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AOL, You've Got Misery

Twenty-six months ago, at the height of the Internet bubble, America Online (AOL) announced it was buying Time Warner Inc. for more than $130 billion in stock. Analysts generally lauded the merger, as did BusinessWeek. But these days, the exultations have evaporated--along with more than two-thirds of the value of AOL stock. And the company has lost so much credibility on Wall Street that its shares are limping even as the market recovers from the economic slowdown and tech bust: Since Nov. 30, they've lost 33%, while other media stocks have gained 3%.

Certainly, the downturn and the advertising drought have hit AOL's core businesses hard. But AOL has deep-seated problems that are hampering its ability to hold its own in the fast-changing media world. The company is financially weaker than it was a year ago because rising debt and a falling share price have left it without the means to make the deals it needs to keep up. And executives have angered big institutional investors by missing growth targets and spinning financial reports to make their performance look better. "They're in the penalty box," says John Tinker, managing partner of hedge fund Steamer Capital LLC. "Mutual funds feel they've been misled and just want to get rid of a mistake."

Wall Street's antipathy could be a severe handicap as a major consolidation of the cable-TV industry gets under way. AOL is counting on cable to deliver the synergies from its online, entertainment, and news franchises that it promised at the time of the merger. But it can't afford to spend $10 billion for a deal with cable-giant Comcast Corp. (CMCSA)--one that could help put its entertainment and news on broadband lines in one-fourth of the nation's wired homes--unless it plunges deeper into debt, possibly driving its BBB+ bond rating down three notches to junk status. "We are committed to maintaining our strong investment grade rating," says Chief Financial Officer Wayne Pace, who regularly meets with credit-rating agencies. Meantime, the company is holding a poor hand as it tries to hang on to another partnership covering one-sixth of Time Warner's current cable subscribers. And, though it's looking to foreign markets for future growth, AOL is now having to slash its marketing in Europe where its online service is a distant fourth.

AOL executives insist their problems are temporary and under control. The company has $10 billion of untapped bank credit. Movies such as Harry Potter and the Sorcerer's Stone and Lord of the Rings prove the company is capable of delivering box-office bonanzas. And, as the economy rebounds, execs argue, so will advertising at bedrock publishing and TV businesses, thus boosting earnings and cash flow and lifting the stock price. "The only catalyst that matters is bottom line performance," says Robert W. Pittman, co-chief operating officer. Some analysts figure the stock, at around $23, is as low as it will go.

For now, though, AOL is piling on more debt. On top of the $23 billion it owed at the end of 2001, the company is borrowing a further $7 billion because it is being forced to buy the half of AOL Europe it doesn't own. Under a contract signed in March, 2000, at the peak of the tech bubble, AOL gave German media giant Bertelsmann an option to sell its half of AOL Europe to AOL for $6.75 billion. Now the German company is bailing out. That's a double whammy for AOL. Not only will it have to borrow heavily, but it will be stuck with all of AOL Europe's losses, which ran $600 million last year.

AOL could make far better use of the borrowing capacity it still has. To further its ambitions in broadband, it needs to do a deal with Comcast for access to 23 million cable subscribers. Comcast is about to become the owner of 25.5% of Time Warner Entertainment, an important subsidiary. AOL says its doesn't need to buy back the TWE stake. "There is no gun to our head to do this deal," says CFO Pace. But Comcast wants to unload the stake, which analysts value at $10 billion, so AOL may have to buy it as part of negotiations to secure access to Comcast's cable systems. The risk is that a rival--such as Microsoft Corp.'s MSN online service--could get on Comcast's systems first.

Meanwhile, AOL's own cable system, the nation's second-largest, may lose a sizable chunk of its 13 million subscribers. In its annual report filed Mar. 25, AOL says the Newhouse family, which publishes newspapers and magazines, is considering withdrawing from a partnership with AOL and taking 2.3 million cable subscribers with it. The two parties have hired investment bankers to value the stake. At a time when scale is becoming all-important in the cable business, losing those subscribers would be a step backwards.

In the past, AOL might have offered its stock to Comcast and the Newhouse family. But the shares are down. Many investors turned skeptical after the company belatedly conceded last fall that it wouldn't make its aggressive 30% earnings growth projection for 2001. Since December, analysts have slashed their estimates for this year by 27%.

Some of the pessimism stems from the lagging growth of AOL's online subscribers. But much is due to the way the company spins its numbers. For example, analyst Jordan Rohan of SoundView Technology Group complains that AOL uses a tax break it gets when employees exercise stock options to concoct an earnings-per-share number that overstates results by 45%. AOL disputes that anything is amiss. "It's a value to our company," says Pace. Either way, the tax break is now worth much less because AOL shares have fallen so much.

Meanwhile, AOL is still grappling with the dilution to earnings per share that comes from handing out options. Last year, in an effort to keep this under control, it spent $3 billion to buy back 76 million shares--still 33 million short of the number issued when employees exercised options. This year, AOL won't be buying back shares, even though they're down in price, because it needs to conserve the $700 million in cash it still has.

AOL is hurting itself by continuing to emphasize its earnings before interest, taxes, depreciation, and amortization (EBITDA) as the key measure of its financial condition. Many other media companies, such as Viacom Inc., use it, too. But in its Jan. 30 press release, AOL trumpeted 2001 earnings of $9.9 billion using its favorite formula, even though it actually lost $4.9 billion under the generally accepted accounting principles mandated by the Securities & Exchange Commission. Daniel Peris, an analyst at Argus Research Corp., told his clients that EBITDA minimizes the effect of AOL's heavy debt load and that he'll use other measures in the future.

AOL dented its credibility further by offering two different tallies of its 2001 EBITDA results. The first was the $9.9 billion figure headlined in its press release, up 18% from 2000. The second was $9.3 billion, up just 14%, and was reported in an attached spreadsheet headed "2002 pro forma trending schedules." AOL told analysts to use the higher number for assessing its performance last year, and the lower one as the baseline for judging whether it hits its target of increasing earnings by 8% to 12% this year. The rationale: Last year, AOL did not consolidate the $600 million loss made by AOL Europe, but this year it will own all of the company and have to book all of its losses.

Oddly enough, consolidating AOL Europe gives execs a leg up in reaching their 2002 EBITDA profit-growth targets. AOL executives say they will halve AOL Europe's $600 million losses by slashing the cost of marketing to potential subscribers. That alone will lift EBITDA by $300 million. "We do have a fair amount of control over that," Pittman told analysts earlier this year. Lehman Brothers Inc. media analyst Holly Becker, in a recent report, called the move "a windfall improvement." But taking that one-time windfall will crimp AOL's ability to build a base in key markets.

In coming weeks, AOL will suffer yet another embarrassment: taking the largest single write-down in corporate history, a $54 billion charge to its books for the lost value of its acquisition of Time Warner. The charge isn't a big surprise: Months ago, the company warned it was coming--and it won't cost AOL any cash. But it is a stark reminder just how far short AOL is of delivering on its promises. By David Henry and Tom Lowry in New York, with Catherine Yang in Washington

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