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Wall Street unhappy with AOL Time Warner

Oct 22, 2001  •  Post A Comment

AOL Time Warner’s honeymoon with Wall Street is over.
While the company generally is meeting performance expectations, analysts are questioning whether it is relying too heavily on cost cuts for bottom-line gains. They are also assessing the potency of first-time weakness in the company’s America Online service and wondering how aggressively AOL Time Warner can pursue cross-platform strategies and new business initiatives in a weak advertising market.
AOL Time Warner maintained after its January merger that it was insulated from fluctuations in advertising spending and would be carried by its subscription-based AOL, cable and publishing platforms. Last week, while acknowledging the severity of the advertising recession, company officials underscored the strength of its subscription businesses, which provide nearly half of its overall revenues.
Subscriptions and content combined generate 79 percent of AOL Time Warner’s revenues and are “even more valuable in this kind of environment,” AOL Time Warner CEO Gerald Levin told analysts during a third-quarter conference call last week.
The company reported a wider third-quarter net loss of $996 million, or 22 cents a share, up from $902 million, or 21 cents a share, a year earlier. Subscriptions, filmed entertainment, cable and synergies drove a 20 percent growth in cash earnings (excluding one-time charges and goodwill amortization) to $2.5 billion, or 30 cents a share, on 6 percent growth in revenues to $9.3 billion. The company said that more than 70 cents of every incremental dollar of revenue during the quarter contributed to earnings.
Merrill Lynch analysts Henry Blodget and Jessica Reif Cohen greeted the news by lowering their rating on the world’s largest media company to “neutral” from “buy,” citing concern about underlying trends in the AOL segment. It is the first such downgrade for the company, which merged in January. The analysts questioned the “sustainability of working capital … financial flexibility, potential commitments, underlying advertising growth and the change in carrying the value of goodwill on the balance sheet.”
“Revenue and EBITDA [earnings before interest, taxes, depreciation and amortization] were weaker than expected, primarily as a result of a 12 percent sequential decline in advertising and commercial revenue,” the analysts said. “We are not optimistic about a near-term recovery in AOL’s [advertising and commerce] revenue.”
During an earnings conference call with investors, analysts questioned the 12 percent decline in AOL’s advertising and commerce revenues, and earnings fell below analysts’ expectations.
Mr. Blodget pointed out that this is the first time there has been weakness at the AOL division. Morgan Stanley Dean Witter analyst Mary Meeker said that even with a price increase in the AOL service at midyear, “One would have hoped there would have been a little more bang for the buck for the price increase,” instead of a decline in revenue per subscriber.
AOL Time Warner Chief Financial Officer Mike Kelly defended AOL’s position. “We’re very pleased that we saw a 7 percent increase in [pure] advertising spending at AOL when most of the industry is down double digits or more in advertising in a year-over-year basis. We are where we thought we would be,” Mr. Kelly said.
Mr. Levin emphasized the strength of AOL Time Warner’s subscription-based services: AOL, cable and publishing. “Advertising is simply a handmaiden to that kind of usage,” Mr. Levin said.
However, CIBC World Markets analyst John Corcoran said the company will not be able to avoid limited earnings growth “until the advertising sector starts growing again. Accordingly, we expect the company to continue its focus on cost-cutting into next year.”
Mr. Kelly-who insists the measuring stick for the merger is three years out, not nine months-conceded that more across-the-board cost-cutting is ahead but declined to elaborate. The company will have realized an estimated $12 billion in cost cuts and synergies in its first year as a merged entity.
Aggressive cost cuts so far at the company’s cable networks resulted in a 29 percent rise in third-quarter segment cash flow to $450 million on just 4 percent revenue growth to $1.66 billion.
Time Warner Cable cash flow grew 11 percent to $791 million in the quarter on a 17 percent increase in revenue to $1.8 billion. Filmed entertainment earnings grew 43 percent to $307 million on a 5 percent rise in revenue to $2.1 billion.
But future growth will clearly need to come from such new business initiatives as the rollout of multiple Internet service providers and high-speed data on Time Warner Cable systems, video-on-demand, Internet-protocol cable telephony and AOL Internet radio.
Mr. Levin and Mr. Kelly said AOL Time Warner remains on track to meet its lowered forecast of 20 percent earnings growth on 5 percent to 7 percent revenue growth.
Mr. Kelly said fourth-quarter returns will be boosted by the full reflection of recent cost-cutting, historical gains in subscriptions and increased cold-weather usage of online and television services.
Analysts generally are expecting AOL Time Warner to report just under $10 billion in earnings on about $38 billion in revenues this year. As for 2002, Mr. Levin would only reiterate the company’s projected “double-digit EBITDA growth.”
Richard Bilotti, analyst at Morgan Stanley Dean Witter, said the worst-case scenario for next year is 10 percent earnings growth on 5 percent revenue growth, while the best case is 25 percent earnings growth on 15 percent revenue growth.
Mr. Levin reiterated the company’s plan to aggressively buy and invest in growth businesses, tapping its free cash flow-which grew more than 200 percent to $1.3 billion in the third quarter-and tapping $12 billion in bank financing. It also is about halfway through a $5 billion share buyback program.
The company’s 137 million subscriptions are the primary driver of consolidated revenue. Subscription revenues grew 13 percent to $4.2 billion and make up 45 percent of total revenue. Content revenues rose 6 percent to $3.2 billion and account for 32 percent of total revenue.
Advertising and commerce revenues fell 5 percent to $1.9 billion. Network advertising declined 6 percent to $535 million from a year ago. But The WB and The Cartoon Network saw advertising increase in the quarter. Time Warner Cable advertising and commerce revenues rose 41 percent to $175 million, reflecting cross-platform deals with third parties and the launch of new services.
Management said cross-brand initiatives are key as a hedge to advertising and general economic weakness. AOL Time Warner is increasingly dependent on the AOL platform to market its own TV, film, online and publishing brands.
“We are in the process of changing the marketing dynamics of the entertainment business,” Mr. Levin said. Despite the advertising slump, the company’s global marketing solutions group has closed 22 cross-platform deals worth $700 million so far this year, involving advertisers such as Bank of America, Philips Electronics, WorldCom and Toyota.
“We wouldn’t put our products and services at risk if we didn’t think this was probably one of the most efficient mediums we have ever seen. I believe I am the best example of what someone should do in this environment,” Mr. Levin said. AOL Time Warner is the second-largest advertiser in the United States.