Boy, have I been wrong about AOL Time Warner (NYSE: AOL).

When the largest multimedia merger in history was announced in January 2000, I listened, I read, I thought about it a while, and then I kept thinking some more.

I didn't like Time Warner's $18 billion long-term debt. I didn't care for the slow-growing print media division. I learned about the hit-and-miss nature of the movie and music business. I was surprised by how quickly the cable business was growing, and I thought the merger would assure AOL's broadband dominance. What a mix of bad and good.

Overall, the merger of Time Warner's media empire with AOL was so interesting and had so many moving parts that I believe an investor could have taken either side of the argument -- that the merger was good or that it was bad -- and made a strong case.

David Gardner didn't like the idea from the get-go. Others, including me, wrote about how the merger could work out -- given execution on management's "vision." Those saying the merger could work were giving Time Warner, with its up-and-down past, the benefit of the doubt. Because there were plenty of doubts.

So far, the doubters have been painfully prescient, probably to a degree even they didn't predict. AOL's stock (now AOL Time Warner of course) has declined from the $60s to $15.

What happened?
What did happen is a major source of revenue for the company, advertising, plummeted.

What didn't happen? Even though free cash flow rose sharply due to redundant costs being cut, layoffs and other savings, beneficial "synergy" between the two firms isn't easy to spot.

For instance, cross-promotions leading to stronger Time magazine subscriptions, though a nice perk, aren't enough to compensate for the large drop in ad dollars, and doesn't really qualify as "synergy."

Additionally, an inevitable event has occurred: AOL subscriber growth is waning. We wrote in a 2000 Fool research report that this would likely happen soon and the stock would naturally not respond favorably. And as dial-up Internet growth slows, AOL's broadband cable Internet business (Road Runner) is a money loser, expected to lose $75 million to $125 million this year.

On top of this, concerns remain about the company's cable joint venture with AT&T (NYSE: T). AT&T reportedly wants out, and resolving this (partly due to contract promises) could end up costing AOL Time Warner billions. Management reassures Wall Street that it won't pay to resolve this.

Investors are skeptical. Just yesterday, the company relinquished control of 2.1 million cable subscribers while restructuring its cable joint venture with Advance/Newhouse Communications (which wanted the restructuring) after months of negotiation. As of March 31, AOL Time Warner had 12.9 million cable subscribers.

Less than compelling financials
Management isn't in a position to pay, but they're also not in the strongest position to negotiate. Money talks -- and AOL Time Warner doesn't have much. The company's balance sheet went from unattractive but tenable in 2000, to burdensome.

                    3/31/01         3/31/02      Change
Cash              $1.26 billion   $857 million    -31%
Long-term invest. $11.5 billion   $6.1 billion    -47%
Long-term debt    $20.1 billion  $28.4 billion    +41%

Cash and investments fell steeply in just the last year, while long-term debt soared 41%, to $28.4 billion. Carrying so much debt, AOL Time Warner paid $1.37 billion in interest alone last year. Meanwhile, largely due to advertising, sales have declined. The most recent quarter:

                  3/31/01          3/31/02       Change
Revenue         $10.59 billion   $9.76 billion    -7.8%
Gross profit    $4.79 billion    $3.93 billion   -17.9%

One important number has improved, however: free cash flow (which is cash from operations minus capital expenditures). In 2001, free cash flow rose to $1.66 billion from $1.07 billion the year before, up 55%. Given the company's approximately $94 billion enterprise value (at $15 per share), the stock trades at 56 times 2001 free cash flow. This compares to an S&P 500 average of 34 times free cash flow.

Consensus analyst estimates call for $0.88 in earnings per share this year, putting the stock at just 17 times estimates, and well below the S&P 500 average P/E of 28. More than anything, this valuation may show investor skepticism that the estimates will prove out. (Earnings per share is expected to be $0.21 for the June-ended quarter.)

Meanwhile, almost all Wall Street analysts have been wrong about the company since 2000. Currently, 16 analysts rate it "strong buy," seven rate it "buy," and only four rate it "hold." A few years ago, the analysts were even more positive on the company.

It's not easy to follow
A final issue investors have with the company, now, is that it is increasingly complex to understand. Its financials are anything but clear, with various partnerships, one-time costs and gains, growing debt, management's emphasis on EBITDA (although it is truly of little final importance), and pro forma this and that. In a post-Enron world, clear financials are sought and complexity in numbers is feared -- even mistrusted. I'm convinced that this has hurt the stock a good deal.

Today my main concerns with the company include its large debt, slowing growth of former star divisions, and the complexity and cost of its cable operations, including unhappy partners. AOL Time Warner has so much going on that something always seems ready to disappoint. It doesn't seem to be a focused, strong company so much as it seems a sprawling, "let's hope it all works out," expensive-to-run conglomerate.

To the company's credit, the advertising market is so weak that it threw the entire firm into a defensive mode. When the ad market reaches some normalcy, hopefully AOL Time Warner plans to see what is working best and what isn't, and then will streamline (yes, streamline) into a media empire that hits on all cylinders. Then, hopefully, it will become financially strong over the years by paying down debt. But all this may be hoping for a lot.

Where do you see AOL Time Warner in five or ten years? Take it to the AOL Time Warner discussion board.

The Motley Fool has a disclosure policy. The author's stock holdings are shared online.

Rule Breaker Portfolio Returns as of 6/24/02 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week      -3.49%**   -4.19%   --      -5.98%
Month     -6.33%**   -6.97%   --      -9.62%
Year     -22.82%**  -13.53%   --     -25.13%
 8/4/94   22.59%     10.28%  12.79%    9.37%

*Dividends added.

**Please keep in mind that these figures will be distorted for the RB Port once a quarter when we deposit $12,500 in new cash. See next note! 

***Compound Annual Growth Rate using Internal Rate of Return. This performance measure accounts for the periodic deposits. Total return wouldn't be meaningful, because we started adding cash to the portfolio in July 2001. In a total return calculation, or (Current Value - All Cash Deposited)/All Cash Deposited, cash added shows up as returns.