Can Top Media/music Marriages Be Saved?

What has happened to Vivendi Universal and AOL Time Warner? Heralded since their conception as new models for media companies-able to push their music and other entertainment offerings across all sorts of "platforms," from such traditional ones as TV to such new, Internet-based ones as hand-held computers-they have seen their stocks hit record lows in recent weeks.
In December 2000, after Vivendi completed its acquisition of French pay-TV company Canal Plus and Seagram's Universal entertainment assets, Vivendi Universal's U.S.-listed American Depositary Shares began trading at $65. Now, they are around $35. (Its Paris-listed shares have been the worst performer this year in the CAC-40 stock index.) When AOL Time Warner officially came into being in Jan- uary 2001, the company's shares were around $45. Now, they are near $21.
A low share price is itself not a serious problem, but it does signal a change in investor sentiment.
The collapse of Enron has made investors wary-and Wall Street analysts more watchful-of companies that lack transparency. Because they are the products of recent mergers, year-over-year performance comparisons have been difficult. Vivendi's picture is further skewed by a complex shift from French to U.S. accounting standards.
Both companies said earlier this year that they would be taking one-time, multi-billion-dollar write-downs-non-cash charges that do not affect the companies' operations but signal that some of the key assets they've bought are worth less today than they were at the time of acquisition.
Vivendi and AOL Time Warner stress that these charges are one-time events. They stem from a new accounting rule that requires companies to record all at once any declines in the value of goodwill-the difference between the price paid for an asset and its tangible value. Previously, companies had to write down the value of the goodwill on their balance sheets on an annual basis during a set period of time.
Still, the charges are significant. AOL Time Warner's $54 billion charge is believed to be the largest one-time charge in history. Vivendi's charge of 12.64 billion euros ($11.1 billion) led to its reporting a 2001 net loss of 13.6 billion euros ($11.9 billion), the largest in French corporate history.
Are these growing pains for what are still young companies? Or are there fundamental issues concerning how they have been put together and how they are meant to operate?

ONLINE IN THE DOG HOUSE
Few can dispute the strength of the media and entertainment assets, including music, under the AOL Time Warner umbrella.
Once the dominant record company, Warner Music Group has been rescued by chairman/CEO Roger Ames from years of market-share declines. In first-quarter 2002, its share of U.S album sales was 16.9%-two percentage points better than a year ago and good enough for second place behind Universal.
Yet Warner's success takes place against the backdrop of declining sales industry-wide, as consumers turn to the Internet and CD-burning for the music they want. Through April 14, U.S. album sales are 9.4% behind last year's pace, according to SoundScan.
Currently, AOL Time Warner's highest-flying business is movies. Thanks to the success of two films-Harry Potter and the Sorcerer's Stone and The Lord of the Rings: The Fellowship of the Ring, each the first in a series-and the ongoing DVD boom (its revenue in 2001 was $8.76 billion), it is slightly ahead of the flagship America Online Internet division.
The company says its strength is the diversity of its brands-from the movie franchises to its Time Inc. stable of magazines to its America Online Internet service-which, with more than 34 million subscribers, is the world's largest.
"We have a unique mix of diverse businesses," an AOL Time Warner spokeswoman says, "and we are focused on creating sustained and predictable growth for our shareholders."
Though its market capitalization-the total value of its outstanding shares-has declined from some $350 billion when the merger was announced in January 2000 to $96 billion, it is still the largest media company in the world. Viacom is next, at $87 billion. Vivendi Universal is worth $38 billion.
Yet, as some see it, the vast sprawl of AOL Time Warner's media and entertainment businesses is a problem. "The bottom line is that, along with AOL, Vivendi are in the dog house, as far as market perception is concerned," says Nicholas Bell, a media analyst with Bear Stearns in London. "These are big companies, and the trouble is there's always something somewhere that's not going quite right. And when you're in the dog house, that's what people focus on."
At the moment, people are focusing on AOL Time Warner's renegotiation of a cable-TV partnership with the Newhouse family, owner of Advance Publications. If the Newhouse family walks, it could take with it 2.3 million of AOL Time Warner's cable subscribers.
Though the price to retain them may be high-as much as $11 billion-company observers expect AOL Time Warner will make every effort to do so. Late last year, it lost out to Comcast in a bid for the largest company, AT&T Broadband. In 2001, cable generated for AOL Time Warner a hefty $3.2 billion in earnings before interest, taxes, depreciation, and amortization (ebitda)-more than any other division.
Yet the company is also spending $6.75 billion to reacquire a 49% stake in AOL Europe held by Bertelsmann. In early April, AOL Time Warner issued $6 billion of bonds, which is expected to raise its debt level to $28 billion by the end of 2002. Analysts speculate that adding another $10 billion or so in debt to solidify its cable partnerships could put the company at risk of losing its investment-grade rating. That would raise its cost of borrowing money.
The AOL Time Warner spokeswoman says that "we have the financial capacity and flexibility to execute our strategy."
There also are concerns about the rate at which America Online is adding subscribers and the degree to which its margins may be shrinking as it offers promotions and discounts to retain them.
"The real problem with AOL Time Warner is that the AOL service subscription growth is not there," one New York media investment banker says. Any substantial decline at America Online would be serious, as it generated 23% of the company's revenue and 30% of its ebitda in 2001.
In a late-March research report, Lehman Brothers new-media analyst Holly Becker wrote that "the AOL division and advertising in particular" is the "single biggest risk to AOL Time Warner's near-term earnings." She indicated that "a surge in intercompany advertising"-a main driver of AOL's growth-may be subsiding. Becker lowered her forecast for the AOL unit's first-quarter advertising revenue to $535 million-25.8% lower than the same period a year ago; without the benefit of intercompany sales, she estimates it would be 40% lower.
AOL Time Warner executives point out that America Online remains the dominant Internet service; Microsoft's MSN is a distant second, with 7.7 million subscribers. They say that the recent decision to put AOL Time Warner co-COO Bob Pittman back in charge of AOL is a signal that it is taking steps to address any weaknesses there.
In an e-mail memorandum to America Online employees explaining the change, Pittman wrote that "advertising, which remains soft in the entire media sector, is the challenge. Getting this back on track is our highest priority."
The New York media investment banker believes a pickup in the advertising market could go some way toward boosting AOL Time Warner's share price. "It will help the perception more than the reality. The issue with AOL subscribers going down or not increasing as much as they should is not going to be solved in the next three months. But the perception that they're kind of on a roll may."

WHAT IT IS VS. WHAT IT APPEARS TO BE
At Vivendi Universal, the key challenge is becoming what the company says it is. Through a flurry of deals in the past two years, chairman/CEO Jean-Marie Messier has transformed a water-utility company into a media firm that boasts Universal Music Group (UMG), the world's largest music company, and Universal's and USA Networks' film assets.
Yet it remains a hybrid. "It's a complex company," says one analyst who follows the firm. "I'm a media analyst, but half the revenue comes from the utility business."
Bell says, "The trouble with Vivendi, to an extent, is it still looks like a bit of a conglomerate." AOL Time Warner has its America Online Internet service that can serve as a focal point for marketing its collection of media assets, whereas at Vivendi, "there isn't the obvious glue sticking it all together that gives it the ability on a longer-term basis to achieve sustainable growth rates above the industry average."
While other media companies, including AOL Time Warner and Viacom, cut their 2001 growth forecasts during the course of the year, Vivendi did what it set out to do in 2001: grow revenue and ebitda by about 10% and 35%, respectively. UMG dominates the market-share charts, and its film studio is among the best-run in Hollywood.
Still, Vivendi has seen its share price tumble some 40% so far this year, while Viacom is up about 9%. Part of the concern is that 2002 will be a slower year for the Universal music and film businesses. More worrisome, though, may be structural concerns with Vivendi itself.
In a recent research note, Merrill Lynch analysts noted, "In the post-Enron world, investors (rightly so) have placed a heightened focus on debt levels (both on and off balance sheet); financial flexibility, i.e., acquisition capacity; and free cash flow." Vivendi ended the year with 18 billion euros ($15.7 billion)-a figure that's expected to rise once Vivendi shifts from French to U.S. accounting standards when it reports its first-quarter financial results April 29.
In early February, Messier said Vivendi remains "open to good opportunities" but is no longer in the market for marquee acquisitions. "There are no Omissing pieces' in our strategy," he said. "Our priority for 2002 is internal growth [of at least 10%]."
Analysts say Vivendi must focus on reducing debt levels and putting the company in a stronger financial position. That would reassure investors of its soundness and pave the way for acquisitions when the time comes.
Vivendi must also address issues with its non-entertainment businesses. Vizzavi, the European Internet portal it formed two years ago with British mobile-phone company Vodafone, has yet to catch on. Intended for both PC-based Internet users and those on mobile phones and hand-held computers, Vizzavi could claim 6.5 million users at the end of 2001. But in 2001, Vivendi's combined Internet operations-which also include MP3.com and EMusic-produced a combined $184 million in revenue and an operating loss of $301 million. Early this year, Vizzavi cut 100 jobs and Evan Newmark, its CEO since inception, exited.
Cegetel, the telecommunications company in which Vivendi has a 44% stake, is profitable, but Vivendi has been criticized for its practice of recording 100% of its results as its own. While it is allowable, analysts say it is misleading.
On April 12, Canal Plus COO Denis Olivennes, who had butted heads with Messier over the unit's efforts to reach profitability, resigned. Four days later, Messier fired Olivennes' boss, Canal Plus co-founder and chairman Pierre Lescure.
Messier admits that Vivendi is complex, though he and the company are taking pains to assure investors that it is on solid financial footing. When the company announced its 2001 financial results March 5, it hosted three different conference calls with analysts and the media. It also published a list of "Ten Important Accounting Answers" to assure investors it had no off-balance sheet holdings of the sort that were at the center of Enron's collapse.
"The only way you can dispel rumors is through transparency," Messier said at the time. "The price of the transparency is very high, so we have to do a lot of work to get there."
Though both companies are now well into their second year of existence, issues remain from the mergers out of which they were created. Earlier this year, AOL Time Warner and Vivendi both announced that they would be taking multi-billion-dollar write-downs on intangible assets that they carry on their balance sheets.
Such a write-down is not "a damnation of what the company's future prospects are," but it is "a recognition of the fact that things aren't worth" what they had been, says Partha Mohanram, associated professor of accounting at New York University's Leonard N. Stern School of Business. Vivendi's deal to purchase Seagram and America Online's deal for Time Warner were struck during the height of the technology-fueled stock-market boom; the write-downs suggest that each may have overpaid for those assets.
Yet a write-down can have a positive effect on a company's future reported performance, as both AOL Time Warner and Vivendi have acknowledged.
"If you take a large write-off, people typically tend to ignore that write-off, whether it's right or wrong," Mohanram says. "What they don't realize is by doing this huge write-off, essentially the company is setting itself up for higher profitability ratios in the future."
Though a casual observer may conclude that a company is "becoming more lean or efficient, that might not be true. All that might be happening is they've taken a large write-off for goodwill. They've reduced their asset base, and therefore improved their ratios."

CAN THE MARRIAGES WORK?
The big question now for Vivendi and AOL Time Warner is whether they can make cross-divisional initiatives work and fulfill the notion of synergy on which they were founded.
Opinions differ on how well they've done so far. In a recent research note on AOL Time Warner, Goldman Sachs entertainment and new-media analysts wrote that "revenue synergies that the combined company could achieve have been virtually nonexistent to date."
AOL Time Warner officials express satisfaction with cross-promotions, including the promotion of the first installments of Harry Potter and The Lord of the Rings. Every two weeks for the past year, Pittman and Parsons have been gathering the CEOs of all the company's divisions to discuss cross-divisional projects. There are also regular councils that draw together executives from various divisions around such themes as marketing, advertising, and communications.
In its effort to grow without acquisitions in 2002, Vivendi late last year formed a committee of its entertainment CEOs that gathers monthly to manage the integration of its music, film, TV, games, and education assets and further develop cross-divisional initiatives. In February, it announced a new internal policy that gives its business units the right of first and last refusal on any intellectual property created in-house. Business units will be "incentivized to utilize intellectual property resources that are available within the company instead of using third parties."

FALLING OUT OF FAVOR
The collapse of Enron has made investors jittery about stocks of all sorts, even those of such long-revered firms as General Electric (GE). On April 11, when it reported lower-than-expected first-quarter revenue along with a $1 billion non-cash charge related to a decline in the value of goodwill, GE shares closed down 9.3% at $33.75.
On that same day, Vivendi shares in New York fell 5.1% to $31.69. AOL Time Warner closed down 5.3% at $19.60, close to a three-year low.
As companies tied to the Internet continue to fall out of favor, America Online is seeking to reposition itself as a media company. Announcing Pittman's appointment as the new AOL head, AOL Time Warner CEO-elect Richard Parsons asserted that "our revenue, combined with the total amount of time people spend on our service, makes AOL one of the world's leading media companies in its own right."
AOL is adding top executives from the traditional media world. James de Castro, former CEO of AMFM, was recently named its head of interactive services. Pittman-himself a co-founder of MTV-takes over the leadership of AOL from Barry Schuler, whose background is mostly in technology.

BETTER OFF APART?
Yet it is the Internet service that is being discounted by Wall Street. Goldman Sachs analysts noted in their report that AOL's share price is well under "a reasonable sum-of-the-parts valuation of $32." In an observation that seems to cut both ways, they add: "The current discount implies that the individual businesses would be worth more on a stand-alone basis than what the combined company trades at."
Some also wonder how well America Online can parlay its success in the traditional world of dial-up Internet services to the nascent broadband market. The slowness with which it is being rolled out and embraced by consumers is clearly an inhibiting factor in the development of new, Internet-based music and video distribution methods.
In Vivendi's case, the concerns are even more apparent. "The whole AOL Time Warner merger was about merging the online with the content," says one analyst who follows Vivendi. "The Vivendi pitch was, OWell, we've got all these diverse assets, we've got this pay-TV platform in Europe, we've got this mobile platform in conjunction with Vodafone, and we're going to create this multi-access portal.' Now, I don't think there's anyone out there who thinks Vivendi is going to be strong enough to bind it all together."
Messier has gained fame for his acquisitiveness. But the company that he has assembled lacks coherence. Vivendi's finances are so complex that it wasn't until April 15 that it published details of its 2001 financial performance-including its balance sheet-beyond what was contained in a March 5 press release.
In an April 12 research report, Merrill Lynch analysts noted that Vivendi has come under pressure "from a number of stories too numerous to mention." One scenario has Messier ceding some power or exiting altogether. Some analysts are even calculating how high Vivendi shares might rise if he were removed.
On April 24, Vivendi holds its annual general meeting in Paris and announces its financial results for first-quarter 2002. That same day, AOL Time Warner will report its first-quarter numbers. For two companies that once seemed to have it plotted out, the future is increasingly uncertain.