AOL TW: Bad to Worse

Huge loss is only one of the media giant's mounting problems

Posting the biggest single loss in U.S. corporate history—nearly $100 billion—should be bad enough news for AOL Time Warner. But, looking into the company's future, it's clear that plenty of dark days lay ahead.

The Big Drag
It's not just AOL that is sucking wind; other divisions are leading to a no-growth 2003
Division Sales Cash flow
Source: Sanford Bernstein & Co.'s Tom Wolzien
Online 3.0% -21.7%
Networks 5.6% 3.3%
Publishing 4.0% 6.9%
Music 1.1% 2.9%
Studio 3.8% 1.4%
Cable 6.5% 5.8%
Total 4.2% 0.0%

AOL Time Warner's acknowledgment of further decay of its operations was accompanied by new disclosures of unexpected problems. The company doesn't expect to generate any growth in cash flow this year, far worse than the already modest forecasts on Wall Street. The company's fast-growing cable systems are unexpectedly faltering, partly because results were artificially inflated by launch fees from cable networks. The crunch hits just as AOL Time Warner is preparing to take the cable unit public. What little subscriber growth America Online was generating in the U.S. has disappeared, the Internet service is seeing its first decline in customers, and the unit's already plunging cash flow should drop another 15%-25%. In early December—just three weeks before the end of the quarter—AOL executives told investors they expected to ad subs for the period.

Ted Turner's abrupt resignation as vice chairman is one more straw, not so much of a material loss but yet another sign of disarray. AOL executives used to brag how the media giant was a "large-cap growth company." Now, newly christened–and newly chastened—Chairman and CEO Richard Parsons is talking about 2003 as "a reset year for our company in terms of growth."

Investors slammed the company, slicing its stock price 20% to $11.50 by midday Friday. The reaction was similar to the fallout from December's "AOL Day," an investor meeting during which Parsons unveiled an underwhelming turnaround plan for the online unit.

Analysts said they can't find much good news in the company. "It has a management team in place. It's going to take the management team time to do what it needs to do," said Sanford C. Bernstein & Co. media analyst Tom Wolzien. "It sounds like the arms inspectors."

The most startling news was the slowdown at the cable unit. Time Warner Cable executives have prided themselves on generating steady, above-average cash-flow growth, in the 12%-14% range. Parsons warned that 2003 growth could fall below 10%, traditionally an important threshold in the minds of investors.

The issue is how Time Warner Cable has been artificially inflating its results with launch fees from cable networks. Even though the $2 to $7-per-sub fees are funneled through as local ad spots on the systems, most operators credit them against programming expenses, spreading the deductions over the five- to 10-year life of the contract.

Time Warner Cable, however, books the fees immediately as current advertising revenue, as if the spots had been sold to a local car dealer.

That has been artificially inflating its reported ad sales by $130 million for a year, something the company had disclosed. The surprise is that the fees are plunging abruptly, although the company won't specify how much they'll fall.

In a company with $42 billion in sales and $8 billion in cash flow, that's barely a ripple. But it's just the latest surprise from a company that has been full of them, including an accounting scandal over similar kinds of payments to the online division. That has drawn an inquiry by both the Securities and Exchange Commission and criminal investigators at the Department of Justice.

"We knew about the fees," said Merrill Lynch media analyst Jessica Reif-Cohen. "We didn't know how much it was going to fall off."

The news comes as AOL Time Warner is preparing to take the cable unit public as part of the unwinding of its Time Warner Entertainment venture with Comcast. The company has been expected to try to raise $4 billion by selling stock to the public, using some of the cash to pay Comcast $2 billion for its interest in TWE's entertainment units, HBO and Warner Bros.

Participants in AOL Time Warner's earnings conference call, however, noted that Parsons remarked that the IPO proceeds might cover "all or a portion" of the obligation to Comcast. A company spokesman said Parsons' comment was merely boilerplate.