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AOL Time Warner's Credibility Gap

By David Shook Would U.S. Global Investors Fund Manager John Derrick invest in AOL Time Warner, the world's biggest media company? No way. "AOL is a soap opera. We don't own it," he said recently. "It's a mess."

Many investors clearly feel the same way. Trading at $14.55 a share as of Oct. 24, AOL (AOL) is up from its nadir of $9.50 in July, but still down 75% from a February, 2001, post-merger high. The media giant's reputation has been sullied by accounting investigations, management turmoil, unrealistic financial goals, and serious growth problems at Internet division America Online.

More than anything, AOL Time Warner needs to restore its credibility. Only then can shareholders expect the stock to regain momentum. While it recovered a bit of ground after a fairly positive third-quarter earnings report on Oct. 23, rising 7.5% the following day, lots of risk is still hanging over it, says Tom Wolzein, media analyst for Sanford Bernstein.

ONGOING INVESTIGATIONS. AOL's earnings call represented a start in the right direction. CEO Richard Parsons announced that he would restate 2000 and 2001 financial statements to reflect the reduction of $190 million in revenues at America Online from partner deals that started in 1999 and should not have been recorded. Many investors had fretted that a much bigger restatement was at hand. But the $190 million amounted to only 1% of America Online's revenues during a two-year period.

Still, the credibility issue lingers because the accounting investigations aren't over. Parsons, who initially told investors he had hoped to conclude an internal review in the third quarter, now says he hopes to finish by yearend. And he can't rule out further readjustments to earnings. "Our investigation is ongoing," he said.

More worrisome, the Securities & Exchange Commission and Justice Dept., both of which launched probes into AOL's accounting over the summer, aren't finished. The feds could comb AOL's accounting prior to mid-1999, and they may not stop at the America Online unit. Analysts believe the feds could be looking at Time Warner, too. Says Kaufman Brothers media analyst Paul Kim: "We'll see whether the government guys are satisfied with what the company has turned up."

ONLINE WOES. Some money managers at large institutions have publicly called for former America Online Chief Executive Steve Case -- now chairman of the combined company -- to step aside. No one is holding him personally responsible for the accounting problems, and he says he wasn't aware of any accounting issues. His former deputy, AOL Chief Operating Officer Bob Pittman, abruptly left the company in June and hasn't been heard from since. (Neither exec could be reached for comment.) But Rich Moroney, portfolio manager for Horizon Investment Services in Hammond, Ind., and editor of Dow Theory Forecasts, says Case's departure might mollify many investors who blame America Online and its original management for the losses they've suffered.

The Internet division continues to drag on the parent company's performance. A closely watched benchmark at AOL Time Warner is known as EBITDA -- earnings before interest, taxes, depreciation, and amortization. It fell 1% in the third quarter, to $2.2 billion, primarily due to a 41% drop in EBITDA for America Online. The decline was offset partially by double-digit EBITDA growth at the Time Warner cable, publishing, music, and networks divisions. "Except for America Online, all of our businesses are doing quite well," Parsons pointed out in the earnings call.

That's for sure. The AOL unit has performed so poorly that the parent company has had to revise earnings guidance downward three times in the past year to reflect negative trends in ad sales and online subscription growth. The latest guidance is that 2002 EBITDA will finish the year at the low end of a previously announced growth range of 5% to 8%, due almost entirely to weak expectations from America Online, which generates about 20% of total sales, Parsons said on Oct. 23.

GOODWILL HUNTING. Meanwhile, AOL Time Warner says it could have another big noncash charge against fourth-quarter earnings to reflect the declining value of the Internet-division assets. The issue has to do with goodwill, an intangible asset that represents the premium for businesses acquired over the current book value of those assets.

In April, AOL reported one of the largest-ever charges against earnings -- a $54 billion write-down of goodwill -- to reflect a decline in the "fair market value" of Time Warner businesses. At the time, the company seemed to imply it was a one-time event. But now, analysts estimate, AOL may have to take another write-down to reflect the decline of America Online, which still has more than $35 billion in goodwill assigned to it.

In the past, companies could carry the goodwill over many years, writing it down a bit at a time. But new accounting rules prohibit carrying over goodwill, putting AOL in a tight spot. While a charge against goodwill is noncash and therefore doesn't affect cash flow, it might affect credibility, says Peter Cohan, president of investment strategists Peter S. Cohan & Associates in Marlborough, Mass.

CABLE CONNECTION. Unfortunately, the problems don't end there. AOL also has its investment-grade credit rating to worry about. The debt rating is just a few notches above junk level, and credit-rating agency Standard & Poor's says it's reviewing the company for a possible downgrade. AOL has $26 billion in debt and must pay Comcast $2.1 billion in cash in coming weeks as partial payment for a chunk of cable assets that will be combined with Time Warner's cable unit and then partially spun out to investors in a public offering early in 2003. AOL is banking on that cable IPO to be a huge success, maintaining that it will generate sufficient cash to pay back Comcast and pay down a fair chunk of existing debt.

However, "Last time I checked, cable stocks weren't exactly a big hit in the market," says Kaufman Brothers' Kim. "It's another risk factor, and the company is being a bit of a Pollyanna in saying that this IPO is a sure winner."

TARNISHED LEGACY. Certainly, Parsons inherited a world of trouble when he took the CEO job from the now-retired Gerald Levin, who'll go down in history as the chairman who sold the prized and profitable Time Warner family of media companies to an Internet service provider now struggling to make ends meet.

What's done is done. Now, it's up to Parsons and his management team to restore AOL's credibility with investors by resolving the accounting issue, maintaining the credit rating, and launching a successful cable-division IPO next spring. It's not an impossible task. And if he can do it, Parsons will have regained the respect on Wall Street that AOL has lost in the past year. The stock price could sure use the boost. Shook is a reporter for BusinessWeek Online in New York

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