AOL TW picture will get worse before it gets better

Dec 9, 2002  •  Post A Comment

The turnaround plan announced for AOL last week will test the patience of investors and consumers before it ever yields the intended results more than a year from now. And that could be the online unit’s undoing.
While the broad outline for recovery during a much-anticipated Wall Street briefing Dec. 3 is two years too late, it is a step in the right direction, say leading analysts who follow AOL Time Warner.
But some, including influential analysts Mary Meeker and Richard Bilotti of Morgan Stanley Dean Witter, have lowered their rating on the stock to equal weight because evidence of sustainable growth at AOL won’t come until at least 2004. Until then, AOL will continue to be a drag on AOL Time Warner’s stock price and perceived value in relation to other media giants.
The financial impact of AOL’s plight is just one part of the story.
AOL Time Warner officials dropped a bombshell just ahead of the investors meeting, saying the online unit’s already free-falling advertising and e-commerce revenues will decline another 50 percent next year-pushing overall AOL cash flow at least 20 percent lower on revenues down 3 percent. This compares with the $2.7 billion in advertising and commerce revenues AOL generated in its heyday, which, according to ongoing probes of the unit’s accounting practices then, were not supported by completely solid numbers.
Just to keep it in context, AOL this year will generate $1 billion in free cash flow and about $1.7 billion in earnings before interest, taxes, depreciation and amortization on $9 billion in revenues for AOL Time Warner, which will post its own modest 5 percent gains in $9 billion in earnings on $40.8 billion in revenues, according to Morgan Stanley.
Warning signs
Still, last week’s earnings warning was the latest and steepest in a series of lower guidance announcements from AOL Time Warner management in a year in which it has been dogged by accounting scandals, intensified competition, internal strife and a skittish economy.
Even though AOL’s new CEO Jonathan Miller and AOL’s longtime leader, AOL Time Warner Chairman Steve Case, emphatically declared that the online unit will “hit bottom” next year, Wall Street remains concerned that things will get even worse before they get better. AOL Time Warner’s battered stock declined 14 percent the day after the meeting.
Indeed, any liabilities stemming from the regulatory probe findings would have a far more devastating impact on AOL Time Warner’s balance sheet.
To be fair, The Walt Disney Co. is facing the same resistance from investors, who are numb to what has been two year’s worth of continual lowering of earnings estimates and expectations. Disney last week revised its latest fiscal fourth-quarter results to reflect a $74 million pre-tax write-down on its failing new animated film “Treasure Planet.”
Investors say the relentless downside at Disney and at AOL has become an awful blur. Both companies need to make a more convincing case about their value proposition. That’s where AOL stumbled last week.
AOL failed to provide enough convincing details about two critical matters: how it will convert more of its 35 million subscribers from narrowband to a more lucrative, cost-effective broadband service and whether it can accomplish that economically and rapidly enough to improve its financial fortunes while really getting into the broadband game.
JPMorgan analysts Spencer Wang and Jason Bazinet, who have written an extensive report on broadband, say AOL has at least 18 months to still get in the game. Its more immediate challenge is to retain subscribers and entice them over to broadband pay content and services-where all media meet.
Although broadband is only in about 15 million of the 55 million U.S. online homes today, that number will nearly triple by 2007, when there will be some 74 million online homes in the United States. But the JPMorgan research shows that consumers will resist paying for more services and content unless there is some differentiated value involved. “That is AOL’s real broadband challenge,” Mr. Wang said.
AOL last week said it will peel exclusive content from AOL Time Warner’s house brands-from CNN to HBO and The WB to Time Inc. magazines-for starters. In paying and treating them just like outside content providers, AOL will begin to deliver on part of its two-year-old merger promise.
While that is an economical place to start, it will clearly require more enterprising content and services to secure its transition with consumers and advertisers, with whom AOL says it is anxious to make amends.
The release of AOL 9.0 next fall will catapult AOL from a mechanical Internet service provider to an interactive content and services provider by allowing subscribers to access rich media music, television and film applications and insert them into e-mails.
But Tom Wolzien of the Bernstein Research estimates that AOL’s new premium services will need to generate $1 billion by 2006 to offset new content costs. Company officials made clear it is all about premium service and transaction fees and more conventional advertising business going forward. The challenge is getting there.
“We just can’t shake the feeling that this meeting/plan two years ago would have been a `take the hill’ plan, but now it just seems late, as so many competitive players on the field have made impressive advances,” Ms. Meeker and Mr. Bilotti told clients.
No one knows how long it can take, what consumers want or how much they will pay for content and services, which is why Mr. Case made his own personal online appeal to AOL members last week seeking e-mail advice. (Do you think a Dear Steve column might work?)
Missing the boat
All we do know right now is that AOL was perfectly positioned to take a commanding place in the broadband universe and admittedly missed the boat. AOL officials can’t say why, but being distracted by losing $200 billion in value since the AOL Time Warner merger in January 2001 must have had something to do with it.
AOL Time Warner executives can’t tell you exactly how they will win the support of other content providers and distributors, who want to believe AOL’s new offer to be “a good business partner” but still sting from having been bullied for years. That is no small matter considering that AOL aspires to be a cable MSO-styled gatekeeper of free and premium online content and services, as Mr. Miller described.
To be sure, there is plenty of real value in AOL and its subscriber base and what both can bring to AOL Time Warner. But there wasn’t enough concrete evidence in AOL’s presentation last week to drive it home.
Mr. Wang estimates that an AOL subscriber today is worth about $450 in cash flow over his or her lifetime. But that value will likely remain under $500 in the early years of broadband conversion without knowing anything about the economics, number and type of premium services that take hold.
If cable is any indication, the only service consumers have keenly supported is high-speed data-a segment that AOL has been unsuccessfully grappling to penetrate for years through carriage pacts that exist only with its own Time Warner Cable and its partner Comcast Corp. If it waits any longer, cable modems will be so cheap that AOL will find itself priced out of the digital cable market, which is why it has completely reversed its strategy and will now sell to any distribution platform and any service at any price just to connect with broadband users.
That lack of quantifiable value AOL can bring to broadband, and the huge gap of time before it can be delivered, make AOL’s makeover appear more defensive than proactive. AOL is, after all, fighting to retain a stranglehold on the Internet, with both narrowband and broadband users. But it also is fighting to secure a bigger piece of broadband’s more lucrative turf for AOL Time Warner’s leading content businesses, such as Warner Bros. Television and films, Turner cable networks, Warner music and Time Inc. publishing.
The Deals page is edited by Diane Mermigas, who can be reached by phone at 708-35
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