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AOL Time Warner


, they're singing a song unfamiliar to old

America Online

shareholders: The best thing in life is free cash flow.

When AOL Time Warner conducted its daylong meeting with analysts in January, it spotlighted free cash flow as one of the "key metrics" that Wall Street should use to judge the company as a whole. The emphasis on free cash flow -- a concept long used in the analysis of media companies, but never a yardstick for AOL -- illustrates how longtime AOL investors have to change how they assess the company's performance in the wake of the

Time Warner

acquisition. And it illustrates how AOL Time Warner, by judicious selection of which numbers it makes public, can frame the issues by which the company is judged in the market.

AOL Time Warner's shares were at $47.12 Monday, putting them down 10% since analyst day but up more than a third for 2001.

Certainly AOL Time Warner has generated a lot of numbers for investors to chew on, starting with the $40 billion in revenue and $11 billion in earnings before interest, taxes, depreciation and amortization that it forecasts for 2001. But free cash flow -- a number close to

EBITDA, but not quite the same thing --is important, too. In her report on the investor meeting,

Morgan Stanley

analyst Mary Meeker called AOL Time Warner's forecast of free cash flow "the most interesting and important metric" of its marathon presentation.

Salomon Smith Barney

analyst Lanny Baker terms free cash flow a near-sacred measure of valuation and a company's ability to make money, "a better-than-earnings proxy for earnings."

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To understand exactly what free cash flow is and why it might be important, let's look at why companies like AOL Time Warner and the analysts who cover them find traditional earnings (the ones guided by generally accepted accounting principles) to be an unsatisfactory measure of financial performance. A cynic would argue that it's because they can come up with what looks like higher earnings if they coax some nontraditional numbers out of financial statements, but it's not that simple.

The problem with GAAP earnings in the analysis of most media companies, says Baker, is that the goodwill associated with acquiring intellectual property and intangible assets -- property such as broadcast licenses -- understates earnings per share. Like tangible assets such as hotels, gas stations and routers, these intangibles possess great earnings power. But unlike those, they have little physical value. Amortization of those assets reduces an acquirer's earnings, but doesn't consume cash.

And cash, of course, is crucial, particularly cash that a company is free to employ how it sees fit. "Free cash flow is the money a business generates at the end of the day, once all the bills and costs have been met," says Baker, adding that cash is the financial resource that can be used to reinvest, acquire, pay dividends, reduce indebtedness or repurchase shares -- "all choices that tend to directly influence shareholder value."

So why not just look at EBITDA? After all, that subtracts out noncash charges like depreciation and amortization.

The problem with EBITDA, say analysts and investors, is that it overlooks financial obligations a company might have related to raising money and investing in future growth.


So one figure that's subtracted from EBITDA to reach free cash flow is interest expense -- something that may be useful in analyzing future acquisitions by AOL Time Warner, which has telegraphed its intentions to bulk up further, and which is already paying upward of $1.3 billion in interest annually. Such acquisitions will increase EBITDA, but if free cash flow doesn't grow along with EBITDA -- because of the higher interest payments associated with the acquisition -- that will raise questions about the cost of those acquisitions, suggests John Tinker, a longtime media analyst who's now managing partner of

Steamer Capital

. "You want to make sure the acquisitions are incremental, they're accretive," Tinker says.

Of course, AOL Time Warner could finance acquisitions by issuing new shares instead of borrowing additional money. To reflect that, it's better to examine free cash flow per share than a free cash flow figure for all of AOL Time Warner, says

Thomas Weisel Partners

analyst Gordon Hodge. That's because if a company issued new shares to finance operations instead of taking on more debt, the higher share count would depress the free cash flow per-share figure. AOL Time Warner reported a pro forma figure of 20 cents of free cash flow per share for 2000, but hasn't forecast a per-share figure for 2001. (Pro forma results assume America Online and Time Warner merged at the beginning of 1999.)

Along with interest expense, another item that's subtracted from EBITDA on the way to free cash flow is total capital expenditures -- the investments a company makes to buy and improve tangible assets. That part of free cash flow's definition is key to understanding why AOL Time Warner has forecast that its free cash flow will rise from a pro forma $920 million in 2000 to more than double that figure in 2001. In 2000, Time Warner was spending heavily to upgrade its cable TV systems. But in 2001, with only 8% of those systems left to be spruced up, those particular capital expenditures should decline, putting AOL Time Warner back in the neighborhood of its $2.4 billion pro forma free cash flow for 1999.

Swing Low

This wide swing in free cash flow illustrates one of the caveats to keep in mind about the figure: its wide variability. That's why analysts say one shouldn't hang on the figure quarter by quarter, but instead look at its trend over several years. AOL Time Warner forecasts a 50% compound annual growth rate in free cash flow over the next few years.

Another problem: the definition and calculations underlying free cash flow vary widely, too. AOL Time Warner defines it, reasonably enough, as its cash flow from operations, minus capital spending, development costs (for example, the cost of writing future versions of AOL software), dividends and partner distributions.

Finally, as with all performance forecasts that companies publish at their discretion, one has to wonder which are wishful thinking, and which are low hurdles that will be easy for a company to clear. If AOL Time Warner blows through its more-than-double-$920-million target in 2001, don't be too shocked: Meeker, expects 2001 free cash flow to be in the range of $2.5 billion to $4 billion; Hodge's preliminary estimate is for a figure of $4.15 billion. (Meeker, whose firm has been an underwriter for AOL Time Warner, has a strong buy on the stock; Hodge, whose firm hasn't been an underwriter for the company, rates it a buy.)

Investors also have to reflect on why companies release, or don't release, certain financial measurements in the first place. The old America Online, for example, never talked about free cash flow; perhaps that's because as recently as its fiscal year ending in mid-1998, according to's

calculations using AOL's current definition, the company didn't have any free cash flow to report.

On the other hand, over the past three years, AOL wasn't at all shy about publicizing its advertising and e-commerce backlog -- contractually committed revenue to be recognized at scheduled future dates. Analysts have obsessed over that number as they've tracked AOL's growth as an online media company. In the midst of the current advertising slowdown, they grew particularly concerned when AOL, for the quarter ended Sept. 30, reported its backlog had remained flat at $3 billion, and they were awaiting the number for the quarter ended Dec. 31. But at the January analysts meeting AOL Time Warner said it won't be reporting that number anymore; it's no longer a "relevant metric," a spokeswoman says, because the company is doing advertising and commerce deals across several parts of the company.

AOL Time Warner, however, is breaking out retrospective advertising and commerce figures for the AOL service and for other parts of the company, including publishing, networks and cable. But perhaps the company would rather have Wall Street look at the big picture than get a close look at one unit's future.