Time to Buy AOL?

What if you dropped in from the planet Fooliana and began searching for investments? Would AOL Time Warner (NYSE: AOL) show up on your list?

I ask this because all the brouhaha over Steve Case's step-down from chairman to random board member carries so much baggage. Was the merger a good idea? What about the pending restatements of America Online pre-merger revenue? Should AOL have gone with "You've Got Sex" (I kid you not)? Investors are right to focus on the past if it tells them something about the future, but it often does not.

The painful near future
The future for AOL Time Warner clearly involves some pain for America Online employees. As an employee of a media company that faced its own challenges in 2001 when the online advertising market fell off the mountain, I know how excruciating the cuts will be. AOL Time Warner CFO Wayne Pace reportedly said that of the 18,000 America Online employees, 6,000 to 7,000 form the "core headcount," with 3,000 to 4,000 in international operations and most employees in customer service. When someone tells you that a third of the employees are core, the other two-thirds are in danger.

But cuts are absolutely essential for the long-term survival of a business. Just as generals must make decisions in war for the good of all, Congress must allocate money among competing demands for the general health and welfare of the nation, and parents must balance their resources among children's unending financial needs, so too must management act. 

For investors, who are part owners of the company, reducing costs is a good thing as long as it does not threaten the core business. As any gardener knows, you must prune for a plant to thrive. (Another gardener, David that is, lets his intriguing investment case for AOL Time Warner grow in the Motley Fool Stock Advisor, his monthly newsletter stock face-off with brother Tom. Check it out!)

From Fooliana to Fooldom
Our visitor from Fooliana undoubtedly can't research every stock, so instead she employs a few highly personal screening metrics using numbers from a company's 10-Ks and 10-Qs before sitting down with a fresh glass of carrot juice (they lack vegetables on Fooliana) and reading the fine print. 

Let's call her Jo Fool, because on Fooliana, as in the U.S., women live longer than men and are learning everything they can about investing to be able to manage the assets they'll end up with. Her husband Joe expects to live long, but he believes in sound financial planning -- and is home caring for the Fool-lettes while Jo explores. He has an Internet job on the side and telecommutes. To Uranus. 

To Jo, Earth is an exciting international investing opportunity, even if she is not altogether fond of its accountants' Generally Accepted Confounding Practices. Let's watch as she examines the last seven reported quarters for AOL Time Warner -- not many, but the only seven whose results reflect the company's performance since America Online merged with Time Warner effective January 2001.

Revenue growth and gross margins
Jo Fool first takes a look at sales and gross margins for the company. Gross margins tell her how much is left after the company pays for labor and materials. She finds a deteriorating situation:   

    Year-Over-Year Gross
       Revenues    Margin
Q3 '02   7.1%      33.0%          
Q2 '02  14.2%      32.5%
Q1 '02  10.1%      35.7%     
Q4 '01   N/A       45.5%
Q3 '01   N/A       48.7%
Q2 '01   N/A       52.4%
Q1 '01   N/A       49.4%

Sure, sales have grown year over year for the last three quarters, but each has become less profitable. Cost of goods sold as a percentage of revenues has increased markedly, leading to declining gross margins. Seven quarters is nuthin', but these first ones say to her that the only way she's going to be interested in this company is as a special situation, a turnaround, or as they say on Fooliana, a Foolaround. In short, something better be changing the situation.  

Debt and cash
Jo likes to check quickly whether a debt-laden company has the cash and cash flow to pay the interest and how close the margin of safety is if, say, business worsens and interest rates increase.

        Total  Interest  Cash      Total
        Debt   Expense   From Ops. Cash   
                (all $ mils.)           
Q3 '02  28,333    544    1,931     2,349
Q2 '02  28,022    591    2,207     1,709
Q1 '02  28,482    505    1,787       857
Q4 '01  22,840    429    1,064       719
Q3 '01  20,749    413    1,961     1,505
Q2 '01  20,477    428    1,293     1,357
Q1 '01  20,193    423      976     1,268

KEY:
Total debt = short-term debt + long-term debt + preferred stock (if any)
Interest expense = interest expense plus minority interest exp
Cash from ops = net cash from operations (a closer look might subtract any tax benefit from stock options, working capital changes, etc.)
Cash = cash plus short-term investments

Jo sees that the while the company is an Atlas shouldering a world of debt, it appears well able to service it for now. If interest rates increase, there could be some trouble. Jo knows that she would have to scrutinize the notes to the financial statements in the latest 10-K and 10-Q for information on the debt maturities, any covenants disclosed, and so on, to better understand the company's debt situation.

Working capital management
Jo has read Bill Mann's Show Me the Money! and knows the importance of the cash conversion cycle (CCC, and its three components of days sales outstanding (DSOs), days inventory outstanding (DIOs), and days payable outstanding (DPOs)), which is a measure of how long it takes a company to turn a dollar paid to its suppliers into a dollar of income. She also likes to examine a company's Flow Ratio, telling how quickly the company collects from customers versus how long it can put off paying suppliers. Or, "I'd gladly pay you Tuesday for a Follyburger today."

        Flow
        Ratio DSO + DSI - DPO = CCC
Q3 '02  0.66  44    26    29    42*              
Q2 '02  0.67  46    26    33    39
Q1 '02  0.70  46    30    33    43 
Q4 '01  0.74  53    29    36    45
Q3 '01  0.71  54    31    37    48
Q2 '01  0.73  54    32    38    47
Q1 '01  0.79  50    34    34    50

*Minor variations are due to rounding.

AOL Time Warner sports an excellent and declining Flow Ratio, and a stable to declining cash conversion cycle. Jo would want to compare these numbers with other media conglomerates, such as Vivendi (NYSE: V) and perhaps Disney (NYSE: DIS), to see whether AOL is better or worse than competitors. The problem is that it arguably competes with Microsoft (Nasdaq: MSFT) in certain areas and these other media giants elsewhere, so comparisons are not entirely helpful.  

Turnaround?
These few superficial screens show a company whose sales have turned less gross profit each quarter on average since the merger and that needs to confront a Kangchenjunga-sized mountain of debt. On the other hand, at first glance it manages its working capital pretty well. But Jo hopes that when the 2002 10-K comes out, she will see that stock options came in well under 2001's 3.68% net dilution from stock option grants (grants minus cancellations as a percentage of diluted shares).  

All of this overlooks one big, honking factor. Even on Fooliana, investors know the importance of brand, and America Online and any number of Time Warner's media franchises are massive interplanetary brands that impart gargantuan intangible value. In just one small example, I cannot imagine conducting a large part of my business (and other) life each day without AOL Instant Messenger. Yesterday, I felt positively teenagerish with three going at once (my 13-year-old goddaughter is reported regularly to have up to a dozen)! 

More importantly for investors in the near term, management is embarking on a plan to spin off part of its cable operations, raise capital, pay down debt, and lower costs. And if the rumors about spinning off the America Online operation prove true, it would almost certainly mean greater value for current combined-company shareholders, who would presumably receive shares in the spinoff. (Caveat: If the alleged pre-merger revenue shenanigans at America Online are shown to have persisted post merger, all bets are off.) 

Until now, Jo has preferred to keep her money under the floating water bed, protected by a force field, but she is no longer betting on deflation on Fooliana. She smells a turnaround opportunity at AOL Time Warner and is going to continue her research. Sure, she would have liked to have bought under $10 a share, but she may find that the company is a better investment at current prices than it was then.

Here's to living in Fooldom here on Earth! Have a great week.

Tom Jacobs (TMF Tom9) has always impressed those who know him as being from another planet -- Foodiana. Check out Stocks 2003 -- available now -- for his and The Motley Fool analyst gang's best ideas for the year just starting. Tom goes behind the hype each month in The Motley Fool Select. Start your 30-day free trial today!  He owns no shares of companies mentioned in this column. To see his stock holdings, view his profile, meticulously prepared according to The Motley Fool's disclosure policy.  

Rule Breaker Portfolio Returns as of 1/13/03 Market Close:

            RB        S&P     S&P 500
            Port      500      DA*    Nasdaq
Week        2.74%    -0.30%    --      1.74%
Month      10.92%     5.28%    --      8.28%
Year       10.92%     5.28%    --      8.28% 
CAGR 
 using IRR**
 since 
 8/4/94*** 21.93%     8.68%   10.43%   8.60%
10/20/98*** 1.97%    -3.31%   -2.92%  -4.24%