The most astounding thing about the problems and challenges vexing AOL Time Warner is that they are happening at all.
Eighteen months ago, the merger of the companies was heralded as a bellwether for integrating new and old media and mining the Internet’s marketing and commerce promise.
Today the media giant, whose stock price and market capitalization have been halved, is wrestling with many of the problems plaguing its more conventional, smaller competitors-economic volatility, weak advertising trends, difficult distribution gatekeepers and mounting higher-priced debt.
The company’s annual report, filed with the Securities and Exchange Commission last week, provided a litany of woes that will continue to test AOL Time Warner’s initial merger strategies, even in better times.
Those woes are dramatically punctuated by a first-quarter $54 billion write-down that AOL Time Warner has announced, representing the merger value paid for and still not realized. The combined company was valued at more than $180 billion when the merger was announced in January 2000 and valued at about $105 billion when it closed a year later. AOL Time Warner stock has lost nearly 50 percent of its value since then.
Storm clouds ahead
The promise of the company’s historic merger hasn’t been fulfilled in these challenging times-and it might never be.
But AOL Time Warner’s problems run deeper and are even more specific, underscoring that even the biggest media company in the world is vulnerable to the most basic business factors.
Consider the company’s tussle with Advance/Newhouse and the latest problem for its long-troubled Time Warner Entertainment partnership.
The very notion that Time Warner could lose 20 percent of its cable subscribers if the Newhouse family withdraws its lot from TWE is mind-boggling, considering AOL’s recent push to extend its cable reach.
A decision by the Newhouse family, which could come as early as this week, to withdraw 2.3 million cable subscribers-one-third of the total-from the TWE venture, would be a significant strategic setback for AOL Time Warner. It would set off a string of new financial troubles.
For starters, the current situation likely will prompt AOL Time Warner to spend tens of millions of dollars to acquire more smaller cable operators such as Cablevision Systems, Adelphia Communications, Charter Communications or even Cox Communications to shore up its No. 2 base of 12.8 million cable subscribers against the soon-to-merge Comcast Corp.-AT&T Broadband. Analysts say it is the only way for AOL Time Warner to put the brakes on Wall Street’s anxious concerns, which have led to a new series of downgrades and lowered earnings estimates.
Digital cable is a critical springboard for advancing the high-speed Internet service of AOL and the content of Time Warner, and broadband is a strategic antidote for AOL’s slowing subscriber growth and services. These are areas where AOL Time Warner can’t afford to lose ground to the soon-to-merge 22 million cable subscriber base of AT&T-Comcast.
The potential dilution of its cable subscriber base takes the edge off the prospect that AOL Time Warner could acquire Newhouse’s stake in its high-speed Internet service, Road Runner, which has logged nearly $300 million in losses, as part of any settlement.
But it gets worse.
Staggering numbers
The financial hit to AOL Time Warner would be the loss of up to $600 million in earnings and $1.1 billion in revenues that has been generated annually by Newhouse’s portion of TWE, according to Tom Wolzien, an analyst at Sanford Bernstein. The overall restructuring of TWE (which includes HBO, Warner Bros. and Time Warner’s cable systems) could result in an $830 million, or 9 percent, pro forma reduction in earnings, although there would be no effect on reported earnings, as the reduction would be offset by changes in other income and minority interests, Mr. Wolzien said.
Even if AOL Time Warner can once again prevent Newhouse from exiting TWE, as it did a year ago, it could be subject to a little known “put” by the Newhouse partnership in the event that the family’s aging principals die.
In that case, AOL would be required to come up with two-thirds of the market value of the partnership-and its 25 percent TWE partner, AT&T-Comcast, could be required to come up with $2 billion.
Sources say Comcast officials, who were unaware of this condition or the payment they would have to make, are concerned about coming up with the funds in the midst of executing its proposed $72 billion acquisition of AT&T. Comcast also is concerned that AOL Time Warner might not have the resources necessary to buy out AT&T-Comcast’s $2 billion stake of TWE, which it has been planning to sell. In that case, Comcast would be forced to sell its TWE stake to the public, which could open a new can of worms for AOL Time Warner.
And there’s no telling what else AOL Time Warner may have to sell or swap to appease the Newhouse clan, which entered the TWE partnership in 1995 with a $338 million investment now valued at about $8 billion, according to the SEC filings.
Regardless of how the matter is resolved, analysts and investors are concerned it will further diminish AOL Time Warner’s cable base and overall financial flexibility.
Some analysts say AOL Time Warner’s current commitments could lead to a financing crunch at the world’s biggest media company.
The $7 billion it has earmarked to buy the 50 percent of AOL Europe it doesn’t already own from Bertelsmann A.G. and the $10 billion-plus it could have to pay to dissolve the TWE partnership with Newhouse and AT&T-Comcast would leave the company with thin resources to acquire more cable systems, TV stations and other forms of distribution.
The company also revealed last week in a proxy filed with the SEC that while it has tightened its top executive bonuses, it will pay departing chief executive Gerald Levin his annual $1 million salary and stock options for three years for him to stay on as an adviser after he retires in May. The company also said it likely will slow its share-buyback program to free up funds.
Cash shortage
The $5 billion in annual free cash flow AOL Time Warner figured it would be generating in better times will be quickly tapped. With revenues off at nearly every core business and its overall resources more limited, AOL Time Warner may not have the financial flexibility it once expected in an era of believing that scale makes all things possible.
So what’s a media behemoth to do?
Another SEC filing last week revealed that industry powerbroker and creative financier John Malone is jockeying to play a more prominent role at AOL Time Warner by converting his passive 4 percent stake into full voting shares, which would likely win him a seat on the company’s board.
The fact is investors and analysts are uneasy about AOL Time Warner’s most likely having less than $3 billion in borrowing capacity and about $700 million in cash by the time it irons out its problems. The company is considering additional financing options through its bank lenders and by going to the capital markets to raise funds, all of which would be shaped by other outstanding obligations, such as the $800 million construction of the new AOL Time Warner Center in New York, sources said.
Katherine Styponias of Prudential Securities last week became the latest analyst to cut her AOL Time Warner estimates, echoing the concerns set in motion a week earlier by industry veteran Holly Becker at Lehman Brothers, who said she had hoped AOL Time Warner management’s conservative forecasts for the company this year would have proven to be “a worst-case scenario.” In fact, it looks like “the worst” of the company’s financial challenges are still to come.