Financial analysis: SEC investigation adds to AOL's woes

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AOL Time Warner's disclosure that the Securities and Exchange Commission is investigating its accounting punched another hole in the company's freefalling stock.

The SEC investigation follows a series of stories in The Washington Post, which reeled off charges that America Online had manipulated transactions to reflect growing revenue leading to the January 2001 closing of its takeover of Time Warner. Some of the claims include booking revenue from the sale of ads for Web auctioneer eBay as AOL ad revenue and bartering computers for advertising, which would then show up as ad revenue.

In one case, the paper claimed AOL closed a deal to trade advertising for stock warrants-the right to buy stock at a set price later-in a software company. The Post reported AOL placed the value of the warrants-the value of the stock AOL would eventually get minus the amount it would pay for it-on its books as ad revenue for that period. In another case reported by the Post, AOL settled a lawsuit with an online advertiser that agreed to buy advertising on AOL equal to the amount of the settlement, which allowed AOL to show the amount as ad revenue.

old news

Some assertions were not news. AOL Time Warner and predecessor America Online, for example, have long disclosed the practice of reporting barter revenue; when the company trades ads for goods or services (as it has done with Compaq Computer Corp., for example) it books the ads as revenue and reports cost of buying the product or service as an expense.

Chief Financial Officer Wayne Pace reassured investors that AOL Time Warner and auditor Ernst & Young stand by the accounting. But he offered the company will disclose more "granular" information about the AOL division, especially a more detailed breakdown of ad revenue (see chart, P. 3).

The investigation could dog the company for awhile. The SEC has no statutory time frame to complete an investigation, and that will depend on the facts and circumstances, said an SEC spokesman.

If wrongdoing is found, consequences include a range of civil or administrative penalties. If no wrongdoing is found, the party investigated can request a letter stating the outcome, said the spokesman. He noted that letter would not be a public document; it would be up to the individual whether to make it public.

Beyond the regulatory consequences, AOL Time Warner faces a hard climb in a hostile investment environment. Investment firms including Goldman Sachs, Salomon Smith Barney and Deutsche Bank Securities downgraded the stock, fearing investors will stay away, even as the analysts maintained confidence in the company in the long term.

The SEC inquiry "suddenly clouds the landscape for the stock," wrote Salomon's Lanny Baker.

low point

The already-depressed stock closed at $11.40 July 25 before management disclosed the inquiry in an earnings call. In trading the next day, the stock bottomed at $8.70, its lowest point since April 1998. It recovered some losses July 26, closing at $10.90 but still down 5.3% for the week.

Hal Vogel, CEO of Vogel Capital Management, who correctly forecast a move into the single digits (AA, July 22), expects the stock to hover in the $7-$10 range. Given that low valuation, Mr. Vogel said: "There is now a stronger potential for breakup."

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