Another Big Charge for AOL?
By David Shook
In April, AOL Time Warner (AOL ) reported one of the largest-ever charges against earnings -- a $54 billion write-down of goodwill. The noncash charge against first-quarter income accounted for how much AOL overpaid for Time Warner assets in January, 2001, in the largest corporate merger ever.
End of story? Maybe not. Unless the economy and the market turn around fast, it's looking increasingly likely that AOL might have to take a further write-down of goodwill -- to reflect the decline in value of its beleaguered Internet division, America Online, some company watchers say. (Goodwill is an intangible asset that represents the premium a company paid over the current book value of businesses it has acquired.)
AOL still has $80 billion in goodwill on the books, including $35 billion assigned to America Online from acquisitions made before the Time Warner merger. The $54 billion write-down was meant to reflect a drop in market value of the Time Warner businesses, not America Online. Yet the Internet business is possibly the company's hardest-hit unit this year.
The $80 billion in remaining goodwill represents about half of total assets at AOL. In addition to the $35 billion in goodwill assigned to America Online, $20 billion is assigned to the Warner Bros. TV networks and Turner Broadcasting, and $10 billion to Time Warner Cable. The remaining $15 million is assigned to smaller Time Warner divisions, as of Mar. 31 figures.
Another hit to earnings -- even a noncash goodwill impairment -- would likely matter to AOL's frustrated shareholders (see BW, 7/15/02, "Dashed Digital Dreams"). It might be perceived by some as yet another sign that a combined AOL and Time Warner wasn't such a good fit after all.
The merger's goal was to increase shareholder value by leveraging the power of Time Warner's media brands with the vast online reach of the No. 1 Internet company. Instead, AOL Time Warner has been reeling from an advertising downturn and mounting competition in the Internet services industry. AOL's stock has fallen 77% since its 2001 high of $55. On July 2, it dipped to a new low of $12.06 before recovering to close at just under $14 on July 8.
If the long-awaited rebound fails to materialize, the merger that formed AOL Time Warner will continue to be scrutinized, with goodwill getting an especially hard look. In years past, that figure would sit on the balance sheet largely unnoticed after a merger, amortized over many years. "Nobody paid much attention to it," says James Harrington, financial accounting expert at PricewaterhouseCoopers in Florham Park, N.J.
The rules changed as of Jan. 1, 2002. Now, companies must reassess every year the estimated fair value of each operating unit that carries goodwill. If poor performance pushes the fair value below the value recorded on the company's books, then a write-down to reflect the difference between the two figures is required.
SLOWER SUBSCRIBER GROWTH.
No one is trying to argue that AOL's businesses are in jeopardy of failing. But now that the gravity-defying growth of the 1990s is gone, America Online looks increasingly vulnerable to a write-down. The Internet unit still accounts for 24% of total sales, yet its first-quarter revenues were flat compared to a year ago, at $2.3 billion.
An assault from the likes of Microsoft, Comcast, and other competitors selling fast Internet service to homeowners has caused America Online's subscriber growth to decelerate for the first time. And its advertising sales fell 31% in the first quarter. The result: Operating earnings for America Online of $433 million, a 15% decline compared to a year ago.
Peter Cohan, financial consultant and author of E-Stocks, points out that further impairment charges would harm AOL's net worth. While AOL's credit rating remains intact, it has $28 billion in debt -- $6 billion more than last year. With an accumulated deficit of $57 billion and more loans on the balance sheet, AOL's debt-to-equity ratio has nearly doubled since the first-quarter goodwill charge, rising from 15% to 29%. That's close to the high range for a diversified media company.
NO BIG DEAL?
Company spokeswoman Tricia Primrose, responding to questions about the remaining goodwill, dismisses the risk to investors and says even if another goodwill charge were taken, it wouldn't hurt financially. "Although any future impairment charge would affect the company's debt/equity ratio, it would not affect the company's borrowing capabilities, cost of capital, or future economic prospects, nor would it cause the company to be in violation of any of its current debt covenants," she says.
At this point, Wall Street doesn't seem to be overly concerned with the goodwill left on AOL's books either. A write-down won't affect the cold, hard cash coming in the door. AOL Time Warner has successfully sailed clear of any of the accounting questions shadowing other companies, and many analysts are expecting a turnaround for the company with free cash-flow growth for AOL next year -- assuming the advertising market improves (see BW Online, 6/28/02, "The Spark AOL's Stock Price Needs"). Free cash-flow growth wouldn't only lessen the risk that AOL has to take another goodwill charge but it would also raise its net worth.
AOL says it will decide in the fourth quarter whether another goodwill write-down is necessary. While fair value is an estimation made by its own accountants, it can and often does change depending on the underlying financial trends of a business, says Terry Warfield, accounting professor at the University of Wisconsin at Madison. And the Internet industry is still new enough that it's difficult for accounting experts to gauge what the fair value of such businesses are. Yet in an environment where all accounting moves are under intense scrutiny, it's a strong bet that AOL will play it straight down the middle with its estimates.
If a write-down is necessary, it would be one more blow to the confidence of those investors who have hung in there. In the last year, AOL Time Warner has lowered its earnings guidance three times, reported decelerating growth at the flagship Internet unit, and been forced to shell out $6.75 billion for the 49.5% of AOL Europe that it didn't already own.
Buffeted by bad news all year, AOL investors will have to remain braced for more unpleasant surprises. They may not have heard the last of AOL Time Warner's goodwill charges against earnings.
Shook covers financial markets for BusinessWeek Online in New York
Edited by Beth Belton