Officials Probe AOL's Actions With Partners - Its Tough For An Honest Company To Compete

Monday August 26, By Julia Angwin and Martin Peers, Staff Reporters of The Wall Street Journal

For America Online, investing in companies that then advertised on the Internet service was about as crucial to its growth as taking in oxygen. Literally.

Last year, AOL invested $30 million to $50 million in Oxygen Media Inc. and arranged for the women-focused cable channel to be carried on parent AOL Time Warner Inc.'s cable systems. At the same time, Oxygen agreed to buy about $100 million in ads that mostly ran on America Online -- a hefty amount for a start- up media company.

The Oxygen trades were one of the many complex deals that were a way of life at the America Online unit -- and many other technology companies -- during the boom years. At AOL, these deals sometimes included an investment. Other times, AOL squeezed its suppliers for advertising revenue. Either way, the deals weren't much of a secret -- AOL was proud of its ingenuity in crafting the arrangements and expected AOL partner companies to buy ads on AOL.

"If we're one of their big customers, we expect them to be one of our big customers," Robert Pittman, the since-departed chief operating officer, said in an interview last year.

That customer coziness, though, is now coming back to haunt AOL as federal investigators at the Securities and Exchange Commission and the Justice Department pore over dozens of deals AOL struck with its partners. Earlier this month, AOL said in an SEC filing it may have inappropriately recognized as advertising revenue $49 million from three transactions. At least one of these transactions was a round-trip deal with WorldCom Inc., which counted AOL as one of its biggest customers.

While AOL declined to comment on specific transactions, the company's internal investigators are scrutinizing scores of deals done by the America Online unit - - including the one with Oxygen -- as part of an inquiry to determine the extent of the accounting problems at its Internet division. The company hopes to finish its probe by the end of the third quarter, at which point it could decide to restate past results.

A key question in the round-trip deals is whether AOL and its partners placed fair values on the assets they were exchanging. Accounting experts say barter transactions are all right, but only if they are valued fairly. People familiar with the investigation of the AOL-WorldCom relationship say the transaction involved inflating of revenue on the AOL side of the deal. A WorldCom spokesman said investigators are reviewing all of the telecommunications company's accounting.

A similar swap deal with Qwest Communications International Inc.is also likely to come under scrutiny, said a person familiar with AOL's internal investigation. A spokesman for Qwest, which the SEC is investigating for its own accounting issues, said the company is cooperating with the SEC.

And some investors are starting to worry that as these deals get unwound, AOL's cash flow could decline further. "If WorldCom stops advertising on AOL and AOL still needs the services WorldCom provided, then AOL could lose the ad revenue but still incur an expense from either WorldCom or another provider resulting in less cash flow," Goldman Sachs analyst Anthony Noto wrote in a note to investors Friday.

Some of these deals were sizable. One of the biggest such arrangements was struck in 1999 when AOL invested $1.5 billion in Hughes Electronics Corp., which owns DirecTV. At the same time, Hughes promised to spend $1.5 billion on marketing and joint development of new products for various AOL and DirecTV initiatives -- including a promise to spend more than $150 million marketing to America Online subscribers. So far, no new products have been brought to market under the venture. Hughes declined to comment.

But it is hard for investors to sort out which of AOL's many round-trip deals are problematic. After all, many of them were fully disclosed. For example, in 1998, America Online agreed to buy $500 million in computer equipment and services from Sun Microsystems Inc. over four years. At the same time, Sun guaranteed that America Online would receive $350 million in advertising and software licensing fees over three years. The transactions were disclosed in an AOL filing with the SEC in 1999. A Sun spokeswoman declined to comment on the arrangement.

Even so, many Wall Street analysts were surprised earlier this year when America Online said its ad revenue was declining in part because of the dissolution of the Sun agreement. They hadn't realized what a big chunk of AOL's profit -- as measured by earnings before interest, taxes, depreciation and amortization -- was due to that arrangement.

"The question is whether investors would have to know more than AOL was disclosing about the mutual back-scratching nature of the transactions," said Doug Carmichael, director of the Center for Financial Integrity at Baruch College in New York.

These days, AOL is making an effort to provide more details about its online advertising revenue. In a recent SEC filing, the company said America Online's top 10 advertisers accounted for 42% of the unit's U.S. revenue during the first six months of the year, compared with 29% a year earlier.

The Oxygen arrangement was somewhat complex. In April 2001, Oxygen and AOL signed a three-part deal in which AOL agreed to carry Oxygen's cable network on Time Warner Cable systems and invested $30 million to $50 million in Oxygen. At the same time, Oxygen agreed to spend roughly $100 million advertising on AOL Time Warner properties, mostly on the America Online service. The advertising ran from about the second quarter of 2001 through the second quarter of this year. For the AOL division, the commitment from Oxygen was significant: At the time, online advertising was declining. The $100 million represents 3.4% of America Online's ad revenue over the five quarters.

The deal raises questions about the real business purpose behind Oxygen's advertising commitment. The AOL agreement came four months after Oxygen had cut the number of Web sites it operated from more than a dozen to four -- a move Oxygen says reflects its decision to consolidate its promotion on a smaller number of sites.

Oxygen's chief operating officer, Lisa Gersh Hall, insisted the agreement was an "excellent deal for us" because it met three criteria Oxygen sought: an equity investment, cable carriage and online promotion. She said Oxygen didn't commit to buying advertising in order to get the cable carriage. But when she was asked whether Oxygen would have bought advertising if it wasn't seeking carriage, Ms. Hall said it was a three-part deal and "I wouldn't separate" any of the elements.

Ms. Hall said that at the time of the deal, the online space was a "key strategic priority for the company." Since the deal was announced, Oxygen has shrunk its Web presence even further, reducing the number of its sites to just two, Oxygen.com and Oprah.com. Ms. Hall said that while AOL was effective at driving traffic to Oxygen's Web sites, Oxygen wasn't able to "monetize" the traffic by selling advertising. "The deal was less lucrative than originally anticipated," Ms. Hall said. She added that the advertising deal also helped promote Oxygen's cable network.

-- Andy Pasztor contributed to this article.