The unrelentingly bad advertising market caught up to AOL Time Warner in a big way last week when Morgan Stanley Dean Witter reduced estimates for the company’s 2001 and 2002 earnings and revenue, leading other analysts to do the same.
The challenge to the company’s ambitious 2001 financial targets, which sent AOL Time Warner stock plummeting more than 15 percent by midweek, further underscored the notion that things clearly are going to get worse before they get better for all ad-supported media companies.
Although the latest reduction brings Morgan Stanley analysts Mary Meeker and Richard Bilotti in line with the already lowered estimates of some of their Wall Street peers, their move will have a broad negative psychological impact not only on AOL Time Warner but on all advertising-dependent media companies and their stocks.
It is sure to contribute to the delay of the third-quarter rally in media stocks that analysts were hoping would be a prelude to a 2002 recovery. There is no rationale for a recovery to be under way until next year’s fourth quarter, at best.
Morgan Stanley reduced its second-half-2001 estimates by 2 percent to $39 billion in revenues and $10.5 billion in earnings before interest, taxes, depreciation and amortization, which is slightly below industry analyst consensus, with the biggest reductions coming in AOL Time Warner’s program networks, the AOL online service and film. Morgan Stanley also lowered its 2002 estimates as much as 8 percent to $13.2 billion in earnings on $44.7 billion in revenues.
Such downward estimate revisions are a big deal, especially from one of the company’s own major investment bankers, because AOL Time Warner is so vehemently sticking by the 2001 financial targets it set for itself more than a year ago-before its January merger-of $11 billion in earnings on $40 billion in revenues.
To get there, the company has launched another round of aggressive cost reductions that includes at least another 1,000 job cuts in America Online and in Time Warner’s music division by month-end, sources said. America Online accounts for one-quarter of the company’s overall revenues and 31 percent of its earnings, while music is 10 percent of revenues and 5 percent of earnings.
Although CNN’s recent makeover actually rendered some cost cuts, there could be more expense reductions in the company’s network division, which has been the hardest hit by the ad downturn. Coupled with the elimination of redundancy elsewhere, the company could achieve at least another $300 million in savings, analysts estimated.
Overall this year, AOL Time Warner will shave at least 5 percent of its 90,000 worldwide workforce and more than $1 billion in expenses.
“The company is taking two years’ worth of [cost] cuts in one year,” said Merrill Lynch analyst Henry Blodget.
But the real story is bigger than that.
The fact that a company as diverse and financially able as AOL Time Warner will likely miss its earnings and revenue estimates for this year-or will have to take more extreme measures to match them-speaks to the severity of the advertising situation and any media company’s lack of immunity to it.
Although only 24 percent of AOL Time Warner’s revenues are generated from advertising, its remaining income is tied to broader economic trends affecting consumer and content-related spending. AOL Time Warner’s zealous push for cross-promotion and multimedia ad selling is anchored in advertisers’ willingness to spend money. In other words, there is no hiding from this thing.
“Our worst-case scenario is that the economy flounders for the next several years, and we need to think of AOL Time Warner supporting 10 percent revenue growth [vs. our 15 percent estimate] and 15 percent [earnings] growth [vs. our 23 percent to 26 percent estimate], implying a target valuation for the stock, over the next 12 to 18 months, of $55 to $60 a share,” Morgan Stanley said.
That is well off the $75 price targets Wall Street set for AOL Time Warner earlier this year, a year-long high of $62 a share and the $38 per share price the company’s stock was trading at last week-a new four-month low.
In typical pack fashion, other analysts, including those at Lehman Bros., Credit Suisse First Boston and Merrill Lynch, followed suit in lowering their 2001 and 2002 earnings and revenue estimates for AOL Time Warner, having already repeatedly slashed profit and revenue forecasts for other high-profile media conglomerates such as Viacom, News Corp., its Fox Entertainment subsidiary and The Walt Disney Co.
The collective impact of these downward adjustments will not only suppress media stocks but prolong an advertising recovery. In fact, Morgan Stanley’s latest AOL Time Warner report assumes that recovery doesn’t really set in until 2003-and with good reason.
Most media companies privately concede that typical fourth-quarter holiday advertising will be absent this year, down at least 12 percent to 15 percent from last year. The pent-up ad spending won’t necessarily spring loose in 2002, because first-quarter ad spending is different in its intent and target, and it too will be vulnerable, analysts said. There is no impetus for second-quarter ad spending to be strong. So the hopes for the ad market slide to the end of 2002, when companies that buy and sell advertising are likely to come up short again.
As this negative slide continues, one lethal fact remains: Media companies collectively are reserving a majority of their ad inventory this year-as much as 60 percent-hoping for better scatter advertising markets that may never materialize. With reluctant buyers and a glut of discounted inventory, the Wall Street response can only be more lowered estimates and even downgrades. That vicious cycle could continue into 2003.
That giants such as AOL Time Warner and Viacom, which have been shouting their invincibility into the wind, finally are showing signs of wear and tear creates a negative backlash for all media. After all, if the mighty are susceptible, where does that leave everyone else?
So just how will media players climb out of this trough? Not easily.
Tom Wolzien, analyst at Sanford Bernstein, published a report last week estimating that advertising revenues will not recover to their normal percent of gross domestic product until 2005.
The spillover effect of AOL Time Warner’s situation was evident last week in Mr. Wolzien’s most recent lowered estimates on Viacom (reducing 2001 revenues $200 million to $23.77 billion and earnings by $60 million to $5.59 billion) and Disney (reducing revenues by $64 million and earnings by $53 million). His below-consensus 2002 estimates for the companies’ revenues and earnings are even more dramatically reduced and point to such things as a prolonged and gradual recovery and the difficulty of sustaining huge cost cuts. These are the kind of concerns that won’t go away any time soon.
“The secular ad trough is seen deeper and the recovery longer than the economy overall,” Mr. Wolzien said. “The real risk is that cable is worse than anyone thinks. Right now, cable seems every bit as bad as broadcasting, and that’s made worse by the fact that a cable recovery will come after a broadcasting recovery begins.”
However, most analysts agree that AOL Time Warner is better positioned to weather the continued storm in 2002 than any of its media peers. For instance, it can partly ameliorate depressed ad spending in 2002 by converting more of its own advertising spending on other media to its own on-air, in-print and online inventory, which reduces both expenses and unsold inventory in one swoop.
Last week AOL Time Warner got a $5.9 billion boost to annual net income as a result of new accounting rules and news of more restructuring, according to a Securities and Exchange Commission filing by the company. But even that news did nothing to bolster AOL Time Warner stock, which is down more than 20 percent since the company announced lackluster second-quarter earnings last month.
The problem is even though AOL Time Warner earnings are likely to grow at least 20
percent with adjustments in 2002, its stock is expected to trade only a hair above the 15 times cash flow of other media companies whose growth rate is barely half as good.
Concerns about the repositioning of AOL Time Warner’s cable networks and the rather unlikely dilutive acquisition of AT&T Broadband weigh heavily on investors’ minds. But the most important long-term factor affecting the company’s growth is its ability to capitalize on the deployment of broadband in the next three years with its AOL service and other branded businesses.
As a JPMorgan H&Q report last week underscored, the global media outlook for the third quarter and full year “isn’t pretty.”
“While some U.S. media players are beginning to call a bottom to the ad recession, much of the rest of the world, including Europe and Japan, appear to be earlier in the cycle. For those regions, the worst may be yet to come,” the JPMorgan H&Q report stated.
Those regions happen to be among the foreign growth markets global media conglomerates such as AOL Time Warner and Viacom have pledged to infiltrate.
A domestic advertising pickup that happens too soon or “a spillover effect from the sluggish U.S. economy could further affect earnings, confidence and advertising in Europe,” the report said.
One line of defense available only to large global media companies such as AOL Time Warner and Viacom is “offering cross-platform integrated media packages that include interactive media.”
The only problem is that a majority of the world’s top advertisers also happens to dominate the U.S. advertising market and will generally curb its spending worldwide. And wouldn’t you know-AOL Time Warner is one of them.