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AOL: Goodwill punting

Everyone expected AOL Time Warner last week to temper its earnings outlook for 2002. But no one saw AOL casually acknowledging that its asset base has shrunk up to $60 billion since it acquired Time Warner a year ago and that a massive charge against net earnings is due at the end of the first quarter.

AOL acknowledged that 2001 results weren't as perky as forecast even in recent months and that 2002 looks to be worse. AOL said revenues this year will grow a sleepy 5%-8% and cash flow 8%-12%. Advertising for AOL's online service, cable networks and magazines is getting hammered.

But the write-off proved startling. AOL Time Warner CFO Wayne Pace said new accounting standards will prompt a write-down of $40 billion to $60 billion of past acquisitions on its balance sheet. Put that another way: That's 25%-30% of the company's asset base.

The company did not specify what assets that it covers, but one analyst said the company is writing down much of the value of Time Warner, which was acquired for $147 billion.

The move is a non-cash write-off and, hence, does not affect the company's operation or cash flow. But it does highlight that the recession and Internet bust didn't just flatten teeny, revenue-free startups but have savaged the holdings of even huge companies with established operations.

But the bulk of AOL's write-off is the value of cable systems, networks, film libraries and magazine titles of Time Warner. The assets being written off are not so much the Internet assets that AOL brought to the table when it completed the Time Warner takeover last January.

"The numbers are gigantic, but then, the company is gigantic," said Sanford Bernstein media analyst Tom Wolzien.

The move is related to new standards on how companies account for acquisitions, Financial Accounting Standard 142. Takeovers create what is called "goodwill" on a company's balance sheet. A cable system, for example, has copper wires and other video gear worth perhaps $1,000 or so per subscriber. But companies are priced according to the amount of cash they are expected to generate, so cable-system buyers are willing to pay $4,500 or so per subscriber.

The difference between those numbers is goodwill. And, like other assets, goodwill is depreciated a little bit each year, which depresses the net income companies report even though it doesn't affect how much actual cash they generate.

Writing off that goodwill doesn't really hurt anything, but it does help in one way. New accounting rules make a company's return on invested capital more significant. Shrinking the book value of assets will make AOL's ratio—currently just 2.5%—look better even if cash flow doesn't increase.

Media companies that have made huge acquisitions in recent years, including Viacom, AT&T and Charter Communications, are most likely to take large write-offs.

"This is your one-time chance to open up the closet and bring out the skeletons," said Wolzien. "It's Halloween time in television.