The long-suffering shareholders of media giant Time Warner (NYSE: TWX ) , a recommendation of the Motley Fool Stock Advisor newsletter, are paying a hefty price - $3 billion dollars in cold cash ($2.4 billion of which is a settlement fund). That's the reserve set aside to settle lawsuits regarding the aggressive reporting (overstatement) of revenue at AOL between 1999 and 2002.
This settlement comes after the company agreed last December to pay a $60 million penalty and establish a $150 litigation settlement fund with the Department of Justice (DOJ). That was followed in March by the announcement of a $300 million penalty imposed by the Securities and Exchange Commission (SEC). The DOJ's $150 million will be transferred to the company's settlement fund, and Time Warner is making its "best efforts" to get the SEC's $300 million moved over as well -- thus increasing the size of the reserve fund and, in essence, creating a catch-all litigation/settlement fund. These funds were previously unavailable under the aforementioned allocation.
The bombshell lawsuit news came with the company's second-quarter results, which were off target. Compared to the second quarter last year, revenue decreased 1% to $10.74 billion. Analysts had expected it to grow $700 million to $10.69 billion. Adjusted operating income (which is being used here to ignore the settlement costs) decreased 3% to $2.6 billion.
Although sales fell at AOL and Filmed Entertainment, it was the $202 million (59.6%) decrease in operating income at Filmed Entertainment that really hurt results. Falling profitability at Networks probably didn't help, either. This is also a reminder to shareholders that the heady years of the Lord of the Rings trilogy are now past.
But before you get discouraged, listen to the CEO: "Importantly, we generated industry-leading free cash flow of $2 billion through the first half of the year, demonstrating the vitality of our businesses." Sounds great, doesn't it?
Read down into the fine print of the financial results until you reach this pearl on free cash flow: "A limitation of this measure, however, is that it does not reflect securites [sic] litigation payments, which reduce liquidity." Though it would seem to indicate the core business is relatively strong, that gives a whole different meaning to free cash flow and the CEO's vitality statement, doesn't it?
Also lurking far below the headlines is the second quarter's $925 million gain from the sale of Google (Nasdaq: GOOG ) shares and the $1.2 billion benefit from state tax law changes.
The company also announced a $5 billion, two-year program to repurchase its own shares. That may or may not be a wise investment. While analysts expect the company to compound earnings at 12% annually for the next five years, the stock is selling for a fairly rich 22 times expected 2005 earnings (before one-time adjustments) -- even after falling from $95.81 in Dec. 1999 to $17.28 a share today.
Compare Time Warner to Disney (NYSE: DIS ) which, without all the litigation baggage, is selling for 19.5 times estimated fiscal 2005 earnings, and is expected to grow earnings at 12.0% a year for the next five years, and you'll see the obvious earnings vitality today.
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