a Noah's Ark, with two of each species on board. Two self-styled visionaries: Case, the chairman, and Levin, the CEO, who like to peer around corners, think big thoughts, and act statesmanlike but prefer not to soil their hands with operations. That's fortunate, because they've got two chief operating officers: One is AOL's Bob Pittman, the big man on campus who will guide the cable and broadcast networks, cable systems, magazines, and online businesses, which together bring in 65% of revenue. The other is Time Warner's Dick Parsons, an affable diplomat who will oversee TV, movie, and music production. Let's not overlook the two virtual vice chairmen: CNN founder Ted Turner, who keeps offices in New York and Atlanta and isn't about to retire to his Montana ranch; and little-known Ken Novack, Case's trusted advisor, who shuttles between a Boston law office, New York, and AOL's headquarters in Dulles, Va. (These two keep a low profile, but they matter.) Having all that talent around is a plus, Case says breezily. "Yes, there are a lot of cooks in the kitchen," he says, "but this is quite a feast that we want to serve."

No doubt, but another media mogul wonders what's on the menu. "In a merger, someone eats somebody else," John Malone, the former cable kingpin, said recently about the AOL Time Warner deal. "The idea of a merger of equals is bullshit." In this case, the challenge will be for AOL to transform Time Warner's operating divisions into paragons of Internet-linked efficiency without destroying the qualities that have made most of them industry leaders. Each is a multibillion-dollar enterprise run by an executive whose business card says CEO. This isn't like acquiring Netscape or CompuServe. Time Warner has 70,000 worldwide employees, many in creative businesses that AOL executives know little or nothing about. Already a few Time Warner operating executives have bristled at what they perceive as the arrogance of the conquerors from Dulles.

So there you have the downside. There's no shortage of risk built into this deal. Given all the dangers, you'd expect AOL Time Warner's competitors to be standing aside, chortling, waiting for this monster to go careening off a cliff. But of course they haven't been: They hate this deal. Disney and Microsoft, companies that don't normally call for more government oversight, asked regulators to attach all kinds of conditions to the merger. And the regulators did: Before voting 5-0 to approve the deal, the Federal Trade Commission required Time Warner to open its cable systems to Internet service providers other than AOL. (As with so much about this new colossus, that dictate cuts both ways; it should help AOL pry open cable systems not owned by Time Warner.) As FORTUNE went to press, the battle had shifted to the Federal Communications Commission, where opponents get a last chance to object. It's clear that if and when the deal closes, this new company will enter the world with few well-wishers.

The title of a detailed report on AOL Time Warner by analysts at ABN Amro tells why; it's called "No One Catches Up." With the possible exception of Microsoft and Disney, it's hard to think of any two companies that can go head-to-head with AOL Time Warner on the Internet and in entertainment. Says ABN Amro analyst David Londoner, who's been following the entertainment industry for 20 years: "This merger creates a media powerhouse that may well be impossible to duplicate."

Seen in that light, Steve Case looks even smarter today than he did when he made the deal in January. Two months before Internet valuations began to evaporate, Case used AOL stock to acquire great content brands and assure broadband delivery via Time Warner's cable systems. In so doing, he probably put a floor under AOL's stock. True, it has fallen by as much as 51% since the beginning of 2000, but eBay at its nadir was down by 75%, Amazon fell by 83%, and Yahoo at one point lost 86% of its value. Although no one will dance a jig at the next shareholders' meeting, AOL stock is still up 1,900% over the past five years.

Levin, for his part, got a momentary Internet pop in Time Warner's stock price, but that's not really why he did the deal. He had probably squeezed as much growth out of Time Warner's mature businesses as he could. His Internet initiatives had flopped; the company expects losses of close to $200 million online for 2000. But now, failing online means more than missing an opportunity: The Internet is threatening to disrupt the music, TV, and publishing businesses. Levin saw that he could either ride the wave or be drowned by it. Besides, he has an almost religious faith in the marriage of entertainment and technology, going back to his early days at HBO, his Full Service Network extravaganza in Orlando, and Time Warner's Roadrunner broadband play.

Those who say, with 20/20 hindsight, that Levin gave up too much because AOL shareholders will own 55% of the new company miss a couple of points. He's still the CEO--emerging, as he did after previous mergers with Warner Bros. and Turner, from a deal that some thought would engulf him. And even though Time Warner will contribute about 75% of the new entity's revenues, AOL should deliver more than 50% of its pretax income, according to ABN Amro's analysis, because Time Warner has high depreciation and interest charges and AOL little depreciation and more cash than debt. AOL is simply a higher-margin, faster-growing business.

AOL's got something else Time Warner lacks: Parsons calls it "Internet savvy." Time Warner needed the shock of this deal to get its people to fully embrace the digital world. "It's very hard to do, because people have a tendency to circle the wagons around what they know," Parsons laments. Just how far the company had fallen behind the curve was brought home to him when his 26-year-old son, Gregory, wanted to get into the Internet business. When Parsons invited him to talk to Time Warner, Gregory told him: "Dad, you guys ain't happening." Says Parsons: "He spoke for a generation. To all those young kids out there, we weren't happening. AOL was happening."

We won't bore you with a history of Time Warner's Internet woes here, but for a glimpse of the problem turn to page 12 of this magazine. See the blurbs for fortune.com? Nothing wrong with that, except you'd see similar promotions in Time Inc.'s Money and the company's CNNfn business-news cable network pushing their own sites. Time Warner hasn't figured out how to capitalize on its strong brands online. First it married them (remember Time Inc.'s Pathfinder?), then it let them loose, and then it tried to cluster them in "hubs," an initiative that got bogged down in interdivisional squabbling. "You have a lot of disparate efforts going on around Time Warner," observes AOL's Mike Kelly. "You can't make money that way. The world doesn't work that way."

That's the voice of "Internet savvy," and Time Warner is about to get an earful of it. Pittman explains: "What we're talking about is taking the power of the Internet fully into every aspect of the company." AOL will, for example, aggregate all of Time Warner's financial sites into a personal-finance channel online that will be supported by AOL and Netscape. That'll save money and drive traffic to Time Warner content. "It's a very elegant solution to a problem that's been very difficult for us," says Time Inc. CEO Don Logan. It's not quite that simple, though, because AOL has a three-year, $21 million agreement making CBS MarketWatch its preferred financial news site. Here and elsewhere, AOL Time Warner will find that cross-promotion collides with the need to generate real revenue.

Logan's also getting help selling magazines. Through joint marketing efforts, AOL has already sold more than 600,000 trial subscriptions to Time Inc. magazines; many subscribers have agreed to be billed on credit cards. Credit-card billing has been a goal of publishers for years because it should improve renewal rates and eliminate those costly renewal requests that magazines send out. Says Logan: "Down the road, this will increase our circulation profitability dramatically."

Other Time Warner executives have similar hopes. The company's youth-oriented TV network, the WB, is having its best fall ever after promoting its shows and stars on AOL. Says CEO Jamie Kellner: "AOL has done a wonderful job of building awareness for us." AOL will use its marketing clout to help open Warner movies, sell music, and induce more TV viewers to subscribe to HBO. Time Warner's cable systems will try to sell their customers a souped-up, high-speed version of AOL.

The goal is to persuade the company's customers--the buyers of Time Inc.'s 44 million magazine subscriptions, 12.6 million Time Warner cable subscribers, and especially the 26 million AOL subscribers--to spend more of their money with AOL Time Warner. "The customer base is our biggest asset, far and away," says Kelly. "It's about finding new ways to offer them products and services they want. And we try to do it using the infrastructure we have built here so it doesn't cost us as much as anybody else. That's the key." Yes, it's cross-selling, an old idea that hasn't paid off much in other businesses. But this may be different because of AOL's market dominance and the peculiar hold the service has over its users.

There's no getting around it: AOL towers over its rivals. With its 26 million subscribers, it is five times as big as the No. 2 Internet service provider, EarthLink, and it's still growing fast--it has added six million subscribers in the past 12 months. We don't know any other media business with more paying subscribers. (By comparison, the nation's ten largest newspapers have a combined circulation of less than ten million.) More important, AOL properties capture about one-third of all time spent online, three times as much as runners-up Microsoft and Yahoo combined. The average AOL household spends more than an hour a day online. Says AOL's new CEO, Barry Schuler: "It's funny. We're at a point where the [stock] market is all doom and gloom, but consumers are really breaking out in their enthusiasm and embracing Internet habits."

Interestingly, AOL keeps growing even though, at $21.95 per month, it's the most expensive way to get dial-up Internet access. What's more, its customer satisfaction ratings from J.D. Power and others are consistently below average. (A new University of Michigan consumer survey ranks AOL below the postal service and the airlines.) High cost and low quality don't usually add up to market clout, but AOL is different. It blossomed on the strength of great marketing and ease of use, and now it won't be uprooted. One reason is the network effect: The more people use AOL's buddy lists and chat rooms, the more other people want to use them to chat with friends and relatives, send instant messages, and the like. More important, it's a pain to change e-mail addresses and even harder to switch Internet providers after setting up a home page, a stock portfolio, a calendar, or a photo album. Just try getting your teenager to give up AOL.

No wonder Microsoft doesn't like this merger: AOL has become the de facto Internet operating system for mass-market America. This is what worries competitors and regulators, but it's also the reason AOL has a big leg up on everyone else, whether it comes to cross-selling, delivering content, or giving consumers additional points of entry to the service, a strategy it calls AOL Anywhere. For people who want voice access to the Internet, it built AOL by Phone (see following story). For those who prefer to surf the Web on their TV sets, there's AOL TV. Those who can't live without instant e-mail access from anywhere can buy an AOL device built by the people who developed the Blackberry. These product extensions all grow out of the idea that people want a single, AOL-branded Internet gateway, with their personal preferences intact. They are cost-efficient because they run off AOL's existing infrastructure. They are propelled by AOL's online marketing machine. But--and here's a critical point--exploiting these opportunities demands a corporate culture that is speedy and collaborative.

Time Warner is neither. It is slow moving and so decentralized that the CEOs of the various divisions had never met regularly until Pittman and Parsons began holding merger-related sessions last summer. AOL people can't believe how unaccustomed Time Warner executives are to cooperating. "What's not good is for two divisions to fight, and one loses and one wins," notes Pittman. "To the corporation that's a net zero. Maybe even a net loss." The AOL crowd was thunderstruck when Time Warner Cable kicked Disney's ABC-TV network off some of its cable systems during a contract dispute last spring, at precisely the moment when AOL and Time Warner were laboring to convince Washington regulators that they had no intention of acting like bullies after the merger. Earlier, Warner Bros. tried to charge the company's broadband venture an outrageous sum to use the Roadrunner brand. These are classic examples of parochial thinking.

So AOL is undertaking a comprehensive makeover of Time Warner, designed to get everyone to play well together. One huge issue is compensation. Historically, Time Warner executives have been rewarded with cash bonuses based on the performance of their individual units; that's why they fight so hard for their own bottom line. By contrast, AOL executives make their money mostly from stock options, which aligns their interests. "We're still examining this," Pittman says, "but clearly everybody agrees it's going to be broader based, and equity's going to be a more important component." (Pittman earned $683,334 in cash compensation last year and another $134.3 million by exercising stock options.)

Another big change: Divisions have been told to deliver weekly reports so that corporate HQ can track such metrics as revenues, profits, subscribers, TV ratings, and ad sales. That's new to Time Warner, where until now Levin and his people set quarterly targets and left it up to the divisions to meet them. Pittman and Kelly will push harder and dig deeper into operations. "The big cultural difference is going to be the relentless focus on the bottom line," says Time Inc.'s Logan. "We'd shifted in that direction at Time Warner, but these people are even more focused than we are."

Of course, if the AOL people push too hard, they'll meet resistance. Time Warner's businesses, while run independently, have also been run very well, and those in charge know it. Cable systems, the company's biggest business, has doubled its Ebitda in the past five years. High-margin cable networks like HBO, TNT, the Cartoon Network, and TBS have grown rapidly and steadily. Out of every dollar spent on magazine advertising in America, about 22 cents goes to a Time Inc. publication. Even Warner's TV and movie studio has been consistently profitable. So who needs to worry about sharing? "Some of us are pretty ornery and pretty independent," says a senior Time Warner executive. "We operate that way, and we like it that way." Time Warner executives observe that AOL's success has been confined to one arena, and that "Internet savvy" can't make a movie or cover an election. When Case told a UBS Warburg conference recently that "television hasn't changed all that much in 30 years" other than by adding new channels, some in the audience found it curious that he should overlook satellites, the remote control, and the VCR.

Pittman has tiptoed through Time Warner's minefields before, as a theme-park executive, before taking a detour into the real-estate business. "Boy, this is a culture that would not tolerate a centralized, top-down approach," he says. "Dick [Parsons] and I have wrestled with this a lot. How do you keep that focus on empowerment and yet get the benefits that you need when you go cross-company?" All the media companies--Disney, Sony, Bertelsmann--face this conundrum. They can't operate as they once did because the Internet breaks down the walls between media businesses. No TV network on its own can figure out interactive TV. Nor can any music company solve the issues of digital delivery. Even the world's biggest magazine publisher can't develop e-books on its own.

It's in these arenas that the merger will ultimately succeed or fail. To turn new businesses like e-music and interactive TV into home runs, AOL and Time Warner will first have to bridge the deepest cultural divide between them--their attitudes toward change.

AOL, only 15 years old, thrives on disruption. "AOL has been a transformer," says Schuler. "We make money through change." Case can't wait to attack conventional TV or what he sees as the unwieldy, inconvenient ways that music is sold and stored.

Time Warner, with roots going back to 1923, worries about change, and rightly so. It has enormous investments, both financial and psychic, in the status quo, earning millions of dollars from Friends, ER, and Madonna CDs. That's why, as Parsons put it, people "circle the wagons around what they know."

Now consider what it'll take to make interactive TV, which could be a $30 billion industry in five years, according to Andersen Consulting. AOL-TV is a beginning, offering a nifty program guide, plus the ability to surf the Web, chat, and send instant messages while watching the tube. But true interactive TV will enable viewers to fetch cartoons on demand from the Cartoon Network, see HBO movies on demand, build their own newscast from CNN. Interactive ads will be embedded into the prime-time lineup on the WB. The software to make it happen will probably be built into Time Warner Cable's set-top boxes. Who will market the service? Who will sell the ads? All of that will require unprecedented collaboration and a willingness to put existing business models at risk.

But if AOL and Time Warner together will struggle with interactive TV or digital music, imagine how much harder it would be for either of them to build those businesses alone. This new company will be a laboratory, with all the tools anyone would need to experiment with the future of media and entertainment. It's also the ultimate hedge play in a rapidly changing media universe: If, say, the Internet kills the music business, AOL Time Warner will be both winner and loser. In that complexity lie both the beauty and the peril of this deal. AOL Time Warner could well become the biggest, most valuable, most respected company ever--Case's long-held dream. It's already one of the most complicated. Running it will require virtuoso management beyond anything its executives have been called upon to display up to now.

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