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SEC probe rattles AOL investors

AOL Time Warner shares tumble as worries of a Securities and Exchange Commission inquiry overshadow the company's second-quarter profit.

AOL Time Warner shares fell sharply Thursday as worries of a Securities and Exchange Commission inquiry overshadowed the company's second-quarter profit.

In a bevy of research notes, Wall Street analysts worried about the outcome of the SEC probe and panned the sluggish performance of the corporation's America Online unit. Goldman Sachs removed AOL Time Warner shares from its "recommended list," and other brokerages downgraded the stock.

AOL Time Warner shares closed down were down $1.76, or 18 percent, to $9.64.

Immediately following its earnings announcement Wednesday, AOL Time Warner said that the SEC would be looking into its accounting practices in reaction to a critical newspaper report last week.

"After the (Washington Post) articles came out, the SEC informed us they are conducting a fact-finding inquiry," CEO Richard Parsons said, referring to a report in the newspaper that the AOL division boosted its online advertising earnings through questionable deals amid mounting indications that the company would suffer a collapse in ad revenue.

AOL Time Warner said its auditor, Ernst & Young, re-reviewed all the transactions in the Washington Post article and confirmed in writing that all transactions and disclosures questioned in the article were in accordance with accounting standards.

Analysts said the SEC inquiry could take several turns:

• The SEC could quickly review AOL's accounting and conclude the company's accounting treatment was appropriate.

• It could expand the inquiry to other AOL Time Warner divisions.

• Or the SEC could force the company to restate its historical results.

"In the current environment where rules can shift and political pressures run high, there may be other outcomes of the SEC's probe that could be impossible to anticipate," Salomon Smith Barney analyst Lanny Baker said in a research note. Baker downgraded AOL shares to "neutral" from "buy."

Some analysts held out hopes that the SEC probe could give AOL Time Warner a clean bill of accounting health but noted that an investigation could take awhile. "One source we spoke to suggested that inquiries can take between 3 to 6 months," Bear Stearns analyst Lee Katz said.

Earnings results
AOL Time Warner said Wednesday that earnings before interest, taxes, depreciation and amortization (EBITDA)--a common benchmark for the performance of media companies--rose 2 percent to $2.5 billion.

Net income reached $394 million, or 9 cents a share, on revenue of $10.6 billion for the quarter that ended June 30. That compares with a loss of 17 cents a share from the same period a year ago.

"Our operating results for the second quarter outpaced our expectations," Parsons said in a statement. "The anticipated impact of year-over-year declines in advertising at America Online was more than made up by the collective strength in our other businesses. We expect the improving trends in our traditional media and entertainment businesses to drive accelerating growth over the second half of the year."

On a pro forma basis, cash earnings including depreciation reached 24 cents a share. A consensus of analysts expected AOL Time Warner to post pro forma earnings of 22 cents a share on $10.2 billion in revenue, according to First Call.

AOL Time Warner also reiterated previous guidance for its future financial performance. Revenue growth is expected to hit the upper end of its 5 percent to 8 percent projection for the year, while EBITDA is expected to reach the lower end of its of 5 percent to 9 percent range due to continued softness in the online advertising market.

Count the numbers
Still, subscription growth rates were dramatically lower during the quarter, exacerbated by considerable declines in Europe and Latin America, executives said.

Despite a 20 percent growth in its core subscription revenue, the net additions have slowed. New subscribers reached 492,000 over the quarter. In contrast, AOL added 1.3 million new subscribers over the same period last year. AOL now has 35.1 million subscribers.

Analysts flagged news of the SEC investigation and AOL's lackluster subscriber growth. Despite a mostly solid quarter for AOL Time Warner's other divisions, AOL remained a cause for serious concern.

"AOL has issues," said Jordan Rohan, an analyst at SoundView Technology Group. "It could go down to zero subscriber growth in a couple years because if growth is not coming from Europe or Latin America, it could create problems."

Indeed, AOL's performance this quarter demonstrated why the division has fallen so drastically since merging with Time Warner in January 2001.

Advertising and commerce revenue fell 42 percent this quarter, a sharper decline than last quarter's 31 percent drop.

Chief Financial Officer Wayne Pace said during the company's conference call with analysts that the company will offer more disclosure for performance metrics in AOL.

For the first time, Pace broke down how AOL's 26.5 million U.S. members paid for service. Pace said AOL's base of free trial members, a number long guarded by the company, totaled 3.1 million. Meanwhile, 17.7 million members paid the standard $23.90 a month, 4.3 million paid in the lower per-hour bracket and in the $14.95 "Bring Your Own Access" plan, and the remaining 1.4 million paid through discounted PC bundling deals.

Division breakdown
Aside from AOL, the rest of the company performed well, showing continued strength in its movie and cable divisions:

• Cable. Time Warner Cable reported an 18 percent revenue growth to $2.1 billion while EBITDA grew 12 percent to $872 million. The company cited its subscription and advertising businesses as reasons for the strong gains. Time Warner Cable also added 266,000 digital cable subscribers to a total of 3.9 million, and it added 271,000 broadband subscribers to a total of 2.5 million.

• Movies. Fueled by video releases of "Harry Potter and the Sorcerer's Stone" and "Ocean's Eleven," and the theatrical release of "Scooby Doo," revenue rose 26 percent to $2.4 billion while EBITDA shot up 31 percent to $328 million.

• Networks. Still suffering from a continued weakness in advertising, AOL Time Warner's TV networks division saw a 5 percent EBITDA decline to $420 million and a modest 7 percent rise in revenue to $1.9 billion.

• Music. Helped by cost-cutting efforts, Warner Music Group's EBITDA jumped 17 percent to $102 million while revenue showed a 4 percent growth to $972 million. Warner Music Group is now the second-largest record company with a 17.1 percent market share, according to music industry tracker SoundScan, AOL Time Warner noted.

• Publishing. Incorporating results from its acquisition of European magazine publisher IPC Media, EBITDA rose 14 percent to $337 million and an 8 percent gain in revenue to $1.4 billion.