AOL: On the Road to Recovery?

With the giant's old media businesses showing strength, the long-term outlook may offer investors some new hope

By David Shook

UPDATE: At a half-day meeting with analysts on Dec. 3, executives of the America Online unit of AOL Time Warner outlined a strategy for stabilizing the Internet service's financial performance that generally pleased experts -- even though the parent company's stock fell more than 14% for the day based on the perception that a turnaround won't happen overnight. Jon Miller, the online unit's CEO, struck the right tone when he told the audience of several hundred, "We want our members to love and need us again." His plan for reigniting growth at America Online -- where operating earnings will drop this year to around $1.8 billion, vs. last year's $2.9 billion, even as revenues climb slightly to $8.8 billion-plus, vs. $8.7 billion in 2001 -- is built around four primary initiatives.

Starting immediately, America Online plans to more aggressively market fast, and high-revenue, broadband Internet access. It will also beef up the basic AOL subscription service by making it the exclusive platform for a wide variety of Time Inc. magazine content currently free on the Web. It will add new pay-per-use features such as online video games and Warner Bros. music. And it will introduce technology that's more user-friendly, including automatic reconnect for dial-up subscribers who get bumped off, personalization features for AOL members, and improved ability for broadband suscribers to include photos, video, or music clips inside e-mail.

Moreover, Miller plans to heavily market AOL's "Bring Your Own Access," a campaign to sell the AOL service to customers with broadband connections through local phone or cable companies. Miller also hinted at continuing cost reductions, including layoffs. Says Barrington Research analyst James Goss, who talked to AOL execs at the conference: "The message AOL is sending today is imprecise, but it's on the right track."

On Dec. 3, AOL Time Warner shares dropped $2.47, to $14.10, based on the company's estimate that America Online's operating earnings will decline a further 15% to 25% in 2003, thanks to the expiration of long-term, dot-com era advertising deals, whose demise will lop perhaps $500 million from the online service's income. Such deals no longer reflect the reality of the advertising market, said Steve Case, the parent company's chairman. But he added that, if the expiring contracts are excluded, 2003 revenues from advertising and e-commerce deals will exceed those for 2002.

Despite the stock's Tuesday setback, many analysts are sticking with their predictions that AOL Time Warner shares will reach the $20 range over the next few months, thanks to the performance of divisions other than America Online -- and also because a plan to fix the online service seems finally to be in place.

Following is the story published 11 p.m. Dec. 2

AOL Time Warner has come a long way in four months -- not so much the company as its stock (AOL ), which has shot up $8 and now stands about 100% above its 21st century low of $8.70 as of July 25, 2002. Back then, AOL was suffering from multiple traumas: It was revising its earnings targets downward on an almost quarterly basis. Top brass, including its chief executive and chief operating officer, were heading for the exits. Its America Online unit -- the most closely watched segment -- was deteriorating financially, and regulators had begun investigating for signs of shady accounting.

Worst of all, despite a consensus that the $40 billion company's publishing, movie, and cable-TV businesses were holding up well in a weak economy, disgusted mutual-fund and pension managers who had bet on better things from the merger of AOL and Time Warner were dumping tens of millions of shares.


  The stock has rebounded rapidly in part because the anger of big shareholders has run its course. As the selling pressure diminished, bargain hunters have created enough demand to lift AOL to $16.75 on Dec. 2 -- though that's still far off its 52-week high of $36.

Beyond that, the stock was rather undervalued in July, when even analysts who dissed it viewed AOL as trading at a discount to rival media giants Viacom (VIA ), Disney (DIS ), and Fox (FOX ). Indeed, many analysts, among them Youssef Squali at First Albany, argued that, at the stock's low, investors were valuing the America Online service at less than zero.

Now, he says, investors are beginning to act more rationally. "People recognize that the [original] Time Warner businesses [which account for 78% of the overall outfit's total revenues] are doing quite well, even though America Online is still plagued with problems," says Squali, whose firm has no banking ties to AOL. He expects the stock to continue its climb toward the $21 range over the next several months.


  Other analysts say AOL Time Warner still must clear a number of hurdles if it's to convert the short-term bounce into a sustainable recovery. Probably most important is to get its online unit back on track, an effort it will kick off on Dec. 3 with an "AOL Day" in New York City, at which Jon Miller, America Online's new chief executive, will unveil plans to reinvigorate the online service.

Analysts expect a preview of new strategies aimed at reinvigorating slack online ad sales and decelerating online subscriber growth. Among the possibilities: Using AOL Time Warner's vast proprietary content to lure new subscribers, perhaps by giving AOL users complete online access to Time Warner magazines or free downloads of music by Warner Bros. artists. Either move would give AOL a leg up on archrival Microsoft, which can't offer similar proprietary content. AOL is also expected to push harder to sign up more subscribers for high-priced broadband service. And it'll likely try to generate new transaction revenues for services such as magazine subscriptions.

Moreover, there's talk of a new content structure for the Internet service that appeals more to advertisers, who want to reach targeted audiences such as investors, sports fans, or working mothers. "For the stock to continue to rise from here, the company must outline a clear and convincing plan for stabilizing America Online," says CIBC World Markets analyst Mike Gallant. He expects the stock to trade toward $20 within the next 12 months -- assuming that America Online's profits stop falling and start to turn up. (Gallant says CIBC has no investment-banking business with AOL.) Many analysts, including Gallant, think AOL is heading in the right direction, given its tough talk recently about delivering a turnaround.


  For one thing, America Online may be taking a more realistic approach to ad sales and partnership deals. In the heady days of 1999 and 2000, the online unit signed multiyear deals for tens of millions of dollars with a select few e-commerce partners, who thought riches would be theirs if they could reach the service's subscribers, which now number 35 million. AOL has been unable to renew such deals -- which increasingly look like a relic of the dot-com bubble.

Henceforth, partners who've worked with America Online say, it will instead try to attract a greater number of advertisers regardless of their size or ad budget, instead of turning small players away. Similarly, in signing deals with content companies and technology providers, AOL has been more receptive to smaller ideas that might generate millions of dollars in annual revenue, rather than hundreds of millions.

"If AOL used to expect $20 million a month from partners, that was before our time," says Matt Smith, CEO of PresenceWorks, a company developing a real-time communication tool for business Web sites and customer-service applications that uses AOL's Instant Messenger technology. "Even though we're tiny, AOL was receptive to partnering with us, and we're now working together quite well." Adds Smith: "No one expected us to come to the table with a bag of cash."


  The timing could be good for AOL's revised approach, given an incipient upturn in Internet ad sales. Third-quarter ad revenues for Web publishers grew 36%, according to the Online Publishers Assn. Says Jim Warner, president of Avenue A/New York, an interactive-ad agency whose clients have advertised on America Online: "I can't speak for AOL, but throughout the industry, we're seeing a turnaround in online advertising. We've seen significant increases in spending by many of our major clients." That may help explain why AOL's stock suddenly has traction.

Beyond that, the company appears to have put a lid on the accounting scandal that broke this past summer. An internal investigation turned up $190 million in bogus advertising revenues that America Online recorded from 1999 to last year. But analysts think it fully compensated for that in the third quarter, when it restated earnings for 2000, 2001, and 2002 by $190 million to cover any improprieties -- including a deal with that's under the magnifying glass and is now the subject of a shareholder class action (see BW Online, 12/03/02, "The Nasty Lawsuit at Homestore's Door").

Analysts who closely follow AOL Time Warner are betting that the Securities & Exchange Commission and the Justice Dept., both of which are investigating AOL, may soon stop sniffing around. "I think the company has contained the investigations," says CIBC's Gallant. If he's right, one cloud could lift soon.


  The most important factor in the stock's recovery so far may be the resilience of the original Time Warner units. Most of them met or beat expectations in the most recent quarter, thanks to surprisingly strong ad revenue from magazines and the WB TV network, plus the continuing success of the Warner Bros. film division, which released the much-awaited sequel to Harry Potter in November and is bringing out the next Lord of the Rings installment shortly. The film unit's revenues jumped 25%, to $2.64 billion, in the third quarter, and operating earnings climbed nearly 8%, to $337 million.

Time Warner Cable is posting strong gains as well. New subscribers to its high-speed Internet and digital-cable offerings helped boost cable revenues 15%, to $1.75 billion, with operating profits climbing about 5%. And AOL's $1.4 billion magazine and book publishing empire has hardly missed a beat, thanks to strong ad revenue from People, Sports Illustrated, and In Style magazines. On the TV side, the upstart WB network posted its first-ever profit this year, and premium cable network HBO continues to nab Emmy nominations and high ratings for programs such as The Sopranos and Six Feet Under.

Together, the old Time Warner units are responsible for about three-quarters of the $6 billion in operating cash flow generated in the first nine months of 2002 -- a 40% increase vs. the same period a year ago. If the upward trend continues as expected, AOL should be able to begin paying down some of the principal on its roughly $28 billion in debt, which now costs it more than $1 billion a year in interest. The company has said it wants to pare its debt as soon as possible, if for no other reason than to have more flexibility to buy other properties in a rapidly changing market.


  A planned initial public offering of a new Time Warner Cable network, comprising the local monopolies that control most of Time Warner Cable's subscribers, could further lower AOL's debt burden -- perhaps by several billion dollars, depending on how investors react. Analysts expect the offering in the first half of 2003 -- if there's a recovery in the IPO market, which has been stagnant for over two years.

Bumps along the way will be plenty: AOL already has warned investors of a huge write-down of goodwill associated with the deterioration in value of the America Online business. The charge will come in the fourth quarter and could erase the parent company's net earnings for the final period of the year. That will follow a similar move in this year's first quarter, when AOL wrote off $54 billion in goodwill related to the decline in value of divisions such as Time Warner Cable, the TV networks, and Warner Bros. Music.

Moreover, the turnaround plan for America Online will have to show results by the first half of 2003 to avoid disillusioning investors, analysts say. And anything other than a complete disappearing act by the SEC and the Justice Dept. could bomb the stock again.

Nonetheless, after a rough two years, AOL's projections finally seem in line with its prospects. Among the signs that it's regaining its balance, Gallant says, is that "AOL is now on the road again, talking to investors. That means the company isn't so distracted with its internal problems." So, while AOL still has much to prove, it seems to be persuading investors that it's serious about delivering a turnaround. And that's a move in the right direction.

Shook is a reporter for BusinessWeek Online in New York

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