OL Time Warner disclosed yesterday that the Securities and Exchange Commission had begun an investigation into the accounting at its America Online division.
The company said the investigation was started in response to two articles last week in The Washington Post that suggested that AOL might have inflated its revenue over a two-year period ending in March. The S.E.C. inquiry is the latest setback for AOL Time Warner as its new chief executive, Richard D. Parsons, struggles to cast off investor disappointment with the merger that created the company.
In January 2001, near the height of the Internet boom, America Online used its soaring stock to acquire Time Warner, an old-media company with four times its revenue. Since then the combined company's shares have fallen more than 75 percent as the promised fruits of the combination of old and new media have so far failed to materialize.
In a conference call with investors yesterday as the company reported its first profitable quarter since the merger, Mr. Parsons said he remained confident in the company's accounting and reporting, noting that its outside auditors, Ernst & Young, had certified its books twice — at the time results were first reported and again in response to the newspaper articles last week. He said he had called securities regulators before the articles were published to notify them and to offer the company's cooperation.
"In the current environment, any such allegations will necessarily and appropriately draw inquiry from the appropriate regulatory authorities, even where, as here, they are without merit," Mr. Parsons said.
Shares of AOL Time Warner fell 15 cents, closing at $11.40 before the news was released. They declined as much as $1 in after-hours trading
The Washington Post's articles addressed a particularly sensitive period before the merger was completed, when executives at AOL faced signs of a precipitous decline in online advertising and worked hard to meet their revenue projections.
The articles, citing company documents and former executives, said America Online might have effectively inflated its revenue, in part by reporting some fees from advertisers to end contracts without disclosing that the fees would not be recurring. In another example, America Online reportedly recognized sales of advertising on behalf of another company, eBay, as part of its own revenue. That practice might have affected revenue but did not affect AOL's earnings.
AOL Time Warner said that all examples cited in the newspaper articles accounted for less than 2 percent of America Online's revenue. The company has said that it did not break any laws.
The question of how fully America Online disclosed its financial prospects before the merger is of increasingly keen interest to shareholders of Time Warner as it becomes clear what a terrible deal they got out of the merger. At the time, America Online's shares traded at extraordinarily high prices relative to its profits because investors believed that its executives' projections of continued growth in Internet advertising and commerce.
But since then America Online's performance has fallen off drastically with the end of the boom in Internet stocks. Instead, the prosaic old-media businesses from Time Warner — film, television, music, publishing and cable — have become the mainstays of the company's earnings and its stock.
That trend continued yesterday when AOL Time Warner reported that all Time Warner divisions had posted results for the second quarter that met or exceeded expectations, led by strong growth in film and television. Executives also said they saw some signs of a rebound in advertising at the company's television networks.
The company reported second-quarter cash earnings — excluding certain noncash-account charges — of 24 cents a share, flat from the previous year but 2 cents above analysts' estimates compiled by Thomson First Call.
Net income was $394 million, or 9 cents a share, including $274 million in special one-time costs. That was a contrast to a loss of $734 million, or 17 cents a share, in the period a year earlier, when results were lowered by a $1.7 billion accounting charge the company did not take this year because of rule changes.
Results were dragged down by the performance of America Online, whose revitalization Mr. Parsons called his "top priority" yesterday. The division's revenue fell 3 percent, and its cash flow fell 27 percent from the previous year. In particular, revenue from advertising, which had been very profitable, fell more than 40 percent, with few signs of a recovery anytime soon. At the same time, the company said America Online added 492,000 subscribers, less than half as many new subscribers as in the quarter the previous year.
But the strong performance of AOL Time Warner's other divisions offset the decline at America Online. The company said its second-quarter revenue rose 10 percent, to $10.6 billion, from the period a year earlier, while its cash flow, or earnings before interest, taxes, amortization and depreciation, rose 2 percent, to $2.5 billion.
Responding to fears among investors that AOL Time Warner may face a cash shortage like the one that crippled its rival Vivendi Universal, Mr. Parsons stressed that the company generated $2.8 billion in free cash flow in the first half of the year, a significant increase from the previous year that partly reflected the timing of some expenses.
The company said the results of its film and television studios and networks were particularly strong. The filmed-entertainment division reported a 31 percent increase in cash flow on a 26 percent increase in revenue, reflecting robust sales of home videos like "Harry Potter and the Sorcerer's Stone" and strong box- office receipts of films like "The Lord of the Rings."
Mr. Parsons said he stood by the company's projections for a single-digit percentage increase in revenue in the third quarter and flat or modestly declining cash flow. For the full year, he said the company still expected its revenue to increase nearly 8 percent, near the high end of its previous projections. He said he expected to report a rise of around 5 percent in cash flow for the full year, at the low end of its previous projections, because of the continued falloff in advertising at America Online.
But some analysts said yesterday that the S.E.C. investigation and the continued weakness at America Online overshadowed Mr. Parsons's reassuring comments.
"There are two new looming issues," said Jordan Rohan, an analyst at Soundview Technologies. "The investigation into AOL's accounting and the dramatic decrease in the growth of new subscribers at AOL."
Still, Doug Kass, manager of the hedge fund Seabreeze Partners, said he considered the accounting issues overblown. He said that if one looked hard enough, it was obvious that America Online's advertising revenue would decline with the end of the Internet boom. For that reason, his company sold the stock short, or bet that its shares would fall. Since then, however, he has bought shares, betting that the worst was over.
Instead of faulting the company, he said, investors should fault the analysts who continued to promote the merger even as online advertising collapsed.
