AOL Time Warner's Unfinished Revolution

Yes, it's only one year since the vaunted merger. Still, the obstacles are greater -- and the payoff further away -- than Case & Co. expected

Two years ago, when AOL and Time Warner agreed to do the largest merger in history, executives from both sides granted hours of face time to the editors of Time and Fortune, two of Time Warner's 64 magazines. Their message: The $160 billion marriage of the universe's No. 1 online portal and the old-line publishing giant would change the media world.

Fortune wrote glowingly of AOL Chairman Steve Case's messianic vision: He saw a merged company so influential in entertainment, news, and on the Net that it would literally touch every consumer's life. Time penned a prophecy of "a world where cell phones, televisions, computers, cars, maybe even refrigerators, will all be tapped into a data network that makes it as easy to talk to Singapore as to call your next-door neighbor." AOL would be at the heart of it all -- selling music, movies, and magazines to consumers via its myriad electronic channels.

Case was envisioning a sea change, in both new media and old. After tilting at that goal for one year since completing the merger, however, AOL Time Warner has noticeably toned down its rhetoric. In 2001, the company's revenues climbed only 6%, to $38 billion, while operating income (defined as earnings before interest, taxes, depreciation and amortization) rose 18%, to about $10 billion -- far short of the goal of 30% growth.


 The company's largest division, AOL, is grappling with decelerating subscriber growth, increasing competition from high-speed Internet service providers, and a muddled international strategy. Meanwhile, Time Warner's music, books, magazine, and TV divisions are plodding along -- slimmed down, but still nearly as insular as before AOL arrived. "The company has done a good job of getting its costs down following the merger," says David Card, an analyst with Jupiter Media Metrix. "The challenge now is getting revenues up." The prospects of that happening anytime soon are modest enough that the company's stock has slumped to $26 as of Feb. 1, from $55 a share just after the merger.

That raises the question: Where's the promised revolution? The short answer is that it will take a lot longer to show up than investors originally expected -- if indeed it ever does. There's no denying that AOL Time Warner is big -- in the worldwide media business, no company is larger. Even so, the merger is beginning to look more like an evolution of the kind that's also occurring at Germany's Bertelsmann, France's Vivendi, and Australia's News Corp. -- all players that are in the process of marrying old media with new.

The one superhuman left from the dot-com meltdown may be mortal after all

In fact, two years after the nuptial announcement in which Case donned an uncharacteristic tie and Time Warner CEO Gerald Levin took his off, AOL Time Warner is acting a lot like a traditional media company -- grubbing for advertising dollars in the worst ad recession in years, scratching for subscribers, and cutting costs by sending thousands of employees packing. The one superhuman player to emerge from the ruins of the dot-com meltdown seems to be mortal after all.

The implications are shocking for a company that seemed sure to benefit from the golden touch of Case and Bob Pittman, the magicians who took AOL from 4.8 million members and less than $1 billion in revenue in 1995 to a paid U.S. audience of 26 million and nearly $8 billion in revenue just five years later.


  For one thing, the debate over whether the merged company would turn out to be more old media or new has been settled for now: For all of its prowess online, where its flagship service has 33 million subscribers worldwide, AOL Time Warner's profit margins, revenue growth, operating income gains, and stock price are decidedly old media. That's limiting the options of Case and Pittman, two guys used to spinning money from big ideas -- so much so that archrival Microsoft, whose financials are pristine by comparison, has an unusual opening to steal audience share from its online nemesis. Small wonder that several analysts who follow AOL Time Warner have downgraded its shares lately, from buy to hold.

At the heart of the merger was the logical idea that ubiquity equals prosperity. In fact, the synergies that Case talked about two years ago -- the cross-pollination of AOL's pervasive Internet presence with Time Warner's widely recognized news and entertainment brands -- are paying dividends today. AOL has become the most effective marketing vehicle for signing new subscribers to magazines such as Time, Sports Illustrated, and People. Meantime, Moviefone has become the perfect way to promote Warner Bros. movies. And America Online has proven to be a powerful medium for showcasing the stars and programs on Time Warner's cable networks -- and vice versa.

Synergy: ads in Time Inc. magazines generated 800,000 AOL registrations last year

It isn't always possible to isolate the impact of such cross-marketing. But the company claims that promotions of Time Inc. magazines on the AOL service generate more than 100,000 gross magazine subscriptions per month -- nearly all trial subscriptions (the company declines to say how many are converted to paying customers). And ads in Time Inc. magazines generated 800,000 America Online registrations last year.


  America Online helped Warner Bros. and New Line Cinema deliver movie hits -- 10 of their films ranked No 1. at the box office when they opened. Warner Bros. and New Line combined were No. 1 in box-office receipts for 2001 with a 22% market share, bolstered by Harry Potter and The Lord of the Rings. Pittman says online promos for Harry Potter created 2.5 billion Web-page impressions on the AOL service last year. Total sales from Harry Potter so far have topped $880 million, the company says.

Two questions remain to be answered before cross-pollination can be declared an qualified success, however. One is whether pushing AOL Time Warner's own subscriptions will continue to work, or whether the effect will fade as subscribers tire of getting bombarded by AOL disks plus come-ons for a dozen other Time Warner titles along with their weekly Time magazine. The other question is why the AOL service's growth in new subscribers is continuing to slacken despite the relentless promotion of the service via nearly every AOL Time Warner outlet.

Staying power may also be an issue for Pittman's new AOL Ad Council, where execs share ideas on major ad campaigns that can be sold across several AOL Time Warner properties. Unilever, American Express, and Wendy's are among the big names that bought such campaigns in January. Still, the company said in announcing its 2001 earnings on Jan. 30 that it expects no substantial upturn in advertising for 2002 -- apparently, analysts say, because some big campaigns aren't being renewed as they expire.


  While those elements of AOL Time Warner's strategy have shown promise, its most ambitious plans are still so far from being realized that it's hard to predict when they might bear fruit. "The whole notion of the AOL merger was to apply Time Warner's vast array of media and entertainment content to the power of the Internet as a distribution channel," says Ron Sege, CEO of Ellacoya Networks, a company that develops customer billing technology for Web sites. "But first, AOL has to obtain broadband [high-speed] Internet access for the masses in order to deliver that rich content."

AOL has to push broadband, but not too quickly since dialup margins are so high

As it moves to broadband, AOL must perform an adroit maneuver to avoid losing some of its 26 million U.S. subscribers. It must cajole competing cable operators to offer a bundled service that includes cable TV plus access to AOL for a single discounted price, with a rebate of some kind to the cable company. And it must do so reasonably soon or risk losing dial-up customers who may give their local cable company a try and decide that broadband access to the rest of the Web is sufficient -- and that they don't care to pay AOL its extra $15.

At the same time, it's in AOL's interest not to move subscribers too quickly to broadband. That's because its dial-up Internet access business has become quite lucrative as the costs of providing such service have fallen rapidly over the past two years.

So far, the cable industry has been reluctant to share its systems with outsiders. So it will be up to AOL's normally persuasive management team -- Chairman Case, CEO-elect Richard Parsons, and Pittman -- to woo the industry into partnerships. "AOL is accustomed to pushing other companies around," remarks Rob Lancaster, an analyst for Yankee Group. "But it's difficult to push around the cable companies."


  The wireless world presents a challenge for AOL, too. Since the merger, it has spent millions on a marketing campaign dubbed "AOL Anywhere," a strategy that calls for the service to be agnostic when it comes to the many ways customers connect to AOL news and entertainment. The idea could also be extended, once technology catches up with the company's marketing plans, to give consumers access to a smorgasbord of movies and music that could be downloaded or ordered at any time.

Another service could be entertainment- or information-on-demand that allows consumers to watch The Matrix (a Warner Bros. film) over Time Warner Cable, or a hit song by Madonna (Warner Music) downloaded onto a portable music player, or get their messages and CNN headlines from a Blackberry wireless e-mail device, or buy their movie tickets via AOL's Moviefone.

So far, AOL Anywhere is a modest success, according to industry experts. AOL has signed wireless deals with AT&T Wireless, Sprint PCS, and VoiceStream in the U.S. to offer mobile text-messaging services to cell-phone users. The company has also begun selling AOL Mobile Communicators, calculator-size black devices that let AOL members check e-mail and send instant messages from the palm of their hand. While much of this is early positioning rather than a source of profits, the deals illustrate the company's desire to spread the AOL service across as many forms of communication as possible.


  Case's and Pittman's forte, when they ran just AOL, was to look past all the annoying details of implementation and focus instead on the result they wanted -- their vision. Even now, Pittman has his eye on home networks where AOL could conceivably offer volume discounts to families with multiple PCs and several broadband connections. Households currently spend more than $120 a month on subscriptions of all kinds, according to media analysts, and the AOL service alone collects 24 of those dollars. Pittman wants more.

Even small changes at Time Warner can be billion-dollar decisions

The difficulty in bring the revolution to Time Warner is that it's much larger and more complex than AOL -- and that in a $38 billion company, details can sometimes be billion-dollar decisions. From the start, Case, Levin, and Pittman knew that they would face challenges such as broadband and wireless. What they may not have counted on are some of the other details: a media recession, an international online business that's on the rocks, slumping growth in subscribers, and increased competition from old nemesis, Microsoft -- and enough debt to crimp their style.

For instance, once AOL Time Warner completes the $6.75 billion purchase of the remainder of AOL Europe from Bertelsmann, it will have in excess of $22 billion in debt and a debt-to-operating income (or EBITDA) ratio of 2.8. Analyst Jessica Reif Cohen of Merrill Lynch wrote in a Jan. 31 note that AOL Time Warner can comfortably manage that level of debt.


  She also noted, however, that AOL may wish to buy back AT&T's 25.5% stake in Time Warner Entertainment, the AOL Time Warner unit that holds most of the parent company's film and cable assets. Since Reif Cohen puts the value of AT&T's stake at $10 billion, such an expenditure would raise AOL Time Warner's debt-to-operating income ratio to 3.7 -- which Reif Cohen believes would "push the envelope" on the company's ability to preserve an "investment grade" rating on its debt.

In headier times, as they announced the melding of their companies, Case and Levin emphasized their desire for AOL Time Warner to eventually boast the largest market capitalization of any public company. Two years later, they have a more modest goal: Make a profit. On Jan. 30, as he commented on the company's 2001 results, Levin declared that "AOL remains the revolutionary center of AOL Time Warner." While that's no doubt true, what remains to be seen is how sweeping the revolution will be.

By David Shook in New York