AOL Shares: How Big a Bargain?

They're cheap all right, but analysts have plenty of concerns. Plus, a slow broadband rollout and byzantine accounting won't help

One of the ironies of investing is that as a stock falls in price, it usually looks more attractive. Take media giant AOL Time Warner's (AOL ) shares. On Jan. 30, the company announced that it lost $1.8 billion in the fourth quarter, on revenues of $10.6 billion, and it projected that sales and profits for the first quarter would be flat with last year. Its stock promptly fell $2 a share, to a 52-week low of $24, before rebounding to close at $26.55. That's down from better than $58 last May.

At the stock's current depressed levels, a few analysts are starting to find it tempting once again. Gordon Hodge of Thomas Weisel Partners upgraded the shares on Jan. 30, telling clients, "We believe the sentiment has turned way too negative." A few days earlier, with the stock nearing what was then a 52-week low, Morningstar's George Nichols boldly proclaimed: "Now is a great time to scoop up beaten-down AOL Time Warner stock."

Not everyone agrees, of course -- and many analysts say investors aren't rushing to buy. In a Jan. 30 letter to clients, Merrill Lynch's Jessica Reif Cohen noted AOL's marked-down shares but maintained her neutral rating, which she said reflected "both the strategic and structural challenges" facing the America Online division. Analyst Jordan Rohan of investment bank Soundview Technology on Jan. 31 dropped his price target on the shares to $31, from $35, writing to clients, "We are challenged to find a stock around which there is more pessimism."


  The AOL service is the key to the company's future growth and really the only branch of the complex company Wall Street cares about right now. Analysts are intently focused on tracking the average revenue per user (ARPU) the AOL service generates. It has fallen to around $25 per month, from nearly $30 in early 2000, says Robert Martin, an analyst with brokerage Friedman, Billings & Ramsey.

AOL's ad revenue may not have bottomed yet if long-term deals aren't renewed

During the Jan. 30 earnings conference call, Chief Operating Officer Bob Pittman explained the decline by saying advertising revenue isn't growing as fast as the number of new subscribers. While that puts a positive spin on things, it's of little consolation to investors -- especially since AOL's subscriber growth is moderating significantly, from 23% in 2000 to 17% in 2001 to an estimated 11.5% in 2002, according to Goldman Sachs. And Martin says AOL's ad revenues may not yet have bottomed, since it locked many of its customers into long-term deals that are unlikely to be renewed at the same rates.

The company's plan for reversing the ARPU trend -- given that it sees little improvement in the advertising environment -- is to get more AOL subscribers to pay more for high-speed Internet access. The company believes it can then sell them more premium services, like digital music or movies-on-demand (which would benefit its music and film divisions). Having more broadband customers should also, in theory, bring more advertisers to the online medium, because that would allow for more effective, targeted ads. AOL Chief Executive-designate Richard Parsons, who takes over in May, calls the broadband rollout "the most promising source of growth for our company in years to come."


  The only problem is that the rollout has been slow -- and could continue that way. Although its executives boasted repeatedly during the Jan. 30 conference call that AOL has 4 million broadband customers -- more than any other domestic Internet service provider -- many analysts want to see it pick up the pace. They would like AOL to strike a deal with another cable company so it can offer its service over more than just its Time Warner and Roadrunner cable pipes. Hodge says he hopes AOL will announce a new access agreement soon (see BW Online, 1/4/02, "How Broadband Could Slow Down AOL").

Losses? You'll find those on page three of Jan. 30's earnings release

While stock analysts remain myopically focused on AOL's ARPU and cable deals, many investors and portfolio managers are growing wary of any stock with complex financial reporting -- which AOL has in spades. Its Jan. 30 earnings release could be a case study in what's wrong with current accounting practices. It opens with a one-paragraph italicized disclaimer warning investors that the statements have been "adjusted to normalize out the effect of merger-related costs" and that "unusual or nonrecurring items might occur in any period." That paragraph is followed by several bold headlines reporting news of an 18% gain in EBITDA (earnings before interest taxes depreciation and amortization, AOL's preferred measure for profit growth) and a "normalized free cash flow" gain of 238%, to $3 billion.

Only on page three of the release does the company explain that its reported net loss for 2001 was $4.9 billion, or $1.11 per share, on $38.2 billion in revenues. The losses take into account $250 million in merger-related costs and $2.5 billion in write-offs of "other-than-temporary declines in the value of certain of its investments" (such as Time Warner Telecom and Hughes Electronics). Also on the third page is the statement that first-quarter 2002 EBITDA and sales are expected to be flat compared with 2001, and that full-year sales and EBITDA growth are seen coming in at 5% to 8% and 8% to 12%, respectively -- not quite the torrid pace AOL shareholders got used to in the '90s.


  With Enron-spooked investors calling for clarity and simplicity in financial statements, it's possible that more AOL shareholders could sell first and ask questions later. Rohan criticized the company for "murky accounting" and wrote in his Jan. 31 note: "We find the company has done a number of things to frustrate and confuse the investment community." Technical analyst Paul Shread of believes the stock could slip to as low as $18 or $19. "So caution is advised," he says.

During the two-hour conference call, executives seemed intent on persuading analysts that AOL's results really were pretty good relative to those of other media companies. Of the 2001 results, Parsons said, "Objectively, the 18% EBITDA and 6% revenue growth were very strong." He also noted that his near-term goals for the company are conservative and asked investors to focus on the long-term. "To expect massive or radical differences or changes in the short-term is not practical," he said.

Given the modest goals and difficult business environment, investors attracted by AOL's cheap share price should probably move cautiously. AOL Time Warner is the world's biggest media company, and its tentacles reach deep into the cable, movie, music, and publishing industries. Its sheer size alone makes it arguably the best-positioned media company to benefit from the rollout of broadband and a pickup in ad spending. The only problem: Both could still be a while in coming -- and many AOL shareholders are already tired of waiting.

By Amey Stone in New York

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