AOL Time Warner's New Math Instead of adding up to the world's most valuable company, this merger has subtracted $155 billion of market cap. CEO-designate Richard Parsons promises to do the numbers a different way.
By Carol J. Loomis

(FORTUNE Magazine) – Precisely two years ago, just after AOL and Time Warner announced that they would merge, this magazine--a unit then of Time Warner and now of AOL Time Warner--analyzed the financial prospects for the merger in an article called "AOL + TWX=?" The question mark acknowledged that nobody could really know how this combination of an Internet whiz and an old-media giant would fare. But the executives behind the deal had awesome aspirations for the merged company's stock. They said straight out that they wanted AOL Time Warner to become the most profitable and valuable company in the world. So in the article we carried out a logical exercise, looking hard, and analytically, at how long-term investors might truly make out.

At our moment of inquiry, the financial picture included a couple of dollar figures at war. First, just after the merger announcement on Jan. 10, 2000, the two companies together had an enormous market value of $290 billion, a figure built both on the Internet bubble and on the premium over Time Warner's market value that AOL was paying. As we said, "Regardless of what numbers may dazzle you about the deal, this is the one to focus on: the market cap that the company must push up a steep hill to continue rewarding investors." Meanwhile, we pointed out, there was that other figure to worry about: combined bottom-line earnings so small (for 1999, they turned out to be $2.7 billion, including large gains on asset sales) that they were almost invisible in the picture. To get earnings up to a level that would keep the $290 billion rising at an excellent rate over the long term seemed to us just about impossible. We summed up our thinking: "It will be like pushing a boulder up an alp."

Well, on Jan. 7 this year, the boulder fell--crashing down, so to speak, in an AOL Time Warner conference call for analysts that included two major announcements. On the speakerphone from the company's New York headquarters were CEO Gerald Levin, 62, who had just a month before unexpectedly announced he would retire early, in May, and the three men he'd tapped to become the new top management team. That lineup is co-chief operating officer Richard Parsons, 53, who will be CEO when Levin leaves; the other "co," Robert Pittman, 48, due to be sole chief operating officer; and Wayne Pace, 55, who'd come from Turner Broadcasting in November to take over as chief financial officer.

What the four men suggested that January day was that AOL Time Warner was into a new math, strikingly different from the big, swinging variety previously employed. One of the two announcements said that AOL Time Warner would take a massive accounting charge. The other abandoned a set of widely publicized financial goals that the company had clung to since 2000.

And in the background was everybody's knowledge that the announcements were in a sense anticlimactic, given that two years of ugly rock slides had already hit AOL Time Warner shareholders with colossal market losses. The market value of the company as we closed this article was below $135 billion, compared with that $290 billion from two years earlier. That's more than $155 billion in market cap that has disappeared, obviously a staggering hit. For the investors who got pulverized by the rock slides, moreover, it's not a whole lot of consolation to know that a pile of other stocks got beaten up in the past couple of years also.

The two announcements made in January require some intricate explication, particularly since the massive charge--to consider it first--gets deep into accounting arcana. In this revelation, AOL Time Warner said that in reaction to a new accounting standard it would take an impairment charge for goodwill of $40 billion to $60 billion--yes, billion. Goodwill is the excess that a purchaser (AOL, in this case) pays over the fair value of the net assets of a company that it acquires (Time Warner). Okay, what did AOL pay? The first fact is that it paid by issuing Time Warner shareholders AOL stock. The second fact is that, by accounting dicta, the amount paid is derived from AOL's average share price over certain days at the time of the merger's announcement--$68--rather than its much lower price a year later--$46--when the merger actually occurred. The upshot is that AOL officially paid a whopping $147 billion for Time Warner and at the moment of acquisition recorded another doozy, close to $130 billion of goodwill. That $130 billion is the rub. The merged company, AOL Time Warner, is now saying the goodwill is "impaired," meaning that it's overstated.

Does that mean the company is saying that AOL overpaid for Time Warner? Sort of, in an accounting sense. But the true nature of the overpayment--and who could argue with this now?--is mostly that AOL's stock was overvalued at the moment the merger was announced, which led to an excessive amount of goodwill being recorded. Using the new standard, which is quite flexible in what it allows companies to do in recognizing an impairment, AOL Time Warner is reworking its balance sheet to, in effect, scrub out at least part of the overvaluation of AOL's stock.

In appraising what's going on here, you need to understand just how big $40 billion to $60 billion of impairment is. First of all, the charge--whatever the company ultimately determines it to be--is not tax-deductible, which means it will fall almost straight to the bottom line. That will leave AOL Time Warner, which has very few operating earnings to cushion this shock, with a tremendous reported loss for 2002. In fact, leaving aside what other companies might announce in the way of impairment charges--like the $45 billion write-down recently announced by the fiber-optics producer JDS Uniphase--AOL Time Warner could end the year with one of those booby prizes that companies loathe: the record for losses in the FORTUNE 500. General Motors has been the record holder up to now, with a $23.5 billion loss in 1992 (mainly because of accounting charges related to health benefits). AOL Time Warner is apt to beat that, going away. If it writes down, say, $50 billion, the charge will have the effect of reducing the total profits of the FORTUNE 500 by some 10%.

Despite the size of the charge, it has been bandied about that this is just "accounting." That's indeed the case--the charge sends no cash out of AOL Time Warner's door--but don't forget that in the real world the combined companies have lost more than $155 billion in market cap since the merger was announced. What we have here is a case of accounting coming to grips, to an extent at least, with what has truly gone on in the financial affairs of this company.

The other announcement in January mercifully got away from megabillions, but was intensely about the old math and new. The issue here is ambitious, long-term financial goals that the company established in 2000 and that were splashily given their first outing in the start-off year of the merger, 2001. Those goals never involved bottom-line earnings, which conveniently, considering their scarcity, get no respect at AOL Time Warner. Instead, as originally stated in 2000, the goals envisioned that revenues would annually increase by 12% to 15%; Ebitda (earnings before interest, taxes, depreciation, and amortization) by 25%; and free cash flow by 50%. For 2001, the revenues and Ebitda goals got freely translated by Wall Street into a war cry: "40 and 11," meaning that revenues were expected conservatively to reach $40 billion in 2001 (that would be up 10.5% from 2000), and Ebitda was to wow with $11 billion (33%).

Given that the Internet bubble had burst in early 2000 and a recession was looming, many insiders believed from the beginning that the "top-down" budgets being imposed on them were madness. And then came the year itself and bitter proof, in the form of an advertising slump that coursed through the company like one of those waves that sweep through a stadium crowd. First the company's television networks felt the slump. Then it hit the Time Inc. magazines (this one included) and finally, in the last half of the year, AOL itself.

Well before AOL felt the power of the wave, the executives most identified with the goals--Levin, Pittman, and then-chief financial officer Michael Kelly--were hearing derisive calls for the goals (and sometimes the people too) to be dumped. But management stayed with the concept. Some executives dreamed that Christmas could save the year, and some wanted to think that the "stretch targets" prevailing in the company would suddenly bring in riches. And then, says Parsons, there was the element that "guys are guys" and are into that "macho" thing. Basically, the goals had become a religion, "presided over," cracks one insider, "by the Taliban."

Reality, as always, eventually forced people to earth. In July 2001, with six months of dismal advertising results in his pocket, CFO Kelly began "guiding down" the expectations for full-year revenues and Ebitda. Then came Sept. 11 and its new shocks to advertising revenues, and still another episode of downward guidance. About that time, also, Kelly was reassigned from his financial job at the parent company to chief operating officer of the AOL unit. Kelly denies that this was a demotion, but one well-informed Wall Streeter says, "He took the bullet. I think everyone inside feared that somebody was going to have to take a bullet if the goals were abandoned, and maybe that's one reason they lasted so long."

When the company, in its January presentation, announced preliminary figures for 2001, they weren't exactly crowding "40 and 11." Revenues were said to be about $38 billion (up only 5%) and Ebitda was really short, at $9.8 billion (up 18%). Free cash flow is a small bright spot: It rose from about $800 million in 2000 to $3 billion, a rousing 250% increase.

With these results reported on the speakerphone, Parsons delivered last rites for the goals. In fact, he allowed that all the past clamor about them had drawn attention away from some very real progress the company had made in 2001. "We got no credit for our achievements," he said ruefully, "because of the high expectations we ourselves created." A few days later the Financial Times quoted Pittman with a still more candid comment about the goals. "I wish I'd kept my mouth shut," he said.

Today Parsons' vow is to be "conservative" about economic assumptions and not fall into the 2001 trap again. "We will not overpromise, and we will deliver," he told the analysts. By his thinking, revenues could grow maybe 5% to 8% in 2002 and Ebitda 8% to 12%. Those aren't "top-down" growth thoughts, but rather percentages based on "bottom-up" budgets put together by operating units that think they know what they can really do and might even be willing to "stretch" a little. "There's a buy-in," says Wayne Pace, the new CFO. He repeats what Parsons said at a recent meeting of the company's top operating executives: "We're all going forward with our arms locked together." Jiminy! This is a company known for its powerful fiefdoms. If some new kind of solidarity is forming, it might turn out to be a strong force.

To have Parsons about to be laird of it all is, of course, amazing, given that after the two merging companies set up their management structure in 2000, he was assumed to be eating the dust of his forceful co-chief operating officer, Pittman. But Levin, in a recent interview with FORTUNE, indicated that the world had jumped to the wrong conclusion. He said, in particular, that his naming Parsons to take on the job of "people development" should have been a cue that here was the man. Parsons says he himself has known for a good while that the top job would be his. Levin says he gave Parsons the definite word last May, when Parsons was thinking of accepting an offer to become CEO of Philip Morris. At that time, Levin says, he added that Parsons' promotion might come relatively soon, because he himself was thinking of leaving the company before his contract expired at the end of 2003.

Tall and bearded, Parsons is also a "teddy bear" type--a description employed by Levin and others--but Levin declares that this in no way makes Parsons "a slouch" in such tough roles as negotiating deals. You wouldn't know that from the recent news: AOL Time Warner, with Parsons negotiating and Levin unrelentingly cheering him on, lost out to Comcast when AT&T put its cable properties up for sale. But Levin points to past, successful negotiations Parsons has carried out with such non-knockovers as Disney, Viacom, and Fox. Meanwhile, says Levin, Parsons has a value system that can be relied on in such crucial matters as journalistic integrity. Says Levin: "I want to be known for having named Dick my successor."

And where does all this leave Chairman Steve Case? Where is Steve Case, in fact? Go to AOL's message boards and you will find that asked repeatedly, as in, "Has anyone heard from Do-Nothing Case?"

A partial answer to the "Where's Steve?" questions was provided by AOL Time Warner in its December press release about Levin leaving and Parsons rising. Case was in there too, by way of wording that said he would remain an "active" chairman. That description didn't pop in accidentally. The aim, says Parsons, was to address the worries of the many shareholders, most of them from the AOL side of the merger, who see Case as the "visionary" and the "entrepreneurial spirit" behind AOL's remarkable growth in the 1990s. "These people would want to know," says Parsons, "that Steve is still active and particularly so in developing the strategy of the company. So that's what was intended, to let people know that Steve is here, he's on the case"--the pun went unacknowledged--"he is not only chairman, he's part of the team."

To that piece of visibility Case added some others in mid-January, when he granted lengthy interviews to the Wall Street Journal and the Washington Post. In those and in an e-mail communication with FORTUNE, he was enthusiastic about his relationship with Parsons. Said the e-mail: "I have always had a terrific relationship with Dick. I think he has the perfect mix of skills to be CEO, and I look forward to working closely with him."

Parsons, who is acting CEO in all but title, says he and Case are already working together closely. Does he think his relationship with Case is any different from the one that Case had with Levin? Parsons laughs in answer, saying that Case and Levin are both e-mail "mavens" who shoot messages back and forth, while he's not quite up to their level. "I lose my computer," he says, "or it goes off and I can't turn it back on." Still, by phone or e-mail, he figures he communicates with Case a couple of times a day.

Let's get back to that fallen boulder. It's smaller now, and therefore maybe easier to push up the alp. On the other hand, AOL Time Warner is a world-class issuer of stock options: The number outstanding is at least 15% of the company's shares. That means any upward move of the boulder will send large rewards in the direction of executives and employees and concurrently curtail what other shareholders get.

That might not matter if the boulder gets way up the alp. In that thought is a reminder: What ever happened to that goal of making this company the most profitable and valuable in the world? Parsons says the goal is intact. But he also acknowledges that companies with middling rates of earnings growth--whoops, make that Ebitda growth--won't be gaining on that goal fast. Looks as if this company has a lot of work to do.

FEEDBACK: cloomis@fortunemail.com