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SEPTEMBER 9, 2002 STREET WISE AOL Time Warner's Debt Drama In addition to accounting probes and declining ad sales, the media giant now has to face a possible credit downgrade to junk status
Parsons is walking a tightrope himself. In August, 2002, he waited until the last minute before signing the Securities & Exchange Commission mandate to stand by the accuracy of AOL Time-Warner's accounting. Upon signing the declaration on Aug. 14, he disclosed that $49 million in past revenue deals by America Online may have been "inappropriately recognized." Parsons ordered company lawyers to sift through all of the Internet division's transactions for any further signs of accounting troubles. As he works to quell the accounting questions that are helping keep the stock in the low teens, not far from its 52-week low of $8.70, AOL may have another fire to extinguish: Its investment-grade credit rating is at risk of slipping into junk-bond territory. With a heavy debt load and the uncertainty surrounding future revenue growth at the America Online division, even a minor misstep could jeopardize the parent company's rating. SNIFFING FOR SMOKE. "AOL bonds, despite their low investment grade, have been trading at junk yields," says Marilyn Cohen, president of Envision Capital Management, a Los Angeles firm that manages AOL bond holdings for its clients. The media giant's 30-year notes that sold in 2001 offering a 7.52% yield, for example, are trading at 86 cents on the dollar with a current yield of 9% -- an indication that investors perceive considerable risk in the bonds. Cohen believes AOL will make it through the accounting probe, but she cautions: "In this environment, wherever there's smoke, there's usually an inferno." Parsons and CFO Wayne Pace repeatedly assured investors this summer that they'll preserve AOL's investment-grade rating. "We're personally committed to rigorously following a roadmap that maintains the integrity and strength of our balance sheet," Pace said on Aug. 21. An AOL spokeswoman on Sept. 6 said Parsons continues to make AOL's quality credit rating one of the compass points he'll use to guide the company. Some fixed-income analysts, however, are convinced that AOL is flirting dangerously with a downgrade. The major credit-rating agencies acknowledge concerns about its long-term debt increasing this year by 25%, to nearly $30 billion, and they hint that AOL would inch perilously close to noninvestment-grade status if a number of short-term financial goals aren't met. "DOUBLE-SECRET PROBATION." Meanwhile, the America Online service is reeling from a drastic decline in advertising and the decelerating rate of subscription growth that has drastically curtailed earnings at the unit, which contributes about 20% of the parent company's profits and sales (see BW Online, "AOL: New Execs, Same Old Problems"). On Aug. 21, Standard & Poor's (like BusinessWeek Online, a division of The McGraw-Hill Companies) added something called "credit watch with negative implications" to its BBB+ rating on AOL. Any fan of the 1978 cult movie Animal House will recognize S&P's move as being akin to putting AOL on "double-secret probation": It doesn't have an immediate impact, but it signals that the outfit needs to get its act together. S&P's rating is the third-lowest investment grade -- and AOL's debt is also under review for a possible one-notch downgrade in coming weeks or months. "There are some open issues that we need to obtain more information on," says Heather Goodchild, a senior corporate finance analyst for S&P, "and those issues could potentially lead to a downgrade." TOO MUCH DEBT? Investment-grade credit is of vital importance to blue-chip companies because it plays a key role in determining how much it costs to raise money. Moreover, many banks' charters prohibit them from owning noninvestment-grade debt, and some mutual funds' charters oblige the automatic sale of bonds that have been assigned a junk rating. At the same time, a fall to junk status would represent a further blow to AOL's image as a media giant with a high-quality financial position. The stock, at $13.13 as of Sept. 6's close, already is well off its 52-week high of $39.21. Moody's Investors Service on Aug. 14 affirmed AOL's debt rating of Baa1 but changed its outlook to "negative" to reflect more than $8 billion in new debt AOL will take on this year after consolidating ownership stakes in AOL Europe and Time Warner Entertainment (a holding company that includes the Warner Bros. studio, Home Box Office, and many other assets). While Moody's rating is three steps above junk status, it signals a fair amount of risk that has built up, explains Robert Konefal, managing director at Moody's. A number of factors warrant concern about a downgrade. The first strain on the credit rating is $2.1 billion in new debt that AOL must take on as part of a deal to compensate AT&T (T ) for its minority stake in Time Warner Entertainment. AOL figures that an initial public offering of its Time Warner Cable assets sometime in 2003 will give it more than enough cash to pay down the new debt, but the IPO market hasn't been so warm recently. And given the telecom meltdown, it's unclear how big an appetite investors will have for a cable company. DECISIVE MOVES. What's more, AOL's largest division, America Online, has seen the advertising slump and slower subscription growth hit home just it faces increased competition for new Internet customers from Microsoft and a slow adoption by consumers of broadband and the premium high-speed Internet services on which AOL has placed its hopes for growth. Parsons should be commended for his actions since he took over as CEO from Gerald Levin in May, 2002. He has drastically overhauled America Online's management, making Time Inc. publishing exec Don Logan, a subscription and circulation guru, responsible for the Internet unit's turnaround. The duo also hired a new CEO for America Online, Jonathan Miller, who has begun to outline a strategy that involves creating all sorts of new content for AOL's 35 million users while slowly switching over as many customers as possible to faster broadband services. Moreover, while the accounting probe of America Online is likely to drag on for months, no one is questioning the myriad other Time Warner divisions including Warner Bros., Home Box Office, and Time Inc. magazines. For Parsons, these recent management changes and the limited scope of the accounting troubles may well mean he can keep his balance on the tightrope. Over the coming months, however, deftly walking the wire will remain quite a feat.  By David Shook in New York Edited by Beth Belton Get BusinessWeek directly on your desktop with our RSS feeds.  Add BusinessWeek news to your Web site with our headline feed. Click to buy an e-print or reprint of a BusinessWeek or BusinessWeek Online story or video. To subscribe online to BusinessWeek magazine, please click here. Learn more, go to the BusinessWeekOnline home page  | | SEPTEMBER |
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