What's AOL Time Warner's Net Worth?


By David Shook On July 25, the day after AOL Time Warner (AOL) reported disappointing second-quarter earnings and disclosed a federal investigation into its accounting practices, the stock tanked. It dropped below $9 a share for the first time in AOL's history and experienced the heaviest trading day since the announcement of the celebrated merger with Time Warner on Jan. 10, 2000.

The shares closed at $11.01 on Aug. 1, even though the Justice Dept. had announced a few days earlier that it had opened a criminal probe, joining a Securities & Exchange Commission inquiry into America Online's recognition of certain revenues. (AOL and its auditors stand by their accounting, and AOL declined to comment for this story.) But on Aug. 2, the shares headed south again as the SEC announced it was widening its probe to include some deals America Online had done with other companies.

A BOTTOM? Even if the federal probe turns up no serious accounting infractions -- as the company insists will happen -- the question about what America Online is now worth remains up in the air. A troubling list of problems confront this Internet pioneer, and investors have ruthlessly judged that the AOL division is worth nil. (See BW Online, 8/5/02, "An Ink-Stained Exec's AOL Challenge") But some analysts believe the stock has bottomed, and that the judgment about the division's worth will be proved wrong.

Parent company AOL Time Warner is trading at a market valuation of 7.3 times 2003 projected earnings, according to First Albany Corp. Take America Online's profits out of the equation and the Time Warner businesses alone are trading at 10 times next year's estimated earnings. "The market is [in effect] assigning no value to the AOL division," says analyst Michael Gallant, of CIBC World Markets, which has no banking relationships with AOL. "In fact, it's assigning negative value to the AOL division."

Could such an evaluation be right? Some Time Warner employees grumble that America Online is like a cancer eroding the value of their stock options. But sooner or later, market sentiment will catch up to the reality that AOL is no Enron or WorldCom. Yes, the outcome of these investigations won't be known for months and, in the meantime, AOL will twist in the wind. It's possible AOL could have to restate its earnings -- perhaps even admit that its accounting wasn't up to snuff. But that wouldn't add up to the demise of one of the most powerful brands on the Web.

"America Online will be around a lot longer than many investors realize," says David Brady, portfolio manager for the Liberty Young Investor Fund, which has sold much of its AOL stake in recent months because of the accounting probe and other factors. But "the stock is very controversial right now. [And] the growth story has disappeared." Nevertheless, the profits are still there, and the doom reflected in the stock price does not appear to be in sync with that fact.

SLOWING GROWTH. America Online is expected to contribute about 18% of the nearly $10 billion in cash earnings or EBITDA (earnings before interest, taxes, depreciation, and amortization) expected from AOL Time Warner in 2002. In the second quarter ended June 30, America Online's EBITDA fell 27%, but still were $473 million. Internet unit sales fell 3%, but still came in strong at $2.2 billion. Subscription revenue for the AOL service increased 20% to $1.8 billion, reflecting a decelerating growth rate from prior years. But the sales growth came from the addition of 492,000 subscribers in the three-month period -- not bad considering that most homes with a PC already have Internet access.

Advertising and content revenues declined 42% to $412 million in the second quarter. But don't mourn the death of online advertising just yet. Yahoo (YHOO), a much smaller Internet company with virtually no paid subscribers, relies on advertising for a majority of sales. It racked up six consecutive quarters of heavy losses due to the slumping ad environment, but in the most recent quarter, it bounced back with a modest profit. The company recorded $135 million in ad sales, down only 5% from a year ago.

The irony is rich. Yahoo doesn't own major media properties or subscription services, and yet it still has a stock market value of $9 billion. America Online, on the other hand, has more than triple the ad sales of Yahoo, subscription sales of nearly $2 billion per quarter, and a strong track record of profits -- yet the market is saying that it's worth nothing on its own.

NEW AD TERMS. To be sure, America Online's ad backlog -- the advertising deals signed but not yet booked as revenue -- declined substantially from nearly $3 billion two years ago to $1 billion this past quarter. "During the Internet boom years, blue-chip companies signed multiyear, multimillion dollar deals with America Online that are now expiring and are either not being renewed or have been renewed on much less expensive terms," says Jim Warner, president of Avenue A/NYC, an interactive ad agency. Though many analysts disagree, Warner says that given America Online's immense subscriber base and the trends he sees in the marketplace, online advertising should stabilize for AOL soon.

If you're still feeling queasy about AOL, don't forget Time Warner, which comprises about 80% of total earnings for the company. Despite a drop of 80% in AOL Time Warner's stock price from its 2001 high of $55, the Time Warner side of the equation is doing just fine. The biggest division, Time Warner Cable, has been growing by selling enhanced digital service, high-speed Internet access, and video-on-demand. Cable posted solid performance in the second quarter. Revenues increased 18% to $2.1 billion, while EBITDA rose 12% to $872 million.

The film studios, comprised of Warner Bros. and New Line Cinema, also did nicely. They especially benefited from home video releases of Harry Potter and Ocean's 11. Overall, sales climbed 26% to $2.4 billion, while EBITDA jumped 31% to $328 million.

NETWORK DECLINE. The networks, which include CNN, HBO, and the WB, were the only Time Warner units to report declining earnings. Overall, network sales increased up 7% to $2 billion in the quarter, while EBITDA declined 5% to $420 million, largely because of weak advertising demand. Still, analysts were satisfied with these results.

Meanwhile, the two divisions of Time Warner that some investors had dismissed as waning businesses -- publishing and music -- continue to show respectable gains. Cash earnings for the music unit increased 17% to $102 million on $972 million in sales, a 4% increase over a year ago. Publishing EBITDA jumped 14% in the quarter to $337 million on sales of $1.4 billion, an 8% rise amid a publishing recession.

Of course, AOL Time Warner faces serious obstacles to rebuilding credibility as a new-media powerhouse. Beyond the accounting investigations, those hurdles include the unresolved talks with AT&T (T) and its merger partner, Comcast (CCZ), over their 27% stake in Time Warner Entertainment, a holding company for much of the Time Warner cable, film, and network assets. Then there is the competitive threat posed by Microsoft's efforts to entice more Internet users toward its speedy broadband service.

CREDIT OUTLOOK. Meanwhile, Standard & Poor's recently revised its credit outlook -- though not the debt rating -- for AOL Time Warner to negative. S&P analyst Heather Goodchild says that if AOL is forced to reduce its earnings guidance again for any reason, a rating downgrade may be in order. (S&P, like BusinessWeek, is a division of The McGraw-Hill Companies.)

"Credit measures are somewhat stretched for the current rating level," Goodchild said of AOL Time Warner. The company has $28 billion in debt -- high for a media company of its size -- which limits its ability to maneuver. Still, Goodchild sees "solid operating performance" across Time Warner and a dominant market share for the AOL service as reasons why a downgrade isn't necessary now.

Clearly, America Online's problems are keeping the stock depressed. But for long-term investors, it may not yet be time to write off this Internet trailblazer with one of the most enduring brands known on the Web. It'll be a bumpy ride but for those who can hang tough, this might be one troubled company that makes it back into investors' good graces. Shook is a writer for BusinessWeek Online in New York


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