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THE DEAL MAKERS : How AOL Hit Its Numbers

Unconventional Transactions Boosted Sales

Amid Big Merger, Company Resisted Dot-Com Collapse

By Alec Klein
Washington Post Staff Writer
Thursday, July 18, 2002; Page A01

First of two articles

In October 2000, a critical question confronted America Online Inc. as it sought to clinch the largest merger in U.S. history: Was it feeling the effects of an industry-wide slowdown in advertising?

AOL's president at the time, Robert W. Pittman, offered a resounding answer: "I don't see it, and I don't buy it," he told Wall Street stock analysts and the media.

AOL Time Warner directors are scheduled to approve the name change at a meeting on Thursday in New York, according to people close to the board. (File Photo - Associated Press)

_____AOL Responds_____
AOL Says Accounting 'Was Appropriate' (The Washington Post, Jul 18, 2002)
_____AOL Series_____
Part II: Creative Transactions Earned Team Rewards (July 19, 2002)
Sidebar: Unorthodox Partnership Produced Financial Gains (July 19, 2002)
The Heart of a Deal: How America Online Brings Advertising Deals to Fruition
Excerpt of AOL E-mail
A Rocky Road: Graphical Timeline Tracks AOL Stock Price
AOL Documents and Deals Reviewed by The Washington Post
_____Time Warner_____
Stock Quote and News
Historical Chart
Company Description
Analyst Ratings
Timeline: Time Warner Highlights
Company Downsizing Actions
_____Time Warner News_____
Former AOL Chairman Heads Luxury Travel Firm (The Washington Post, Nov 23, 2004)
Time Warner Nears Deal Over AOL Accounting (The Washington Post, Nov 23, 2004)
AOL Concentrates On Security Issues With New Software (The Washington Post, Nov 18, 2004)
More AOL Time Warner News

Other AOL officials were less optimistic. While overall revenue from online ads continued to grow rapidly, internal company projections raised caution about one sector: dot-coms. Failures were accelerating among those Internet start-ups, which represented a significant amount of the company's ad business.

About two weeks before Pittman's declaration on Oct. 18, he and other executives were told in a meeting at Dulles headquarters that AOL faced the risk of losing more than $140 million in ad revenue the following year.

That would equal only about 5 percent of AOL's proceeds from advertising and commerce. AOL projected that most dot-com clients would still be able to pay their bills. But the internal warning came when investors were highly alert to any weakness in online advertising. Just a week before Pittman's public statements, for example, shares of AOL's key competitor, Yahoo Inc., plunged 21 percent after the company reported strong ad growth but acknowledged that the pace could not be sustained. A day before Pittman spoke, AOL shares dropped 17 percent on what analysts described as similar worries.

In such an atmosphere, and with its takeover of Time Warner Inc. imminent, AOL sought to maintain its breakneck growth in advertising and commerce revenue. Besides selling ads on its online service for cash, AOL boosted revenue through a series of unconventional deals from 2000 to 2002, before and after the merger, according to a Washington Post review of hundreds of pages of confidential AOL documents and interviews with current and former company officials and their business partners.

AOL converted legal disputes into ad deals. It negotiated a shift in revenue from one division to another, bolstering its online business. It sold ads on behalf of online auction giant eBay Inc., booking the sale of eBay's ads as AOL's own revenue. AOL bartered ads for computer equipment in a deal with Sun Microsystems Inc. AOL counted stock rights as ad and commerce revenue in a deal with a Las Vegas firm called PurchasePro.com Inc.

AOL also found ways to turn the dot-com collapse to its advantage, renegotiating long-term ad contracts it risked losing into short-term gains that boosted its quarterly revenue.

One AOL executive raised questions internally about some of the deals. Robert O'Connor, then vice president of finance for AOL's advertising division, said he outlined his concerns in a series of meetings last year and this year with Pittman, now in charge of the online division; David M. Colburn, who oversees its business affairs; J. Michael Kelly, chief operating officer of the online division; and other high-ranking company executives.

"Clearly, a lot of what they were living on was revenue that was not of the highest quality," said O'Connor, who resigned in March. "I don't know if they're still in denial, but there were some pretty big business issues they were not willing to face. For nine months, I tried to get these guys out of denial. I tried to take the perfume off the pig."

AOL said the deals were handled properly and the company "maintained a strict and effective system of internal controls." The company said the total revenue represented by all the deals reviewed by The Post was "truly microscopic" -- less than 2 percent of AOL's overall revenue, including subscriber fees -- and therefore immaterial to the company's business.

"The accounting for all of these transactions is appropriate and in accordance with generally accepted accounting principles," wrote Thomas D. Yannucci, a lawyer hired by AOL to respond to The Post's questions. "The disclosures in AOL's financial statements are appropriate and accurate. AOL's statements provide our investors with all appropriate material information about our business."

Further, he wrote, the company's outside auditor, Ernst & Young LLP, found the deals to be in accordance with generally accepted accounting principles. The auditor declined to discuss its review, citing the confidentiality of client matters, but H. Stephen Hurst, an Ernst partner, released a statement at AOL's request saying the firm stands by its original view that the accounting and disclosures were appropriate.

AOL officials declined to be interviewed on the record about the transactions.

The Post reviewed a number of AOL's advertising and commerce deals, focusing on several transactions that added up to $270 million. That represented a small portion of AOL's nearly $5 billion in ad and commerce revenue during the period reviewed, July 2000 through March 2002.

Without the unconventional deals, AOL would have fallen short of analysts' estimates of the company's growth in ad revenue (which is reported in a category that also includes revenue from commerce) in three quarters in 2000 and 2001.

Collectively, the deals helped AOL beat Wall Street analysts' expectations for earnings per share -- a crucial profit yardstick for investors -- by a penny per share in two quarters in 2000. At the time, investors punished companies whose earnings were off by even a cent. On the day AOL announced its earnings that October, Apple Computer Inc. said it missed Wall Street's reduced projections for its earnings by one cent, sending its shares down 6 percent a day later.

Revenue Targets

The driving force behind these deals was the powerful business affairs division within AOL, a hard-charging unit of 100 or so deal makers, including many lawyers, who helped negotiate and finalize most of AOL's largest transactions. Inside AOL, the unit was known simply as "BA" and some of its deals were called "BA specials," an allusion to the aggressive ways the division generated revenue.

Former and current AOL employees said company executives were partly motivated to meet revenue targets by the pending $112 billion all-stock acquisition of Time Warner. Even though this merger deal contained no dissolution clause that would be triggered if either partner's stock fell too far, company sources said that some AOL officials feared that if AOL stumbled, Time Warner shareholders could begin clamoring to end it anyway. Time Warner under some circumstances could have backed out of the deal by paying a breakup fee of about $4.4 billion.

"The bubble had clearly burst, but senior management was under enormous pressure to hit the [financial] numbers and close the Time Warner transaction, which would diversify the revenue base and lower the risk profile of the company," said James Patti, a senior manager in AOL's business affairs division at the time.

Patti said he told senior executives he was uncomfortable with some of the transactions pushed by his unit. Shortly after receiving a merit promotion, Patti was laid off in 2001, a move he said he believes was directly related to his refusal to participate.

"I had been asked to paper many of these questionable deals and was unwilling to cooperate, making my concerns known to management," Patti said. "The layoff came exactly one week later. Ultimately, I was happy to leave the company with my integrity and professional ethics intact."

AOL declined to comment on the departures of Patti and O'Connor. It disputes their characterization that it resorted to questionable deals to maintain strong ad revenue growth in the fall of 2000. In its written responses to The Post, AOL said its ad and commerce growth rate was healthy by any measure -- 80 percent higher during the quarter that ended Sept. 30 than a year earlier. It added that failing dot-coms accounted for only a fraction of its overall business and that other, more stable companies were more than making up that revenue.

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