What is AOL Time Warner ( AOL) waiting for?

Though Internet bellwethers such as Yahoo! ( YHOO) and Amazon.com ( AMZN) fell sharply from their early 2000 highs, more than a year passed before AOL Time Warner's shares fell as far and as deep.

But now that Internet headline stocks like Yahoo!, Amazon.com and eBay ( EBAY) have climbed back to levels not seen for more than two years, the question is when AOL Time Warner -- dragged down by numerous issues at its America Online unit -- will join the party, too.

To be sure, AOL's shares haven't done bad lately, rising 50% since late February. But with the media and entertainment conglomerate trading at about a third of its stock price two years ago, investors have to sort out which possible developments at the company will nudge the stock along the road to recovery, and which will block its path.

Some likely drivers are AOL-specific issues such as the recovery of the online advertising market and the attrition rate of AOL's dial-up subscriber base. Or, because investors may have decided conditions at AOL are as bad as they're going to get, perhaps improved conditions at the rest of AOL Time Warner will suffice.

In any event, the news trickling out of AOL Time Warner in the past few months -- including a slow resurgence of support among sell-side analysts -- gives cause for optimism.

"The Street, on average, is neutral to negative on the name," says one AOL Time Warner shareholder, speaking on condition of anonymity. "There's still a fair measure of cynicism on this name. That tells me people can be surprised on the upside."

Given Wall Street's issues with AOL Time Warner management's credibility -- the two years since the merger have been a tale of serial guidance-lowering and other disappointments -- AOL Time Warner is in a unique position among media and entertainment conglomerates, says Fahnestock analyst Peter Mirsky. "I think this is the only company in this space where hitting the numbers is an actual catalyst," Mirsky says.

AOL Time Warner's shares, which have ranged from a high of $18.88 to a low of $8.70 over the past year, rose 32 cents Wednesday to close at $15.53.

Reconsidering

So what is in flux among the key issues affecting the stock?

One element is the state of America Online's advertising business -- the very thing that got AOL Time Warner into its current mess. While other Internet companies were complaining of weakness in the online ad market, AOL Time Warner said its business was fine -- until it wasn't. Yahoo!, notably, got a jumpstart on AOL as far as restructuring its online ad business to contend with the new realities of an era not funded by venture capital and IPO money.

But now that investors have pretty much beaten down all expectations for online advertising, things appear to be turning around. Though the company says online advertising in the first quarter was below the prior year's levels, much of the decline was due to bubble-era deals that expired over the past year; AOL Time Warner says the company is generating more new advertising business this year than it was last year.


Slow and Steady?
AOL creeping higher


And things are looking up all over for online advertisers: The Online Publishers Association trade group -- comprising major Web site operators not including AOL or Yahoo! -- said first-quarter online ad revenue at 24 member companies rose a total of 37.6% over the same period last year.

A more potent unknown is when AOL's subscriber count will stabilize. The Washington Post reported Wednesday that AOL has lost more than a million dial-up subscribers since late last year, but a substantial decline was already expected. In Morgan Stanley's April 7 report upgrading AOL Time Warner, for example, the brokerage house forecast that the company's domestic subscriber count -- including both narrowband dial-up and broadband members -- would decline from 26.5 million at 2002's year-end, when the decline was already apparent, to 25 million at the end of 2003.

As is already understood, AOL Time Warner is losing subscribers both on the low end -- notably the cut-rate dial-up provider United Online ( UNTD) and broadband providers such as Comcast ( CMCSA) on the high end.

Darkest Before the Dawn

The AOL shareholder argues that investors have already passed the key milestone as far as AOL's subscriber count is concerned: The realization, which came with the company's fourth-quarter 2002 financial report, that AOL could ever lose subscribers. Now, he says, that bad news is a debate over shades of gray -- the number of subscribers AOL will lose before its membership stabilizes -- rather than a black-or-white matter. And that's not as bad, he says. "It's not day to night," he says, "but evening to night."

The shareholder says he expects AOL's membership to stabilize somewhere above 20 million, but he'll have to wait to find out if he's right. "We're just not going to know until sometime next year," he says.

In the meantime, the faster that Americans make a transition to broadband connections, the worse it is for AOL, he says, because the company is still developing its broadband offerings. Any broadband price wars in the next three to six months -- say, another round of price cuts such as those recently instituted by Verizon ( VZ) and SBC Communications ( SBC) -- would be bad news for AOL Time Warner.

Other potential positives and negatives lurk elsewhere in the company. Though revenue-recognition problems at AOL Time Warner seem limited to AOL, news that the problems are more widespread -- in the shareholder's words, "if Dick Parsons does the perp walk" -- would be a sizable negative. "The odds of that are very tiny," says the shareholder.

Mirsky, who initiated coverage on AOL Time Warner last month with a buy rating, says the stock has numerous potential catalysts that could send it higher. Most are related, he says, to the company's effort to reduce its debt -- for example, the company's planned initial public offering of stock in its Time Warner Cable subsidiary.

But others relate to the company's operational performance. Despite the bad news about AOL subscriber losses when the company released first-quarter results, says Mirsky, the stock took off, as investors focused instead on the news that the company had met expectations and wasn't once again lowering guidance. "I think a lot of the negative AOL news is getting shrugged off," says Mirsky, since the shareholder base has turned over to include long-term value investors who are prepared for bad news out of the stock. Mirsky's firm has no banking relationship with AOL Time Warner.

Improving conditions at units other than AOL could lead to guidance-raising, perhaps accompanying the release of second-quarter financials. At a Deutsche Bank conference Tuesday, Chief Financial Officer Wayne Pace hinted that strong showings at the company's film and networks businesses might lead the company to raise its estimates for the year, Reuters reported.

Such improved guidance "would certainly be significant," says Mirsky, though he puts the chance of a change at less than 50%.

Mirsky isn't the only sell-sider to be looking kindly at AOL Time Warner in recent weeks. Goldman Sachs upgraded the company in late April, and SoundView raised its price target from $17 to $20 on Wednesday.