By David Shook As AOL Time Warner (AOL) plummets to new market lows each week, investors are no doubt wondering where the bottom lies. AOL's stock tumbled to a postmerger nadir of $12.90 on June 26, down nearly 80% from its 52-week high.
For many investors, it defies logic that a media conglomerate with $38 billion in annual sales and no accounting scandals to speak of could be caught in such a frenzied sell-off. Yet AOL now has a lower valuation and stock price than Internet bellwethers Yahoo! (YHOO) and Amazon (AMZN), cable giants Comcast and Cox (COX), and its diversified media brethren Disney (DIS) and Viacom (VIA). Arguably, AOL has a stronger balance sheet than any of those competitors.
So where's the rational bottom for AOL?
It may be closer at hand than investors realize. It's likely to be reached shortly before AOL produces consistent free cash flow, an important measure of financial flexibility that may be only a few quarters away, nearly all analysts who cover the company say.
TOO BYZANTINE. If they're right, AOL might want to focus on doing a better job of communicating that to investors. Its stock fell 15% on June 26 on unsubstantiated rumors it would issue a profit warning and that cable companies in general might be the next to reveal funny accounting that could result in restated earnings.
While Chief Executive Richard Parsons has said he wants to reform AOL Time Warner's byzantine capital structure so investors can more easily understand it, he hasn't made much progress yet. And the company has been uncharacteristically silent on its long-term strategy and goals. A spokeswoman points out that Parsons has been CEO for only five weeks and needs more time to craft his agenda.
Maybe AOL doesn't want to overpromise and then fail. However, some do see encouraging signs.
BLOCKBUSTER FLICKS. First Albany analyst Youssef Squali believes AOL's free cash flow will be negative $1.38 billion in the second quarter but then start to improve dramatically -- turning positive in the third quarter and climbing steadily thereafter. And despite the sour sentiment on the Street about decelerating subscriber growth at America Online and the reports of mutual-fund managers dumping big blocks of AOL shares, almost every analyst paints the same picture of improving free cash flow for AOL in the next year.
Merrill Lynch's Jessica Reif Cohen expects free cash flow to be negative $2.6 billion in fiscal 2002 but then jump to $5 billion next year, largely through expected blockbuster releases from Warner Bros. studios, more robust advertising sales for AOL's cable networks and America Online, and strong subscription sales of high-speed Internet access, premium cable services, and Time Inc. magazines.
Of all the promises made at the time of the AOL Time Warner merger in January, 2001, nothing the company could do now would reverse the stock slide faster than if it fulfilled its goal of consistent growth in free cash flow, many analysts believe. Investment adviser Peter Temple, in his book Magic Numbers: The 33 Ratios that Every Investor Should Know, characterizes free cash flow as one of the most revealing benchmarks in assessing a company's financial strength. Says John Garrity, analyst for Investec Ernst, an investment research firm: "Some people think free cash flow is the most important element in assessing the financial picture of a technology company."
BETTER THAN BOTTOM LINE. It can be defined in many ways, but free cash flow is generally viewed as the creation of cold, hard cash each quarter through basic operations, minus the cash used for interest payments, taxes, routine capital expenditures, and research and development. It's often a figure more telling than bottom-line net income or losses, and is applicable to companies with many separate divisions that tend to make acquisitions and significant one-time capital investments that don't appear on the income statement as normal expenses. AOL is such a company.
Free cash flow is also a measure of how much money generated by a company goes to shareholders -- whether through dividend payments or simply intrinsic value in the shares. Often, free cash flow results in hefty dividends. But for diversified technology companies like AOL, "free cash flow is important because it gives investors a sense of how much money the company has for other activities, like buying back stock, making acquisitions, or making capital expenditures above and beyond the maintenance capital spending that is part of normal operations," says Richard Moroney, editor of Dow Theory Forecasts.
Free cash flow can also be the currency retained for a rainy day. For AOL, which owns a mountain of media properties but is weighed down by ominous questions about its strategy and direction, having a well-stocked rainy-day fund would give management the flexibility it clearly needs.
FUELING ANXIETY. Since the merger, however, free cash flow has been wildly inconsistent for AOL Time Warner. A series of costly restructuring charges, unexpected acquisitions, and weak advertising sales industrywide have hampered its ability to generate the billions in free cash flow dollars it had promised.
After posting $640 million in free cash flow in the third quarter of 2001, AOL had negative $2.2 billion in the fourth quarter, followed by negative $4.6 billion in this year's first period. The reason for the latter number: the required buyback of half of AOL Europe from Bertelsmann, which chose to act on its option to sell the shares to AOL for $6.75 billion.
The inconsistency is fueling investor anxiety in a market wracked by uncertainty. And while Adelphia is the only cable company being accused of accounting shenanigans at this point, investors seem to fear that others in the industry could have been doing what WorldCom did: capitalizing operating expenses as capital expenses, and in the process inflating earnings.
ABOUT TO TURN? If cable companies have been recognizing their costly broadband upgrades in the same fashion, it's possible that they, too, could be forced to restate earnings -- or so goes the fear in the market. None of these companies acknowledges any accounting concerns.
Given the cloud surrounding cable, one way for AOL management to prove it's on the right track would be to achieve free cash flow growth in the very near future. For at least one more quarter, that isn't possible, most analysts believe. But later in the year, AOL could very well begin to see positive free cash flow. If that happens and the company can build on it, the stock may finally start moving up. Shook is a reporter for BusinessWeek Online in New York