Reality Sets In as AOL Takes Charge

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AOL Time Warner Inc. executives were uncharacteristically subdued in an analyst conference call last week, where they reduced revenue and cash-flow guidance for the second time in three months and revealed a $40 billion to $60 billion non-cash charge in the first quarter to reflect changes in accounting rules.

Although company executives stressed that AOL Time Warner was poised for substantial growth once the advertising slump and the current economic recession ease, the tone of the conference call was markedly different than those of the recent past when AOL executives trumpeted their unparalleled strength in subscriptions and boasted that they would meet ambitious growth targets despite the economic downturn.

Instead, AOL executives admitted their past goals were too high and pledged to take a more conservative approach to estimates in the future.

"Our 2001 results are strong given the current economic environment, versus our industry peers and other large cap companies," AOL Time Warner CEO Gerald Levin said on the call. "But we are not immune to a decline. Our full-year targets proved to high."

Levin, who will retire as CEO in May, said that AOL Time Warner will continue to invest in the future and that the company expects "to be one of the first to benefit from the upturn" when the advertising market rebounds.

But Levin added that the company's 2002 revenue and cash-flow guidance does not account for any rebound in the economy at all.

AOL Time Warner said it expects fourth-quarter revenue to grow about 3 percent to $10.5 billion and cash flow to rise about 14 percent to more than $2.7 billion. For the year, AOL Time Warner said revenue growth should be about 5 percent to $38 billion and cash-flow growth should be 18 percent to just under $10 billion.

The company is scheduled to release its full fourth-quarter and year-end results on Jan. 30.

Company co-chief operating officer Richard Parsons — who will assume the CEO spot in May — said that AOL Time Warner was penalized by Wall Street for its earlier ambitious forecasts, and will not make that mistake again.

"Going forward, our assumptions regarding future economic conditions will be more conservative," Parsons said.

AOL Time Warner had earlier reduced its revenue and cash-flow guidance for 2001, stating in September that year-end revenue should rise by about 5 to 7 percent and cash flow would increase about 20 percent. Those September guidance numbers were significantly lower than the 12 to 15 percent revenue growth and 30 percent cash-flow increase the company had predicted in January 2001, when the merger between America Online Inc. and Time Warner Inc. was completed.

For 2002, revenue is expected to grow between 5 percent and 8 percent and cash flow to rise between 8 percent and 12 percent.

NEW-PRODUCT HOPES

Parsons added that AOL Time Warner's focus in 2002 will be on rolling out new products like digital television, video-on-demand and subscription VOD and in signing on multiple Internet service providers to its high-speed data service.

The company also said that it will purchase the remaining 49 percent interest in AOL Europe from German media giant Bertelsmann AG for about $7.5 billion.

While the advertising market had a major impact on AOL Time Warner's results, co-chief-operating officer Bob Pittman said it could have been worse.

Advertising revenue was down about 3 percent for the year, compared with a 6 percent decline in the market overall. Pittman said that AOL Time Warner will do better than the market this year. He added that as the ad market rebounds, advertisers will flock to those companies that can offer the biggest bang for the buck.

"When the advertising market rebounds, we will outperform the market," Pittman said.

While most analysts revised their estimates for AOL's 2001 and 2002 performance downward as a result of the conference call, most were upbeat about AOL's future prospects.

Goldman Sachs & Co. analysts Richard Greenfield and Anthony Noto reduced their 2002 cash flow estimates for AOL to $10.7 billion from $11.2 billion, but stressed that the company is well positioned for growth.

"Our investment thesis remains unchanged and we continue to recommend AOL as our favorite entertainment/Internet stock based on its unique business mix, industry leading growth and an attractive valuation," Greenfield and Noto wrote in their report.

The two analysts' estimates work out to a 13 percent increase in cash-flow this year, assuming an economic recovery in the second half.

Greenfield and Noto also knocked down their 12-month price target for the stock from $44 per share to $40 per share, but added that key overhangs for the stock — its purchase of AOL Europe, the bidding for AT&T Broadband, management changes and uncertainty surrounding growth rates — have been removed.

"We think this company is at a point now where investors can start liking the stock again without having as many concerns as they've had in the past," Greenfield said in a phone interview. "It hasn't participated in the cyclical rally like the rest of the group has."

Greenfield also didn't see the first-quarter charge — which could be the largest in corporate history — as having a major effect on the company.

"It will have no impact on earnings," Greenfield said in an interview. "Obviously it does have an impact on the balance sheet. You can certainly say it benefits your return on capital and your return on assets because you're decreasing you assets. Regardless of what goodwill was, it was going to the balance sheet and makes no difference in terms of the write-off. But your return on assets should definitely be improved."

Parsons assured analysts during the call that the non-cash charge would have no impact on cash flow, the measurement most closely watched by Wall Street.

The charge partly covers the difference between the merger's financial value and the assessed value of its tangible assets, also known as goodwill. In the past, goodwill was amortized over several years and normally resulted in earnings losses during each quarter. With the new rule, companies can no longer amortize goodwill, instead they must take a charge for all or part of the remaining goodwill if it is determined that the asset has substantially declined in its value.

In the case of AOL Time Warner, that decline shows up in the company's stock price. AOL stock closed at $71.88 on Jan. 10, 2000, the day the merger was announced, more than twice the combined company's current trading price.

'TECHNICALLY' OVERPAID

While the charge was mainly taken to comply with new federal accounting rules, it points out the precipitous decline in Internet stocks during the past two years.

"On the one hand it illustrates technically that AOL overpaid for Time Warner, and it overpaid with stock at a very high price," said Sanford Bernstein & Co. media analyst Tom Wolzien. "It's indicative of what we already know — people who bought at $90 lost a lot of money."

Greenfield stopped short of saying that the charge indicates that AOL paid too much for Time Warner.

"What it shows is that the value of AOL's stock has declined significantly, that stock which was used to purchase Time Warner," Greenfield said. "In the cable sector, I don't think you'll see a charge this big, but there is no other company equal to the size of AOL Time Warner either. I think you'll see charges, but on a much smaller scale."

Investors appeared to shrug the charge off. AOL Time Warner stock was down only about 4 percent, or $1.28 per share, between Jan. 7 — when the announcement was made — and Jan. 10.

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