AOL's Close Call on Debt

Had it not recently renegotiated its loans, the massive writedowns it has made would have put it in an even tougher spot

AOL Time Warner's (AOL ) earnings report for 2002's fourth quarter is bad enough: The company said on Jan. 29 that even though revenue in the quarter rose 10%, to $11.4 billion, it suffered a net loss of $44.9 billion after an unexpectedly large goodwill writedown of $45.5 billion, including a $33.5 billion reduction in the value of its America Online unit. Take a closer look at the numbers, however, and the situation is even more startling than it sounds -- and makes clear why CEO Richard Parsons is so intent on cutting AOL Time Warner's debt to $20 billion in 2003, from the current $27 billion.

The fourth-quarter charge increases AOL's total goodwill writedown for 2002 to $99 billion, reflecting the difference between the high price AOL paid for Time Warner two years ago and the market value of these assets at the moment. Even though the writedown is a noncash charge -- essentially, a bookeeping entry -- it has sullied a key portion of AOL's financials: its shareholders' equity, or net worth. In the past year, thanks to the writedowns, that measure of health has fallen to $53 billion from $152 billion.

The decline was breathtaking enough to force AOL to renegotiate the terms of its loans sometime late last year. Originally, those covenants required it to maintain a net worth of at least $50 billion. Had the figure fallen below that, says Marilyn Cohen, head of Envision Capital Management, a Los Angeles firm that specializes in bond investing, the consequences could have been significant: AOL Time Warner would have had to renegotiate the terms of its loans with lenders. Moreover, credit agencies might have cut its debt rating, and its cost of borrowing might have risen -- by tens of millions of dollars a year. Violating its loan agreements would have been acutely embarrassing for the world's largest media company.


  Thanks to its new deal with lenders, which AOL acknowledged in its Jan. 29 earnings conference call, it no longer has to stick to the $50 billion net worth figure. In the future, it only has to maintain cash flow, or EBITDA (earnings before interest, taxes, depreciation, and amortization), at a certain multiple of its interest expense, which last year totaled nearly $1.8 billion. In 2002, AOL had EBITDA of $9.1 billion. "AOL is too big and too important for the banks to let it stumble," says Peter Cohan, president of Peter S. Cohan & Associates, in Marlborough, Mass., and the author of Value Leadership, a forthcoming book on ways to measure the strength of a company's management.

The less demanding loan covenants give Parsons some time to restore order to a company whose stock has fallen 76% in two years. Still, AOL Time Warner's close call on its loan agreements explains why he's moving so fast to raise money (from the sale of an 8.4% stake in Hughes Electronics on Jan. 29, plus a planned sale of AOL's book unit and a scheduled spin-off of its Time Warner Cable unit this spring). And it's a telling reminder that the problems created by the marriage of AOL and Time Warner are far from solved.

By David Shook in New York

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