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AOL Holders Clutching the Worry Beads

Investors brace for possible surprises in Wednesday's first-quarter earnings report.

At AOL Time Warner's (AOL) current stock price, it's as if investors are getting America Online for nothing.

But maybe that's what it's worth.

That's one of the issues that investors are pondering as they await the scheduled Wednesday morning release of AOL Time Warner's first-quarter results.

Though Internet bullishness has driven up other stocks in recent months -- notably





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-- such optimism has passed over AOL Time Warner's household.

Partly it's because of the unanswered questions about advertising and commerce deals reached at AOL in prior years. Partly it's because of uncertainty over the timing of the planned initial public offering of AOL Time Warner's Time Warner Cable unit. And partly it's because investors doubt AOL will dominate the high-speed home Internet market the way it ruled the dial-up world. The doubts persist even as AOL swings deals such as Tuesday's sale of its stake in

Comedy Central in an effort to pay down debt.

Indeed, AOL Time Warner has lagged behind other general media stocks recently, too, including

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Ahead of the Comedy Central deal, AOL Time Warner's shares rose 30 cents Monday to close at $12.90. The stock, which traded as high as $20.70 a year ago, hit a bottom of $8.70 last August.

Christmas in July

In early 2002, back when AOL Time Warner's stock price had fallen to $23 per share, Wall Street denizens started saying that the multimedia conglomerate's shares were so low that

anyone who bought the stock was getting AOL for free. As

reported last July, investors and analysts kept making the same AOL-for-free pitch as the stock fell to $12.50, well off its post-merger peak of $58.51.

The latest incarnation of that analysis came earlier this month, when Morgan Stanley resumed coverage of AOL Time Warner's stock. The firm upgraded AOL from equal weight to overweight and gave it a price target of $17.

The Morgan Stanley report, from analyst Rich Bilotti, contends that the risk associated with the company's indebtedness is outweighed by potential asset sales and internally generated free cash flow (cash flow from operations minus capital expenditures and interest expense). But Bilotti says that his outlook for the company is based on the assumption that AOL's earnings before interest, taxes, depreciation and amortization -- a common bottom-line yardstick for the media industry -- will stabilize in 2003, amounting to $1.3 billion to $1.4 billion annually through 2008.

In Bilotti's worst-case possibility, however, AOL's EBITDA could continue to fall in 2004 and beyond. Under those circumstances, says Bilotti, his price target drops from $17 to a range of $14 to $15 -- the same price target he would come up with for Time Warner alone.

"Under our bear-case scenario, we believe the AOL division could truly have zero value to shareholders, as the multiple compression caused by its earnings erosion would equally offset its FCF contribution," writes Bilotti.

Compassionate Conservatism

Bilotti, whose firm has done recent banking for AOL Time Warner, says he believes the subscription assumptions behind his more optimistic scenario are sufficiently conservative. For the period 2004 through 2008, Morgan Stanley projects that AOL will keep 50% of the narrowband, or dial-up, Internet market, but that the total narrowband market will be cut in half by the growth of broadband. AOL will capture 15% of broadband subscribers, assumes Morgan Stanley, or 5 million subscribers by 2008.

Along with indicating how the transition to the broadband business is going, AOL Time Warner may also Wednesday shed further insight as to how much more bad news could come out of the Justice Department's and the

Securities and Exchange Commission's

separate investigations of the company's accounting and disclosure practices. AOL Time Warner said last month that

the SEC was questioning $400 million in revenue from Bertelsmann that was recognized in 2000 and 2001, a figure that would come on top of the $190 million that the company has already cut from 2000-2002 revenue following re-examination of prior deals.

In addition, investors will be awaiting news of asset sales as AOL Time Warner seeks to cut its net debt from $25.8 billion at the end of 2002 to $20 billion by the end of 2004. That goal has receded over the past month, what with AOL Time Warner paying out nearly $3 billion in cash. Most went to


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as part of the restructuring of their Time Warner Entertainment partnership, and $813 million went toward buying back shares of AOL Europe.

One possibility is the IPO of Time Warner Cable, which AOL Time Warner, the majority owner, hopes to complete by the end of the year. The company has also been shopping around book publishing and CD manufacturing assets, according to reports.

As for expectations, AOL Time Warner in January forecast 2003 revenue growth in the mid-single digits, implying $43.1 billion in sales. Ebitda was forecast as "essentially flat."

Complicating matters, the company earlier this month changed how it reports its "trending schedules," or separate financial tables that the investment community traditionally uses to follow the company's various operations. Instead of the $9.05 billion in EBITDA that AOL Time Warner reported for 2002, for example, the 2002 EBITDA figure now stands at $8.72 billion in the trending schedules.

The company will also focus analysts' attention on earnings per share based on generally accepted accounting principles rather than "cash earnings per share," a figure that excluded depreciation and amortization costs but included cash tax payments. The result will likely be worse per-share numbers than those usually reported by analysts.