Credit analyst would not recommend AOL credit until Time Warner Entertainment issue resolved

By Ronda Fears

Nashville, Tenn., July 25 - While AOL Time Warner appears to be stronger that its peers, Carol Levenson, director of research at Gimme Credit, said she would not recommend the credit, given the Securities and Exchange Commission investigation and unanswered questions about the fate of Time Warner Entertainment.

Levenson said in a report Thursday that it's hard to believe redrawing the organization chart will have a major impact on the company's financial fortunes, but added: "We would not recommend these [AOL] bonds until Time Warner Entertainment is resolved."

"The symbolic downgrade of the once-invincible AOL (Baa1/BBB+) to just another media outlet within the Time empire, and an underperforming one at that, was unmistakable in [Wednesday's] second quarter earnings release and subsequent conference call," the analyst said.

"Moreover, management seemed to go to great lengths not to refer to the now-discredited concept of merger synergies when speaking of the company's future.

"Unfortunately, despite all the happy talk about the company's mixed second quarter results, the question of paramount importance to bond investors, what will AOL do with Time Warner Entertainment, seems no closer to being answered."

Levenson said it was nice to see an emphasis on free cash flow in AOL's earnings release, but noted management's definition of free cash flow tends to exclude certain cash costs she would be inclined to include. The difference between her definition and AOL's wasn't too great in the second quarter, only $200 million, she noted.

By traditional measures, the company generated $1.3 billion in free cash flow in the second quarter and $2.4 billion year-to-date, the analyst said. Because of the AOL Europe purchase, net debt has increased by more than $4 billion year-to-date.

However, the second quarter saw the first decrease in net debt since the AOL/Time Warner merger, with net debt benefiting from the full amount of free cash flow.

The enormous year-over-year improvement in operating cash flow in the quarter was due largely to working capital items, she said, and management to their credit warned investors not to expect this trend to continue throughout the year.

"Thus we don't foresee significant additional debt reduction," Levenson said.

"Ironically, our April write-up on AOL, published at the time of its big bond deal, referred to the company as one of the few triple 'B' credits out there not yet tainted by some scary accounting, legal, or liquidity story. In fact, AOL's liquidity situation still appears stronger than that of most of its peers."

The company recently lined up $10 billion in new bank facilities with fairly favorable terms, she said, including financial covenants that any strong BBB credit ought to be able to beat easily.

"However, the recent discrediting of EBITDA as an unimpeachable financial measure and a Washington Post article accusing AOL of aggressive accounting for its advertising revenues has put AOL in the investor confidence penalty box," Levenson said.

"Inevitably, the SEC has opened an informal inquiry into AOL's advertising accounting practices. While the revenues questioned by the article were relatively small, no SEC investigation can be shrugged off these days."

The company's EBITDA growth continued to diminish in the second quarter, up a mere 2%, with the AOL division by far the worst performer, posting a decline of nearly 30%, far greater than its decline of 15% in the first quarter, advertising continues to be the culprit here.

"Assuming AOL meets its current EBITDA guidance for the year, which appears optimistic even at the low end of the range, we project debt/EBITDA should linger in the 3 times range," Levenson said.

"Naturally this assumes no stock buybacks or M&A activity, and a miraculous solution to the Time Warner Entertainment dilemma that increases neither AOL's leverage nor its business risk but gets AT&T the cash it needs."

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