AOL Hammered on Outlook, SEC Probe

Analysts raced to downgrade AOL Time Warner and investors
rapidly
hit the sell button Thursday after the media giant disclosed a routine
Securities and Exchange Commission investigation and a sluggish outlook for
its flagship ISP.

During a conference call Wednesday evening to discuss second quarter
results, AOL Time Warner’s CEO Richard Parsons disclosed that the
SEC was conducting a fact-finding inquiry into accounting questions raised in a recent Washington Post article.

In a two-part story last week, the Post raised questions about
how AOL accounted for advertising revenues as the dot-com
collapse was spreading. The report referenced hundreds of pages of
confidential AOL documents in its probe of whether it boosted revenue using
a series of unconventional deals from 2000 to 2002. The company defended its
accounting practices as proper and said its auditor had looked into the
matter and signed off on the accounting.

But the disclosure, combined with a troubling outlook in the
AOL unit, further hammered the company’s stock price Thursday as
it fell below the $10 mark amid heavy selling in broad markets.

America Online’s revenues for the quarter slid by 3 percent to $2.3 billion,
led by a 42 percent decrease in advertising and commerce revenues to $412
million, largely due to the soft online advertising market. But overall, the company posted a profit and revenues were up by 10 percent. But the AOL troubles and the SEC probe eclipsed all other news.

In a research note Thursday morning, Jessica Reif Cohen of Merrill Lynch
said poor visibility for the rest of the year and the SEC inquiry had created new overhang. She downgraded her rating to neutral from buy.

The SEC disclosure was helpful, she wrote, but underlying trends in the AOL unit
were troubling. For example, 83 percent of AOL’s ad and commerce revenues
were advertising-related during the second quarter. Of that $342 million,
$220 million came from contractual commitments and $125 million came from
spot advertising sales, Cohen said.

Because she believes contractual
commitments are slipping, Cohen concluded that advertising and commerce
revenue in the AOL unit would decline by 34 percent in the third quarter and
by 28 percent in the fourth quarter, deeper than she had pegged earlier.

In addition, she lowered her advertising outlook for 2003 from a gain of 7
percent to a decline of 20 percent.

The 477,000 new subscribers that AOL added to its 35 million base during
the quarter also fell short of analysts’ estimations by about 100,000
subscribers.

Alan Mosher, a senior researcher with Probe Research, a telecommunications and ISP research firm, said in addition to the usual problems besetting the AOL unit such as
flattening subscriber growth and declining ad revenues, it has not demonstrated
how it plans to migrate its dial-up subscribers to broadband connections.

“AOL continues to struggle with its broadband strategy and is losing
subscribers to broadband vendors including the cable MSOs and DSL providers
SBC, Verizon, and Qwest,” Mosher noted.

“Verizon and SBC have partnered with AOL archrival MSN and SBC has tied up
with Yahoo!. AOL does offer broadband service through the ILECs (incumbent
local exchange carriers) but at a price disadvantage to its competition.”

Look at the blossoming relationships between Yahoo! and SBC, and between MSN
and Verizon and Qwest, Mosher continued. “How will (AOL) reach customers with
their key network providers (e.g., UUNET) declaring Chapter 11” or becoming
a subsidiary of its enemy, the major telecommunications carriers it competes
with to provide broadband service: the ILECs?

“If the ILECs successfully bring the mobile networks back into their fold —
which looks like the next move —
they can effectively block/raise pricing to AOL for access to customers, and
reduce visibility of AOL by moving it off the mobile IP portals.”

On the cable front, meanwhile, AOL is currently limited to the Time Warner
Cable network which services about 20 percent of the US cable market.

Given that AOL’s major market is here in the U.S., the emerging wisdom among
Mosher and other telco analysts is that AOL is going to have to wage a war
with the ILECS in order to bridge its customers to broadband and survive.

Those concerns, combined with a loss of experience at top-level positions
across the AOL unit spell even more trouble, analysts said, which has worsened an
already hair-trigger selling mood among investors sniffing out any scent of
accounting problems.

Last week, Chief Operating Officer and AOL interim Chairman Robert Pittman
resigned. His duties are being split among two Time Warner executives, Don
Logan, chairman of Time Inc., and Jeffrey Bewkes, chairman of HBO.

The changes clearly put the Time Warner, old media, side of the house in charge at corporate headquarters and help elevate the profile of
James de Castro, president of AOL Interactive, Mosher added.

Given de Castro’s extensive experience in radio, “it may be that Time Warner
believes Internet portal AOL will be better off run like a group of radio or
TV channels rather than as an Internet portal. It remains to be seen if Time
Warner will be able to pull this strategy off and whether or not AOL
subscribers will buy into whatever the product offering the AOL portal
offers over the next year.”

Given the constant drumbeat of woes besetting the media company, the
question now, especially among research analysts, is whether AOL’s new leadership will be able to right the ship and get AOL moving forward once again. Or, as the media has been pondering for weeks now, is it time to cut AOL loose from the corporate ship?

As one media investment banker put it this week, the answer to the questions depends on how much time investors and markets intend to give the company to work through its troubles.

News Around the Web