Time Warner Sets Aside a Problem?

It will put away $500 million to deal with probes of AOL's accounting and restate its earnings in hopes of unshackling its stock

By Tom Lowry and Paula Dwyer

By announcing on Nov. 3 that it's creating a $500 million reserve related to federal investigations into its accounting practices, Time Warner (TWX ) took a giant leap toward removing what has been a debilitating overhang on the media giant for two years.

The outfit also said it would restate its earnings for 2000 and 2001 -- and possibly 2002 -- because it should have consolidated its AOL Europe joint venture, including the unit's huge losses, in its financial statements during that period. The announcements came as part of Time Warner's quarterly earnings report in a phone call to investors and analysts on Nov. 3.

BAD MERGER.

  BusinessWeek Online first reported in June that Goldman Sachs was enlisted in 2000 to take a stake in AOL Europe, an arrangement that kept AOL's position below 50% in the Continental venture, a partnership with German media conglomerate Bertelsmann (see BW Online, 7/30/04, "Is AOL's "1% Solution" 100% Legal?"). As a result of Goldman's 1% stake, AOL decided it didn't need to consolidate the European unit on its books, even though the joint venture's losses were cited in the online service's filings to the government in early 2000.

At the time the Goldman arrangement was struck, AOL was looking to complete its $100 billion-plus acquisition of Time Warner, a deal under review by regulators in the U.S. and Europe. The AOL-Time Warner marriage is now widely viewed as one of the worst mergers in corporate history.

That AOL Europe arrangement has come back to haunt Time Warner and Goldman. The Securities & Exchange Commission is beginning to look into whether Goldman "aided and abetted" AOL in violation of securities laws, say sources with knowledge of the matter. Time Warner officials didn't want to comment beyond their official announcement of the restatement. Goldman officials also declined to comment.

HOW BIG A RESTATEMENT?

  During the merger, the European Commission, the European Union's executive arm, was concerned that the deal would hurt competition in Europe's media markets. To allay those fears, AOL and Bertelsmann pledged that the German group would have no operational control over AOL Europe, leaving the U.S. parent company to manage the unit.

But at the same time, AOL told shareholders and U.S. regulators that it would not control the joint venture, apparently contradicting its promise to the EC. That may have been a mistake and seems to be at the heart of the SEC's case against Time Warner.

Time Warner said the total amount it would restate was still not clear, but an operating profit of $652 million in 2001 becomes a loss of $82 million with AOL Europe consolidated, and an operating profit of $1.8 billion in 2000 is reduced to a $1.5 billion gain. Time Warner said it may have to restate for 2002 as well.

FULL RESOLUTION SOON.

  The restatements don't affect current earnings or projections, executives said. The entertainment giant reported that third-quarter revenues grew 5%, to $10 billion, but that operating income declined 20%, to $1.1 billion.

The outfit said it decided to restate the prior years' results after discussions with SEC staff. "Clearly these are significant matters," Time Warner Chairman and CEO Richard D. Parsons told analysts on a conference call, but he said the company's focus is on moving "our business forward."

A full resolution of the SEC investigation into AOL's accounting could come before the end of the year, say sources. If all of the $500 million reserve is used to resolve the matter with the SEC alone, it would be the second-largest single company settlement with the commission, next to the $750 million WorldCom paid in 2003.

NO GREAT STRAIN?

  Time Warner said it set aside $500 million because it was its best estimate of what would be needed to resolve both the SEC probe and a separate investigation into AOL's accounting by the Justice Dept. The inquiries, many financial analysts believe, have kept the stock depressed since 2002. They have also restricted the Time Warner's ability to issue new shares, which might be used for acquisitions. The shares closed at $16.61 on Nov. 3, up 2% from the previous day.

Time Warner didn't rule out that part of the $500 million reserve could be used to help settle a consolidated private shareholder suit relating to the AOL and Time Warner merger. That case is still in relatively early stages. The damages shareholders sought could increase the outfit's legal liabilities substantially beyond the legal reserve set aside on Nov. 3.

Even if Time Warner did have to use all the $500 million, that wouldn't be a great strain on it, executives suggest privately. The giant said it expects to throw off $3.5 billion in free cash flow this year, and it has reduced its debt level from nearly $30 billion at the start of 2003 to about $17 billion now.

FRESH CONTRACT.

  Meantime, at what has been deemed Time Warner's most troubled business, AOL reported third-quarter results in line with Wall Street's expectations. With revenue essentially flat due to continued subscriber defections, the online unit is nonetheless on track to deliver double-digit growth in operating income before depreciation and amortization.

Profitability growth is coming primarily from a 44% upswing in high-margin online advertising revenues, to $79 million, this quarter. Pitches accompanying Web searches climbed by 70% (or $30 million), and the August acquisition of Advertising.com, a pay-for-performance online ad service, also helped juice sales. U.S. subscribers, however, sank to 22.7 million, down 646,000 from the prior quarter.

Time Warner also said it had renewed for two more years the contract of Don Logan, 60, one of two top deputies to Parsons who oversees Time Warner's subscription businesses, including AOL. His current contract was due to expire at yearend.

Time Warner investors will be relieved by its decision to create the $500 million reserve, although the federal probes that sparked the move are far from resolved. But setting aside the funds and restating its financials are good first moves toward putting the matter to rest -- and possibly reducing the drag on its stock.

With Catherine Yang in Washington

Lowry is Media editor for BusinessWeek in New York, and Dwyer is a senior writer in Washington

Edited by Beth Belton

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