Moody's Investors Service affirmed the Baa1 long-term, senior unsecured and Prime-2 short-term debt ratings of AOL Time Warner Inc. and its 72.4% owned subsidiary, Time Warner Entertainment L.P. Moody's also assigned Baa1 long-term ratings to the new $10 billion senior unsecured bank credit facilities of AOL Time Warner Inc. ("AOLTW"), Time Warner Entertainment L.P. ("TWE"), Time Warner Entertainment - Advance/Newhouse Partnership ("TWE-A/N"), and AOL Time Warner Finance Ireland ("AOLTW Finance"). The only previously unrated borrower in the facility was TWE-A/N. However, the rating outlook for the group has been changed to negative from stable.
The negative outlook reflects Moody's expectation that despite the fact that a definitive agreement has not yet been reached in connection with a TWE negotiated restructuring, some amount of incremental financial risk will likely be required of AOLTW. Such incremental risk for AOLTW would result from both accomplishing its desire to restructure the ownership of TWE and also meet Comcast Corporation's and AT&T's objectives to assure that it can mitigate a portion of the risk of monetizing its ownership stake in TWE in this uncertain market environment. If a negotiated transaction is not struck, then uncertainty regarding debt-like preferred stock issuance to the public by TWE may exist if Comcast/AT&T were to proceed with the registration of its limited partnership interest. Also, without a negotiated deal, we believe that prospects for AOL reaching a broadband ISP carriage arrangement with Comcast/AT&T Broadband for the intermediate future would dim. Any incremental financial exposure (i.e. debt) with an uncertain path to the timing or mode of repayment, could challenge AOLTW's and/or TWE's ability to have their debt-to-EBITDA return to AOLTW's stated target of 3.0 times or less within the near-term, despite targeting a significant portion of free cashflow in 2003 to reduce debt.
Although we understand that the SEC and Department of Justice are conducting investigations, the outlook does not presume that the company's accounting and internal controls are improper in any material respect. If internal controls are found to be materially deficient or accounting practices are not effectively and materially in accordance with GAAP and SEC regulations, more pressure on the ratings will occur.
The outlook also recognizes that company's present financial flexibility, relative to its Baa1 ratings, is constrained following the company's recent acquisition of Bertelsmann AG's 49.5% interest in AOL Europe for $6.75 billion in cash and the acquisition of IPC Group Limited, Britain's leading consumer magazine publisher, for approximately $1.6 billion in cash. The outlook also takes into consideration the significant shortfall in free cashflow generation relative to Moody's original expectations for 2002 and beyond, and the weak ratio of free cashflow to total debt relative to its current Baa1 rating. For 2002, adjusted debt-to-EBITDAR (on a trailing 4 quarters basis, pro forma for acquisitions) is anticipated to be about 3.3 times. The current rating level incorporates Moody's expectation that the company will halt cash or debt financed acquisitions and share repurchasing activity for the near-term. A reduction in fixed capital expenditures over the next twelve months as Time Warner's cable systems will be effectively 100% upgraded by 2002 year end is likely.
The Baa1 rating assignment to the bank facilities is based upon their senior unsecured priority, which are pari passu with the existing Baa1 rated senior unsecured notes and debentures of AOLTW and TWE. Moody's assigned the TWE-A/N portion of the bank facilities a Baa1 senior unsecured rating, as it represents a very large portion of the company's cable TV system assets (over 5 million subs) and it possesses credit metrics that are stronger than those of AOLTW and TWE.
The facilities include a $6 billion 5-year facility and a 364-day revolver with a two-year term out option. They replace three existing bank facilities, which were set to expire in 2002. The facilities are structured to allow senior unsecured borrowings up to the lesser of the total amount of the facilities or the available undrawn capacity, by AOLTW and/or AOL Time Warner Finance. The borrowings are guaranteed by America Online ("AOL"), Time Warner Inc., Time Warner Companies, and Turner Broadcasting System Inc. In addition, AOLTW's 72.4% owned subsidiary TWE may also borrow on a senior unsecured basis, up to the lesser of the total facilities or the available undrawn capacity, and TWE-A/N can borrow on a senior unsecured basis, up to the lesser of $2.5 billion or the undrawn available capacity of the facilities. However, the TWE and TWE-A/N indebtedness are nonrecourse to each other and to AOLTW and its other subsidiaries. Financial covenants include a consolidated minimum GAAP net worth of $50 billion and a maximum leverage ratio of 4.5 times at AOLTW and 5.0 times at TWE and TWE-A/N. The new facilities have no material adverse change clause covering the company's financial position or results from operations, and the financial covenants are not considered to be restrictive such that they could impede the company's ability to draw on the facilities to meet liquidity needs if broader capital market access was limited.
The affirmation of the debt ratings reflect Moody's expectation that the company will endeavor to improve its financial flexibility by bringing leverage back to its stated target of or under 3.0 times debt to EBITDA, its free cashflow generation and its conversion of cashflow from operations to free cashflow on an annual basis, will continue to increase. The adjusted debt to EBITDAR ratio takes into consideration a pro-rata share of debt and EBITDA associated with joint ventures (despite the non-recourse nature of the liability), off-balance sheet securitizations added to debt, significant contingent liabilities and commitments added to debt, and a multiple of off-balance sheet operating leases added to debt, while at the same time giving EBITDA credit for the relative rent expense. Commensurate with the company's financial credit measures, Moody's affirmation considers the company's position as a world leader in media and entertainment, marked by the content richness of their leading brands: Time Warner Cable, America Online, CNN, Warner Bros., People, Sports Illustrated, Fortune, Time, HBO, Warner Music, TBS, and TNT.
The ratings have been and continue to be supported by: 1) the solid liquidity position of the company; 2) continued and expected overall revenue and operating profit growth in 2001, 2002 and 2003, despite the impact on the company's businesses following the September 11th terrorist attacks, and current cyclical pressures on some of the company's business segments; 3) financial leverage levels that at 2003 year-end are expected to be consistent with management's explicitly stated commitments, and Moody's expectation that leverage metrics would be maintained at or under 3.0 times debt to EBITDA; 4) the company's demonstrated ability to maintain and improve its credit metrics; 5) the high predictability of a significant portion of the company's revenues and cashflows (i.e. cable); 6) the extremely high barriers to entry in replicating or competing with many of the company's major franchises; and 7) the significantly increased scale and diversification, and superior capabilities to deliver content via print, Internet, or broadband cable.
With respect to the company's liquidity profile, the group's committed bank debt, cash and internal free cashflow generation exceeds the combination of, the total commercial paper programs (though currently not fully utilized), all off balance sheet securitization programs and the maximum of medium-term annual debt maturities (over $2 billion in 2004) by about 140%. This suggests that there is respectable headroom for unforeseen additional capital needs such as longer-term inaccessibility of the public debt markets or an unforeseen short-term decline in free cashflow, assuming again that the accounting is proper and the company has ready access to its bank facility's unused capacity.
Moody's believes that the company will continue to experience growth in operating profit, despite the prospects of a protracted economic slow down and the company's dependence on advertising. New products and non-cyclical subscriber fees, which make up about half the combined company's revenues, have been less affected by the economic slow down. While Moody's expects online advertising at AOL for 2002 will continue to decline, overall advertising revenues for the company will increase by low single digits. Moody's believes that in order to remain competitive, AOL faces the challenge of converting its substantially narrowband service to broadband, which requires negotiating agreements with other major cable systems other than Time Warner Cable. AOL remains as the largest ISP, with among the most loyal subscriber bases as indicated by lower churn rates than other ISPs.
Moody's believes that the theatrical and television studio production business and library, normally considered an inherently volatile business, will continue to benefit for the intermediate term from a significant syndication backlog and a strong slate of films including the Harry Potter and Lord of the Rings series, set to release another round late this year and next, and with the Matrix set for 2003. However, the segment could be challenged over the longer-term if a protracted ad recession sets in and negatively impacts the negotiation of expiring broadcast output arrangements. Over the near-term, the company should benefit from a relatively strong up-front for the company's WB and major cable networks. The company's music segment has experienced cashflow from operations volatility. This is due to a continued challenging retail environment, inconsistent artist product delivery, a competitive global environment, increasing costs, and a slow if not uncertain transition to new delivery mechanisms (compact discs to DVD Audio and the Internet). Despite these factors, the segment remains profitable with healthy returns on capital and music publishing provides a steady recurring cash stream. The company has a very strong magazine franchise that operates in a competitive landscape. With the IPC Media acquisition the company has geographically diversified its magazine assets. In addition, the company's major magazine titles, including Time and People, command a disproportionate share of industry revenues and profits. This factor has mitigated to some extent the negative impact on operating profit that has occurred from advertising contraction.
AOL Time Warner, Inc. and its 72.4% owned subsidiary Time Warner Entertainment L.P., with their headquarters in New York City, New York, together are a global diversified media and communications company, with interests in interactive communications and services, cable television systems, cable television networks, magazine and book publishing, recorded music and music publishing, television and filmed entertainment production and libraries, and professional sports teams.
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