Past Still Haunts Time Warner

The skeletons in Time Warner's ( TWX) closet were rattling again Tuesday.

Shares in the New York media giant slipped 2% as reputed bubble-era accounting excesses -- an issue to which investors have turned a blind eye during the stock's recent resurgence -- returned to the foreground. Perhaps more ominously, the latest rumblings suggest current leadership could come under fire from regulators.

The Washington Post reported Tuesday that the staff of the Securities and Exchange Commission is ready to recommmend enforcement proceedings against Time Warner over some disputed revenue booked in 2001. At issue is the accounting treatment of certain 2001 deals with German media giant Bertelsmann. The deals gave the company, then known as AOL Time Warner, some $400 million in revenue at a time when it was notoriously struggling to keep pace with Wall Street's giant expectations.

Citing people familiar with the investigation, the Post said the SEC plans to send a so-called Wells Notice, notifying Time Warner that a civil action is possible, by early summer. Time Warner told investors in March of 2003 that the agency was investigating its accounting of the agreements, which were America Online's biggest advertising transactions at the time.

Time Warner, which has for more than a year acknowledged investigations into its accounting by both the SEC and the Justice Department, "intends to continue its efforts to cooperate with both the SEC and the DOJ investigations to resolve these matters," a spokeswoman said Tuesday.

Since being disclosed, the ongoing SEC and DOJ investigations have hung over Time Warner's stock and its strategic planning. A public offering of Time Warner's cable business -- not to mention the occasionally rumored spinoff of the AOL division itself -- are unlikely, Street pundits say, until the parent company can offer a clean bill of health on disputed finances.

On Tuesday, Time Warner shares slipped 34 cents to $17.03. Even so, the stock is up some 40% on its year-ago level and up 70% on its late 2001 low. Shares in Time Warner's predecessor company, America Online, traded as high as $95.81 in the run-up to the 2001 merger that brought the two giants together.

Back to the Drawing Board

The renewed accounting scrutiny is damaging enough to a company that has made a concerted effort to put its troubled past behind it.

CEO Dick Parsons very publicly spent last year trying to simplify the company's capital structure, cut debt and clean up the last remaining messes of the merger of America Online and Time Warner -- including the symbolic measure of dropping the "AOL" from the company's name.

Reining in investors' serially disappointed expectations for the merged company, Parsons once referred to 2003 as a "reset year." Then, in releasing mostly solid fourth-quarter numbers in January, Parsons said, "I'm pleased to say today, one year later, that we're past that."

Meanwhile, in just the past six months or so, the outlook for media stocks of all stripes has improved, as Wall Street has spied a particularly sanguine trend in online advertising.

But now, any SEC action against Time Warner could force another restatement of financial results from around the time of the merger. In 2002, Time Warner wiped away $190 million in online ad sales over the period 2000-02 and said it was reconsidering its handling of an additional $49 million.

But even more worrisome to investors is the prospect of whether Parsons' reputation as a no-nonsense leader could be tarnished. The Post reported that Parsons and other executives at AOL Time Warner approved of the treatment of the revenue line items being investigated by the SEC. That fact could undermine the credibility of current management and call into question the assertion that suspect revenue-recognition policies could all be blamed on the disgraced former management of America Online.

As the high hopes of AOL Time Warner crumbled into missed forecasts and nonexistent synergies, Parsons proved most successful of the former senior executives of AOL and Time Warner at eluding angry shareholders' blame over the deflated results. Former AOL Chairman Steve Case, President Bob Pittman and CFO Mike Kelly came to symbolize slick salesman who had hyped their company's prospects and pulled a fast one on Time Warner shareholders. Former Time Warner Chairman Jerry Levin was denigrated as an aloof visionary who got snookered.

Parsons, the Levin lieutenant who succeeded his boss after a stint as co-chief operating officer with Pittman, has always maintained an image of low-key, no-nonsense wisdom that contrasted with the other execs. In accordance with that persona of a quiet, upright boss who calms a cowboy mentality, Parsons oversaw the 2002 erasure of $190 million in previously recorded revenue, mostly at AOL, from the third quarter of 2000 to the second quarter of 2002.

Ads That Subtract

At issue in the Bertelsmann case are certain advertising deals struck in 2001 while AOL Time Warner was negotiating with Bertelsmann over the dissolution of their partnership in AOL Europe.

Under an earlier version of the dissolution pact, Bertelsmann had the right to put its AOL Europe shares to AOL Time Warner in two stages, for a total of $6.75 billion. AOL Time Warner had the right to choose whether to pay for those shares in cash or in AOL Time Warner stock.

In separate agreements reached in March and December of 2001, the companies changed the earlier terms to specify a cash payment, rather than stock. Meanwhile, "contemporaneously" with the agreements to pay in cash, Time Warner said in SEC filings, the companies reached two separate agreements under which Bertelsmann agreed to purchase additional advertising from AOL Time Warner, valued at $125 million and $275 million.

Time Warner and its auditors say the $396.4 million worth of advertising that ran in 2001 and 2002, virtually all of it at the AOL unit, should be recognized as revenue. The SEC staff said in March 2003 that it believed "at least some portion of the revenue" should instead have been treated as a reduction in the AOL Europe purchase price paid to Bertelsmann.

Into Thin Air
Stock fighting back

A restatement would make the unpleasant decline in AOL's online advertising sales look even worse. Advertising and commerce revenue for AOL fell from $2.6 billion in 2001 to $1.6 billion in 2002. But subtracting out the disputed Bertelsmann deals as well as a total of $400 million in advertising charged to other units of AOL Time Warner, a steep decline turns into an absolute rout -- from $2.24 billion in 2001 to $1.15 billion in 2002.

Bright Side of Life

That said, the news didn't exactly stir up Wall Street's darkest fears. Blaylock & Partners analyst Todd Mitchell noted that if the SEC charges stick, the cost of settling shareholder lawsuits related to the AOL Time Warner merger would rise. But the negatives of the SEC's charges are likely priced into the stock, Mitchell wrote, setting a bottom for value investors. Mitchell has a buy rating and a price target of $23; his firm hasn't done banking for the company.

And in a note published Tuesday morning, JP Morgan analyst Spencer Wang saw a silver lining.

"The potential SEC fine and shareholder lawsuits related to this investigation are managable for Time Warner from a balance sheet perspective," wrote Wang, who has an overweight rating on Time Warner and whose firm has done recent investment banking for the company. "As a result, we would likely view a resolution of the SEC inquiry as a positive catalyst for Time Warner as it would remove an overhang."

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