A Year Later, AOL Struggles to Grow

On Monday, Richard D. Parsons, chief executive-designate at AOL Time Warner Inc., delivered the sour medicine: Revenue and cash-flow growth for the media giant will be slower this year than it had long predicted, possibly in the single digits for both.

But just a day later, Robert M. Pittman, co-chief operating officer, came back with the spoonful of sugar: AOL Time Warner’s “future revenue potential” for its average online customer is $159 a month--more than six times the $24 it currently gets.

On the cable-TV side, the upside is just as optimistic, Pittman said: $230 a month per subscriber, versus $52 now.

“AOL Time Warner is a growth company!” Pittman declared to the audience at an investor conference in Scottsdale, Ariz.

Pittman didn’t say when this revenue growth might arrive, or exactly how the company will get there from here. In an interview last week, he said he meant for the projections only to illustrate how the business of broadband, or high-speed Internet connections, might develop and didn’t mean to imply it would “happen immediately.”

The story of AOL Time Warner’s union always has been about potential, of course, yet it was odd for Pittman to do such cheerleading while his future boss’ sober words still hung in the air.

“We will try not to over-promise,” Parsons vowed Monday, “and we will deliver.”

The mixed message reflects credibility problems that have dogged AOL Time Warner from the outset and that Wall Street is looking to Parsons to resolve.

Parsons also must confront the fact that the America Online division, once thought to be the main engine of future growth for the company, is showing signs of maturity, although the unit remains the sales leader. The vaunted Internet division may be subject to the same swings as the company’s more-established units, such as Time Warner Cable, Time Inc. magazines and Warner Music Group.

In many ways, AOL Time Warner can look back on a solid 2001:

* It completed the $100-billion merger of AOL Inc. and Time Warner Inc.--history’s biggest media marriage--Jan. 11, 2001, a year and a day after the deal was announced.

* Amid an economic recession and one of the worst advertising slumps since World War II, the company generated 6% revenue growth and 18% growth in earnings before interest, taxes, depreciation and amortization, also known as EBITDA or cash flow, the most common earnings yardstick for media companies.

* It named a new management team, led by Parsons, a veteran from the Time Warner side, who will take over as chief executive when Gerald Levin takes his early retirement in May.

Pittman, whose roots are in AOL, will become sole chief operating officer. Wayne H. Pace, former finance chief for Turner Broadcasting System, has replaced AOL’s Michael Kelly as chief financial officer.

AOL founder Steve Case remains chairman of AOL Time Warner and is expected to take a more active role after largely staying behind the scene’s during Levin’s tenure.

* A string of blockbuster movies, including “Harry Potter and the Sorcerer’s Stone,” “The Lord of the Rings: The Fellowship of the Ring” and “Ocean’s Eleven” helped the company’s Warner Bros. Pictures and New Line Cinema studio units have a record year.

“Harry Potter” and “Lord of the Rings” are seen as franchises that will be minting money for years, from films, games, promotional tie-ins and a host of other spinoffs.

Not all the news has been positive, however.

AOL Time Warner’s shares closed Friday at $30.69 on the New York Stock Exchange, about 45% below the post-merger high of $58.51 reached in May and 59% below where the companies stood on the day before the merger was announced.

The stock has been stagnant for months, despite a rally that has swept up much of the stock market. The Standard & Poor’s 500 index, for example, is up 18% from its post-Sept. 11 low; AOL Time Warner is up 5%.

The company said Monday that it would take a one-time charge of $40 billion to $60 billion against first-quarter earnings to bring itself into compliance with new accounting rules.

Although the charge does not affect cash operations, it is a painful reminder of the technology meltdown that followed the merger announcement. The charge, which will be the largest in U.S. corporate history if it exceeds $50 billion, reflects the decline in value of the Time Warner assets that AOL acquired.

The Warner Music Group unit, home to stars such as Enya, Linkin Park and Jewel, sustained a sharp dropoff in revenue and cash flow along with the rest of the industry. Analysts said many artists were reluctant to travel after Sept. 11.

Parsons, in his Monday conference call with Wall Street analysts, said the company isn’t counting on a rebound in the economy or the advertising business this year.

Sales Growth Targets

Undergo a Revision

Revenue growth for this year, he said, will be 5% to 8%, and EBITDA growth 8% to 12%--far below the solid double-digit growth forecasts that AOL Time Warner had been sticking to for most of last year.

With the revised targets, AOL Time Warner “set the bar low enough that even a preschooler could get over it,” Jeffrey B. Logsdon, an analyst at Gerard Klauer & Mattison, said in an interview last week.

This probably will be another transition year for AOL, Logsdon said, adding that he wouldn’t recommend adding shares now.

Most of the three dozen other analysts who follow AOL have stayed the course, affirming earlier “buy” recommendations for the battered shares. Longtime bull Mary Meeker at Morgan Stanley, for example, held to her “strong buy” rating, setting a 12-month “price target” of $39 to $41 a share.

However, that means that by this time next year, AOL should have crawled back to within only 30% of its high for 2001--hardly a lofty goal for a growth stock.

The doubters cite the lack of a “catalyst” to propel sales and cash flow.

A year ago, Levin and other executives were calling the AOL unit the “crown jewel” of the company. Lately, the Internet division is looking a bit tarnished.

By the end of last year, the advertising slowdown had dashed hopes that the fast-growing online unit would come to the rescue and enable the parent company to meet its aggressive financial targets. The company said online advertising revenue grew last year by just 14%, compared with 91% a year earlier. This fall, online ad revenue had skidded to an anemic 3% growth rate.

Equally worrisome, average revenue per AOL subscriber is leveling off despite a 9% price hike last summer and efforts to cross-sell customers additional services, such as AOL TV and AOLbyPhone. During the first nine months of 2001, the company collected an average of $24.15 per customer, compared to $25.75 a year earlier.

“There was always a feeling in the company that the Internet would make up for everything,” said Paul Noglows, analyst at J.P. Morgan & Co. “They really didn’t fully understand the impact of the advertising recession.”

As a result, initial expectations that the Internet unit would become the dominant force at AOL Time Warner are being replaced by the realization that the online division is just one of several high-profile components, including cable-TV and film units.

In an interview, AOL unit chairman Barry Schuler agreed that expectations for the online company were perhaps too high, but he stressed that his division nevertheless performed well, particularly in light of the recession, the Sept. 11 terrorist attacks and the fact that the entire company had just completed a massive merger.

During the first year after the merger, he said the online unit moved quickly to take advantage of “synergies.” AOL boosted its subscriber base, thanks to referrals from Time Warner magazines, and shaved its advertising budget by moving its television commercials to sister cable channels CNN and TNT at discounted rates. Schuler declined to provide specific numbers.

Company’s Hopes

Riding on Broadband

AOL also began its long-anticipated roll-out of broadband service across Time Warner cable lines, which serve about 20% of the U.S. cable market.

The potential of broadband was a driving force behind the merger and will remain a key challenge in the coming year.

It is considered pivotal to the future of AOL Time Warner and other media giants because such high-speed Internet connections will open the door to a variety of new consumer services, such as buying music online, downloading movies and playing computerized games.

Those were the sorts of services Pittman was talking about when he told the Scottsdale audience his dream of $159 monthly fees.

AOL hasn’t disclosed exactly how many broadband customers it has signed up, saying only that the figure is in the “hundreds of thousands.”

Analysts speculate the number probably is under 500,000. Some worry that AOL will fall behind cable companies in the race for broadband customers.

There also has been little visible progress in cutting deals with other cable companies to allow AOL to offer its high-speed service on their wires.

Though negotiations are continuing and AOL is conducting a small test with Cox Communications Inc., the parties still are squabbling over how to split potential revenue and who should control the billing relationship with the customer.

“They need to get more aggressive in cutting deals,” said Rob Martin, analyst at Friedman, Billings, Ramsey & Co. “Our impression is that AOL’s subscriber count is going to slow based on the lack of a broadband upgrade path. They still can’t deliver [cable] broadband to 80% of the market.”

AOL officials are betting that customer loyalty will help them prevail in the broadband race, which they say is just beginning.

“Until this point, broadband has been for the early adopters [of technology],” Schuler said. “We think it’s really going to kick up and become mainstream in the coming year.”

AOL Time Warner also is the king of cable content, as parent of Home Box Office, CNN and the Turner networks. Its Time division’s stable of magazines, including Time, Sports Illustrated and People, reaches 58 million subscribers.

In addition to rolling out broadband on all Time Warner cable systems this year, Schuler predicted AOL will sign at least two deals with rival cable systems.

Online Division Aims

for Growth Overseas

Growth abroad is another key challenge for the Internet unit, which already serves about 40% of the maturing U.S. market for online customers. AOL Time Warner officials say they eventually want to generate half of the company’s revenue abroad, up from less than 20% today.

So far, AOL Europe has generated mostly losses, some $600 million last year. And its European partner, Bertelsmann, bailed out of the venture, exercising an option to sell its 49% stake in AOL Europe to AOL Time Warner for $6.75 billion.

“The international campaign has not been as successful as they wanted it to be,” said Adam Klein, lead partner of the media and entertainment division of Booz-Allen & Hamilton.

In Monday’s conference call, AOL executives said they hoped to cut AOL Europe’s losses in half this year and tried to put a positive spin on the Bertelsmann deal, saying fuller control will enable the company to more easily exploit synergies in Europe.

Back home, AOL’s subscription growth is starting to slow, though it is holding its market share against a renewed assault by rival Microsoft Corp.

The software giant is directly gunning for AOL customers in its advertisements and has copied many of AOL’s best features for its own MSN online service. But MSN remains a distant second, with nearly 7 million subscribers worldwide to AOL’s 33 million.

AOL and Microsoft are fighting for the upper hand in controlling how broadband services will be delivered to U.S. households. AOL hopes its proprietary service will become a major platform, while Microsoft is betting on its own Windows operating system.

“We both have similar visions of what is going to happen in the home,” Schuler said. “They obviously have designs on that vision, as do we.”

AOL officials said they see plenty of growth potential in the U.S. market, which they predict could reach 95 million online households over the next several years, from 62 million now.

AOL, with 25 million U.S. subscribers, already serves a sizable chunk of those households. The company is betting that it will win about half of the 6 million new customers expected to come online each year.

Douglas A. Kass, a longtime AOL short-seller based in West Palm Beach, Fla., thinks the company is in denial about the fact that it’s in a rapidly maturing business.

Short-sellers like Kass make money by selling borrowed shares, then returning them to the lender later, after the price has fallen.

AOL already has “picked the low-hanging fruit” among online subscribers, he said. New subscribers are getting harder to find and more expensive to recruit, often involving promotional payments to computer vendors or free offers to consumers, Kass said.

“I don’t know that there’s ever been any low-hanging fruit,” Pittman said when told of Kass’ remarks.

Competing for subscribers has always been tough work, Pittman said, and AOL has built its online dominance over years. The same thing will happen with broadband, he predicted, but not right away.

“Nothing ever comes immediately,” Pittman said.

Times staff writer Sallie Hofmeister in Los Angeles contributed to this report.