Accounting is terribly important to AOL. The better its numbers look, the more Wall Street loves it and the easier AOL can sell new shares to raise cash to pay its bills. By my analysis, the company is running a cash deficit of about $75 million a year, covering up the shortfall with perfectly legal accounting techniques and covering its cash deficit with money from stock sales. If AOL can’t sell stock, it’s got big trouble. At the least, it would have to drastically scale back its expansion plans. So what about the high-tech accounting that transmutes AOL’s operating losses into profits? “The SEC reviewed our 10K [annual report] and blessed it,” said AOL’s chief financial officer, Lennert Leader. But the point isn’t that AOL violates the rules–it clearly doesn’t. The point is to show how you can satisfy the rules and still make it incredibly difficult for investors to know what’s going on.
This is a particularly good time to look at AOL, because on Oct. 10 it raised about $100 million by selling new shares. AOL sold the stock even though its shares had fallen to $58.375 from about $72 in September, when the sale plans were announced. Most companies would have delayed the offering, waiting for the price to snap back. AOL didn’t, prompting cynics to think the company really needed the money, if only because its trade accounts payable had ballooned to $85 million as of June 30 from $16 million a year earlier. Leader’s response: “We’re not in the business of trying to roll the dice by timing the market . . . we sold into the technology meltdown.” Had the stock fallen somewhat lower–he wouldn’t say how far–Leader said AOL would have canceled the offering. Forgive me, but I think AOL wanted to build a war chest because deep-pocketed rivals like Microsoft are starting an online price war. Because new competitors are emerging. And because the No. 2 online company, CompuServe, recently adopted aggressive accounting techniques and is girding for war.
One of AOL’s hidden assets is the brilliant accounting decision it made to treat its marketing and R&D costs as capital items rather than expenses. It’s really neat. A capital item–something long-lived like a power plant–gets charged to your expenses over a long period. That’s because you want to match the cost of a long-lived asset to its long life. AOL says marketing and R&D create long-lived customer accounts. By my math, these capitalized expenses totaled about $130 million last year, a lot of money for a $400 million company.
Even though AOL shells out the cash immediately, it charges R&D to expenses over a five-year period, a very long time in the online biz. In July, AOL began charging off marketing expenses over two years, up from about 15 months. Had the new policy been in effect in fiscal 1995, AOL would have reported operating profits of about $50 million rather than $23 million.
Why change to 24 months from 15? Leader said it’s because the average life of an AOL account has climbed to 41 months from 25 months in 1992. How many AOL customers have been around for 41 months? Almost none, as Leader concedes. That’s understandable, considering that AOL has added virtually all its customers in the past 36 months. Leader says the 41-month average life number comes from projections. Of course, it will take years to find out if he’s right. What happens to the costs AOL defers? Funny you should ask. Using standard accounting, AOL turns them into “product development costs” and “deferred subscriber acquisition costs,” which become an asset on its balance sheet. These totaled $96 million as of June 30. That’s up from $34 million a year earlier. Translation: AOL’s profits would have been $62 million lower had it charged off these expenses as incurred, rather than treating them as capital items.
None of this means that AOL is going out of business tomorrow. But AOL is riskier than it seems to be, and needs to sell stock periodically to meet its bills. The point for tech investors: don’t be so blinded by the glamour of online that you forget to look at the real bottom line.
