AOL Investors Confront the Unknown

Second-quarter results could well tell the fortune of a recovering stock.
Publish date:

AOL Time Warner (AOL) hurried up. Now it's time to wait.

The media and entertainment conglomerate, which is slated to report second-quarter financial results on Wednesday morning, has regained some of its old Wall Street following by cutting debt and cutting costs in a timely fashion.

But while the operational story continues on the upswing, AOL Time Warner's stock is still being held back by unknowns at the company's America Online unit. And how investors view those blind spots may come to tell the tale of whether this stock can continue its 2003 rebound.

AOL's shares, which bottomed out at $8.70 last summer, fell 39 cents Monday to close at $16.35. Shares in the company have climbed 63% since late February, though they're less than one-third of their peak prices after the merger closed in 2001.

Assets and Liabilities

Chief among the unanswered questions is a legal one: What are the consequences -- or more specifically, the liabilities -- of onetime revenue recognition practices at AOL, dating back from before the merger of America Online and Time Warner? Only last Friday, the California Public Employees' Retirement System added its name to the list of investors suing the company over AOL-related issues.

In the meantime, AOL Time Warner's effort to raise more cash by selling shares in its Time Warner Cable unit apparently remain on hold while the company clears up the AOL accounting issues with the

Securities and Exchange Commission


Another unanswered AOL question is what, in fact, the AOL unit will end up looking like in five years. Even AOL Time Warner's supporters -- such as

recent booster Merrill Lynch analyst Jessica Reif Cohen -- say they expect the company to lose millions of subscribers over the next few years to both high-speed Internet service providers and cut-rate dial-up services. Wall Street seems increasingly confident that AOL Time Warner will be able to stabilize AOL, but investors don't know where it will be, nor how much more expense-cutting will be required.

Still, value investors who jumped into AOL Time Warner last year, when things looked darkest, are able to run a modest victory lap to enjoy the run-up.

The company's revival isn't as sharp as it has been for other stocks closely identified with the Internet, such as





(EBAY) - Get Report

, but the Internet has ceased being considered an outright negative for AOL.

"Last year, people were worried about cable. Now they're happy about cable," says James McGlynn, portfolio manager of the


Summit Everest large-cap value fund, an AOL Time Warner shareholder. "Last year, Internet stocks were still in a death spiral."

But now, says McGlynn, "Cable looks attractive, movies look attractive ... and online looks like it has some value."

Low Bridge

As for operational expectations, AOL Time Warner has set them low, in accordance with CEO Dick Parsons' pronouncement that 2003 would be a "reset year" for the company. The company's corporate guidance is for revenue growth in the mid-single-digits as compared to $41 billion in 2002, and for growth in earnings before interest, taxes, depreciation and amortization "in the low- to mid-single-digits" as compared to $8.7 billion in 2002.

At the AOL division -- "the battleground" in the stock, acknowledges McGlynn -- revenues are expected to be "essentially flat" compared to 2002's $9.1 billion, and EBITDA, says the company, will be "flat to down 10%" compared to $1.5 billion in 2002.

Over on Wall Street, those numbers translate into expectations of $10.6 billion in revenue for the second quarter ended June 30, and $42.87 billion for the year, according to Thomson First Call. Analysts are expecting EBITDA of between $9.2 billion and $9.4 billion for the year, though those numbers include the operations of the CD/DVD manufacturing business the company recently said it would unload.

Some analysts are holding out hope, however, that AOL Time Warner will raise estimates for the year, thanks to improving conditions in the company's cable and filmed entertainment divisions.

AOL Time Warner says it's losing AOL subscribers faster than expected, but it's cutting costs at that division faster than expected, too.

Unsettled legal issues remain, as highlighted by the Calpers suit announced last week. McGlynn, for one, doesn't believe the risk to AOL Time Warner is catastrophic, noting that the alleged wrongdoers have been ousted from the company and that, unlike scandals at other companies, disputed revenues fall well short of the billion-dollar mark.

And, in fact, one reason that Guzman analyst David Joyce upgraded AOL from perform in-line to outperform earlier this month was his perception that "investors are shifting their focus away from the headline risk of the America Online accounting issue to the fundamental strength in most of the AOL TW businesses."