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AOL Time Warner: Hitting Its Stride

By Scott Kessler Although home to valuable properties like America Online, CNN, HBO, Netscape, Time magazine, Time Warner Cable and Warner Bros., perhaps AOL Time Warner's most important asset is its base of 133 million subscriptions that provide annuity-like revenues. In fact, as many of its competitors have struggled in the midst of the dot-com crash and macroeconomic slowdown, AOL Time Warner (AOL) has delivered impressive results, due in great part to its strong relationships with customers.

For the remainder of 2001, S&P expects the company's success to continue and even accelerate due to the continued leveraging of its customer base, the introduction of new offerings, and an anticipated rebound in the U.S. economy. In light of strong and improving fundamentals as well as a compelling valuation, S&P recently upgraded AOL Time Warner to its highest investment rating of 5 STARS.

ALL-STAR LINEUP. AOL Time Warner is a diversified media company whose main operating segments include: America Online (which contributed 24% of revenues and 33% of EBITDA for the first quarter of 2001), cable television systems (18% and 37%), cable and broadcast networks (19% and 22%), publishing (11% and 5%), filmed entertainment (24% and 5%), and music (10% and 5%). Note that these figures account for intersegment eliminations, corporate expenditures and merger-related costs.

America Online is the undisputed global leader in online services. The company's flagship AOL service has almost 29 million subscribers, and growth in Europe and Latin America has been especially strong of late. The CompuServe service is positioned in the value segment and has approximately 3 million subscribers. In addition, hundreds of millions of people use the company's free Internet offerings, which include: Digital City (local city guide), MapQuest (mapping and navigation), AOL Moviefone (movie information and tickets), AOL Messaging ICQ, AOL Instant Messenger, Spinner (streaming music) and Winamp (music player).

Time Warner Cable provides cable service to more than 12.8 customers throughout the U.S. Over 92% of its cable infrastructure has been upgraded, enabling the provision of digital services such as high-resolution video, CD-quality sound, and video-on-demand. Over 90% of the company's subscribers are located in clusters (areas with more than 100,000 subscribers), the largest of which are: New York City (1.2 million subscribers), Tampa Bay (925,000), Central Florida (677,000), Houston (638,000) and Raleigh/Fayetteville (449,000).

The Networks group includes CNN, the world's best known news brand; HBO and Cinemax, the nation's top two premium pay services; leading cable television entertainment properties including TBS Superstation, TNT, Cartoon Network and Turner Classic Movies; and the WB, a television network popular with teens and young adults.

Time Inc. accounts for most of the company's publishing revenues and owns some 64 magazines, reaching more than 268 million readers. Titles include four of the five most popular consumer magazines in the U.S.: People, Time, Sports Illustrated and Fortune, as well as Entertainment Weekly, Money and In Style. In late 2000, AOL acquired Times Mirror Magazines, publisher of Golf, Popular Science and Field & Stream, from Tribune Co. in a transaction valued at about $475 million.

The largest part of the filmed entertainment segment is Warner Bros., a global entertainment company with leading positions in feature films, television, home video, animation, and production/brand licensing. Properties include The Matrix, Batman, ER, Friends, The West Wing, DC Comics and MAD Magazine, as well as the production rights for the first four Harry Potter books. New Line cinema is a top independent producer and distributor of feature films and has created the popular Austin Powers franchise.

Warner Music Group includes record companies Atlantic, Elektra, London-Sire and Rhino, and operates in 68 countries through various subsidiaries, affiliates and non-affiliated licensees. The company's artists, which include Madonna, Kid Rock, Red Hot Chili Peppers, Eric Clapton and Faith Hill, won 20 Grammy awards in 2000.

POTENT BLEND. As indicated by the quality, quantity and diversity of its properties, AOL Time Warner is well-positioned to capitalize on the continuing convergence of content and communication that is being enabled by technology innovation and fueled by consumer demand. Its unique combination of assets, distribution channels, customer relationships, proprietary content brought together through the merger of America Online and Time Warner have provided significant growth and cost-cutting opportunities.

Among the most important growth drivers for the newly merged company are cross-company initiatives. For example, more than 1.1 million new Time Inc. magazine subscriptions have been generated through the AOL service. And, the publishing segment has also been a major source of new AOL memberships. AOL, Netscape and other America Online brands have also driven substantially increased traffic to many of Time Warner's branded content websites. In March 2001, Jupiter Media Metrix reported that Time Warner sites attracted 23 million unique visitors in March, accounting for increases of 69% from the year-ago period and 10% above February's total. The company has also announced CNN Money, an expanded business news initiative that will be supported with added reach, content and promotion from Time Warner Cable, AOL and Time Inc.

Cross-company efforts are also delivering significant successes on the advertising front, despite the sluggish U.S economy. We believe AOL Time Warner has actually benefited from the current slowdown in advertising spending, because it can provide more value to customers across multiple properties than any of its competitors.

In addition, marketers are increasingly interested in efficiency and high-productivity, which are the hallmarks of the Internet and strengths of the company's offerings. Because it's able to offer advertising inventory across a wide range of media (including print, network and cable television, and the Internet), AOL Time Warner has gained market share since completing its merger. The company has entered into a number of significant marketing agreements this year, with partners including Nortel Networks, Cendant, Compaq, Kinko's, Continental Airlines, Swatch, CompUSA and Cisco.

MORE EFFICIENT. The merger has also provided significant cost-cutting opportunities. In addition to the restructurings and headcount reductions often realized from corporate transactions, the combination has also enabled the company to achieve efficiencies in distribution, marketing and infrastructure costs.

For example, a large percentage of America Online's product costs were attributable to the huge amount of compact discs it bought for the distribution of its software. As one of the world's leading manufacturers of CDs, Time Warner's efficiencies in this area have already resulted in significant cost savings. In addition, these CDs have been included with many popular Time Inc. magazines, thereby saving on distribution costs while generating membership growth.

Looking somewhat into the future, digital downloads also offer the potential for significant cost savings. More than half of the expenses for the sale of music CDs are costs associated with manufacturing, retailing and distribution that could be sharply reduced by selling and delivering the audio content over the Internet. The online distribution model also offers benefits as to publishing and video content.

BRIGHT PROSPECTS. Notwithstanding all of the potential associated with cross-company activities, the remainder of 2001 looks quite exciting for AOL Time Warner. S&P expects the company to continue experiencing robust demand for its digital cable services. Also, the company's online music subscription service should debut this summer. During the second half of 2001, Warner Music Group is slated to release a number of highly-anticipated albums by artists including Alanis Morisette, Brandy, Jewel, Madonna and Red Hot Chili Peppers. In addition, S&P expects the launch of the broadband AOL service over Time Warner cable in the fourth quarter. On November 16, 2001, the first installment of the Harry Potter book series will come to the big screen. In December 2001, New Line will release the movie version of "Lord of the Rings." Both of these films are expected to be very successful and perhaps develop into AOL Time Warner franchises.

Standard & Poor's expects the company to meet and perhaps exceed its stated goals for 2001: $40 billion in revenues and $11 billion in EBITDA (or operating cash flow). AOL Time Warner set these targets well before its merger was even completed and has continued to affirm them (even amid the economic slowdown), translating to annual growth in revenue of 11% and EBITDA of 31%. S&P projects 2001 cash EPS to increase 44%. For 2002, revenues should increase 13% to $46 billion, EBITDA 28% to $14 billion, and cash EPS 19% to $1.60. S&P anticipates long-term annual appreciation in revenues of 14%, EBITDA of 24% and cash EPS of 16%.

The somewhat conservative six-to-12 month price target for the stock is $78, or 24 times S&P's 2002 EBITDA estimate of $14 billion. S&P believes the stock should trade at a forward EBITDA multiple at least equal to the company's long-term EBITDA growth rate and in excess of valuations awarded to competitors, due to AOL Time Warner's huge subscription base, market-leading businesses, well-known brands, significant upcoming positive catalysts, and a world-class management team. S&P's price target portends potential appreciation of 45%.

Note to readers: Focus Stock of the Week will not be published on Monday, May 28, but will return Monday, June 4. Kessler is an Internet industry analyst for Standard & Poor's

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