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AOL Time Warner on a rocky road

Jul 23, 2001  •  Post A Comment

AOL Time Warner’s second-quarter results demonstrated three important things: Management’s ambitious merger plan is working; the colossus is vulnerable to economic and advertising downturns just like other media concerns; and intensified cost-cutting will be key to hitting its lofty 2001 financial targets.
In other words, AOL Time Warner is big and it’s different, but it’s not bulletproof.
In fact, it was unnerving to see just how much impact a soft advertising market had in a single quarter despite AOL Time Warner’s declared immunity, citing such uncommon defenses as boundless cross-promotion of its own products and services, robust core subscription revenues and reliance on multiplatform advertising.
AOL Time Warner’s overall second-quarter revenues grew only 3 percent to $9.2 billion in the second quarter instead of the nearly 10 percent growth to $9.7 billion analysts had forecast. About two-thirds of the company’s second-quarter revenue shortfall was related to advertising and commerce revenues.
That’s an important point when you consider that the merger of AOL and Time Warner was forged on the notion that diversified assets, multiple revenue streams and scale are keys to financial and competitive success. So not surprisingly, concerned investors drove AOL stock down 10 percent to close at $45 a share after earnings were announced.
Cable lagging
Most notably, the company’s second-quarter cable and broadcast network ad revenues declined 8 percent, largely due to a 12 percent decline in ad sales at the Turner cable networks. With Turner’s upfront costs per thousand down as much as 15 percent, many analysts now are expecting flat to 2 percent full-year network revenue growth to about $7 billion.
Even AOL’s online advertising and commerce revenues were down 2 percent from the previous quarter but up 26 percent from a year ago to $706 million, which was well below most analysts’ forecasts.
Only Time Warner cable system advertising was up in the second quarter by 19 percent, outpacing analyst estimates. The WB Network posted 12 percent ad revenue growth, and Time’s publishing division actually grew ad revenues about 2 percent in the quarter.
“The second-quarter results demonstrated that the company is capable of using cost cutting and intercompany spending to achieve outsized EBITDA [earnings before interest, taxes, depreciation and amortization] growth,” said Ed Hatch, analyst at SG Cowen. “At the same time, they demonstrated that even a company with the market power of AOL Time Warner is not immune to an overall slowdown.”
Post-merger punch
In a second-quarter conference call with analysts and investors, AOL Time Warner Chief Executive Gerald Levin boasted that the merged company’s profit margins have improved to 28 percent from a pro forma 24 percent margin a year ago. “It’s proof positive we are delivering on our merger promises in a difficult environment,” Mr. Levin said.
Much to its credit, the company has managed to squeezed out $519 million in free cash flow, up 55 percent from pro forma levels a year ago, despite difficult times.
Overall, the company has done a better job of weathering the economic storm and has a broader, more formidable base than other media concerns.
But what AOL Time Warner can’t hide from or stop is the erosion of revenue growth in its core ad-driven media operations, even with steady subscriber gains as a partial offset. The company’s overall subscriber base grew 18 percent over last year’s pro forma level to 135 million, most of that coming from cable and AOL online. AOL’s subscription revenues rose only 2 percent to $1.3 billion in the second quarter.
Last week, AOL Time Warner officials said “the consumer” is still there in the form of growing subscriptions, even if advertising dollars aren’t.
For the near future, ad revenues will be weak and difficult to predict, which has thrown into question whether AOL Time Warner can make what it is now calling the best-case revenue target of $40 billion for the full year. Clearly, the only way it will be able to meet the $11 billion 2001 earnings target it still stands by is through even more aggressive cost cutting.
“Relatively slow year-over-year revenue growth of 9 percent in the first quarter and 3 percent in the second quarter create a big hurdle for second half [forecasted] growth of 11 percent to 12 percent,” said Richard Bilotti, analyst at Morgan Stanley Dean Witter.
A stronger performance by its filmed entertainment division is critical to meet second-half 2001 expectations, given the upcoming release of films such as “Harry Potter” and “Lord of the Rings.”
AOL Time Warner also is heavily reliant on its AOL service, which Mr. Levin considers the company’s “crown jewel.” But AOL already has cut its overhead costs, increased its subscription rates and squeezed what it can from advertising and commerce. Analysts pointed out that AOL’s revenue growth, up 13 percent from a year ago to $2 billion, was below what most of them
expected.
Ironically, AOL Time Warner, which is the second-largest advertiser in the United States, needn’t look any further than its own practices for one reason why ad spending is weakening, as it increasingly relies on the use of its own online, print and television inventory to market its own services and products.
About $20 million of the weakness in AOL’s online advertising in the second quarter was related to the company’s decision to use inventory on behalf of other AOL Time Warner divisions instead of merchandising products directly.
All about costs
But ABN AMRO analyst Arthur Newman may have best articulated Wall Street’s newfound preoccupation with AOL Time Warner in saying, “At this stage, AOL is clearly a cost-control rather than a revenue-growth story.”
Midyear revenues are about $18 billion, less than halfway to the company’s self-imposed full-year goal, while midyear earnings totaled $4.7 billion, or $6.3 billion off the company’s full-year goal.
So what is the company banking on for support during the second half of 2001 to offset continued weak ad revenues?
AOL Time Warner executives concede that since the advertising recession is deeper and longer than anyone expected, they will have to intensify an already rigorous cost-cutting agenda in order to achieve full-year 2001 financial targets. The big question is where those cost reductions and eliminations will be made.
So far AOL Time Warner says it has exceeded its cost-cutting expectations, which were at least $1 billion in expense reductions and related synergies in the first year.
Merrill Lynch analyst Henry Blodget said he would not be surprised if AOL doubled its cost cuts to nearly $2 billion in its first 18 months following the merger. “This is a company with $30 billion in annual expenses. It’s not going to be hard to come up with another $800 million from overlapping expenses and shutting down businesses that are no longer working,” Mr. Blodget said.
Mr. Levin last week said AOL Time Warner in the second half of 2001 will be focused on making strides in emerging broadband service, local advertising, its content and entertainment businesses, its cross-advertising platform strategy and its remake of CNN.
Although there has already been impressive evidence of the revenue-generating and cost-savings gains that can come from its cross-advertising strategy, AOL Time Warner’s stab at a bigger piece of local advertising will be a challenge. Local TV stations and newspapers are losing ground to national advertising and are struggling to reinvent their businesses.
Likewise, the early returns AOL Time Warner enjoys from video on demand and other new digital cable services, while promising, may not come fast enough to offset short-term losses in conventional ad spending.
Acquisition-shy
Even with its treasure trove of free cash flow and credit lines, AOL Time Warner may continue to move cautiously with acquisitions.
For instance, Wall Street has assumed AOL Time Warner will jump into the bidding for AT&T Broadband, which has to exceed Comcast Corp
.’s initial rejected $54 billion bid. And the company may be strategically afraid not to wrestle a 20-million-plus cable subscriber footprint for itself.
But the economic unknowns-even for a hybrid media company with a triple-core revenue foundation-may prove too formidable.
With an ad recession that now seems destined to reach well into 2002, it will be interesting to see how much AOL Time Warner fine-tunes its own expectations as it wrestles with the pains of post-merger integration.
Right now the company expects advertising and commerce, which comprises 23 percent of its overall revenues, to increase to 30 percent by 2006, with subscriptions representing nearly half the revenue pie.
But last quarter demonstrated what happens when two of AOL Time Warner’s three primary “revenue buckets,” as Mr. Levin calls them, fail to fill to anticipated levels.

So far analysts and the company aren’t saying much about altering their growth expectations for the three key revenue areas of advertising, content and subscriptions.
JPMorgan analyst Paul Noglows estimates subscription revenues will come in around $16.6 billion in 2001, compared with $14.8 billion pro forma in 2000. Advertising and commerce will strain to total $9.3 billion this year, up slightly from $8.8 billion pro forma in 2000. And content revenues this year will see only slight gains to $13.2 billion from $12.5 billion pro forma in 2000, Mr. Noglows said.
The big question is how much each of the three key revenue categories will be off for the year, creating a gap between promised vs. delivered revenues that must be filled by cost reductions and synergistic gains.
While it pushed into a future of new services and products, much of AOL Time Warner’s time and energy will be spent in the coming months on meeting that challenge.