Bull!

by Maggie Mahar

  AOL carpet-bombed America with the disks needed to use its service: flight attendants handed them out on American Airlines. They came packaged with flash-frozen Omaha steaks. You could find them on your seat at a football game. Yet the cost of the marketing extravaganza was not subtracted from profits on AOL’s annual earnings statement. Instead, it was labeled an “investment”—as if AOL had invested in new equipment.

  AOL justified postponing showing the expense: the company argued that the new subscribers would be with the company for 41 months. Sloan asked the obvious question: Of AOL’s current customers, “How many have been around for 41 months?”

  “Almost none,” conceded Lennert Leader, AOL’s chief financial officer.

  “AOL had signed up most of its customers in the previous 36 months,” Sloan explained. “Leader said the 41-month average life number comes from projections.”6 AOL’s projections were, to say the least, rosy: at the time Jupiter Communications, an Internet research and consulting firm based in New York, reported that commercial online services usually lost 40 percent of their customers each year. Before long, AOL’s “churn” rate would be even higher.7

  The short sellers were onto the accounting scam: David Tice was among those known to be shorting the stock. But the shorts were taking a drubbing: in the six months ending in November of ’95, investments representing a bet against America Online had lost around $400 million, according to Laszlo Birinyi, who tracked money flows for Birinyi Associates.

  Small wonder. While the shorts sold AOL, mutual fund managers were scooping up the shares. “No one came close to forecasting how fast America Online would grow,” Lise Buyer, a fund manager at T. Rowe Price Associates, said in the fall of ’95. “What the shorts can’t understand is that Wall Street, witnessing such growth, is willing to overlook the company’s losses and well-known aggressive accounting methods.”8

  But the “growth” she was talking about was a growth in the number of subscribers, not a growth in earnings. The cost of acquiring those customers was so high that AOL had not, in fact, yet turned a profit—though thanks to its creative accounting, it was reporting profits.

  Sloan continued to track the stock. By May of 1996, it was clear that AOL had a new and formidable rival: the Internet. In the past, the company’s promoters claimed that the key to AOL was content, pointing to websites such as “The Motley Fool,” an online forum for financial news and gossip available only to AOL customers. But those days were gone. Now, anyone could access The Motley Fool on the Net.9

  In the seven months since Sloan had last reported on the company, AOL’s books had deteriorated. “By my math, AOL ran through $185 million in the nine months that ended on March 31,” Sloan observed. Yet it was still sweeping promotional costs under the carpet—putting off the day when it would have to subtract them from profits. Sloan calculated that the hidden pot of deferred expenses now totaled $315 million.

  Meanwhile, the customers AOL paid so dearly to acquire were whirling through a revolving door. In the March quarter, AOL added 2.2 million new customers—but lost 1.3 million old customers. And now AOL was succumbing to the rate war, announcing that in July, it would begin offering 20 hours for $19.95—cutting a 20-hour user’s bill by almost 60 percent.10 Nevertheless, when Sloan interviewed AOL’s Steve Case that spring, Case appeared unperturbed.

  It was not, after all, Case’s style to emote. Calm, even placid, and always dressed for his Gap ad—khakis, polo shirt, and sneakers—the moonfaced Case appeared unflappable. He had no edge—or so it seemed. One colleague described him as “catlike…always sitting in the back of the room, and watching everything going on. But you couldn’t draw him out. Thoughtful? Yes. Charismatic? No. There was no output.”11

  True to form, in the interview Case could not be drawn into argument. He brushed aside questions about profits: “Only 11 percent of U.S. households are on-line,” he pointed out. “Why aren’t the other 89 percent? They think it’s too hard and too complicated, and they’re right.” Without AOL, he seemed to suggest, Americans would never be able to figure out how to log on to the Net.

  When Sloan wrote about AOL in May, the stock had just lost 25 percent of its value, down from an all-time high of $71 earlier in the month. Long-term buy-and-hold investors had reason to worry. Meanwhile, Sloan reported, Case himself already had cashed in $19.7 million of AOL options. This is not to say that Case was unconcerned about the slide. He still had the company’s future to think about—plus options and stock worth another $100 million.

  That summer, the pressure was mounting. In June, William Razzouk, a veteran FedEx executive who had been brought in to help steady the ship, quit as president and COO after only four flabbergasted months on the job. (A southern gentleman with a penchant for order, Razzouk had not fit into the company’s freewheeling culture.) Razzouk might also have been perturbed that the Federal Trade Commission was looking into AOL’s billing practices amid class-action suits charging AOL with overbilling.12 Granted, Mary Meeker was still loyal—she had just raised her rating on the stock from “outperform” to “strong buy.” But in August, a service blackout infuriated customers—America Online was on its way to becoming known as America Onhold. Meanwhile, Case knew that the new rate of 20 hours for $19.95 was only the first step on the slippery slope to unlimited access for a flat fee.

  Desperate to maintain its cash flow, AOL began to actively research how it might generate more revenues from “adult content.” According to Swisher, the notion was that AOL would create an optional “adult only” channel directly on the service; users would pay a surcharge to be linked to “adult” material culled from the Internet. The question was how to turn porn into profit without undermining AOL’s apple pie image. In August, a month after cutting its rates, the company went so far as to conduct focus groups testing the idea. According to a confidential memorandum, dated August 7, 1996, “After much thought and discussion,” the response in the eight focus groups was “resigned disappointment.”13 Ultimately, however, management dropped the idea.

  In the meantime, the company tried to pump up subscriptions, sending two demonstration trucks on a 30-city tour of downtown shopping malls and fairs across the United States, showering the nation with millions of free disks. The cash expense of the campaign: $240 million to $300 million that summer and fall—twice as much as the two major presidential campaigns were spending, according to USA Today.14

  In November of ’96 Sloan wrote about AOL again—for the third time in 12 months.15

  His AOL stories had not been well received. “I was in serious disfavor where I worked,” he recalled in 2002. “It became more and more of a struggle to get these stories into the magazine. You’d think I was criticizing God. I just kept writing it because I felt I really needed to do it.”16 Sloan was not the only journalist to question AOL’s numbers, but, in the mainstream press, he was the toughest and the most persistent. And his analysis carried a punch: it was written in a way that individual investors could understand.

  AOL continued to mask the size of its expenses. “In the twelve months ending June 30 of 1996,” Sloan reported, “AOL spent some $363 million on promotion—a third of its total revenues. However, AOL charged only $126 million of promotional costs against its profits. The difference of $237 million,” Sloan observed, “was lots more than the $65 million pretax profit AOL claimed.” Indeed, over the years, he calculated, AOL had inflated its profits by some $885 million—“us[ing] these nonexistent profits to bill itself as a money-making company.”17

  On Wall Street, AOL’s aggressive accounting had been an open secret for years. But by the fall of 1996, the pot of deferred expenses had become difficult to ignore. At about the same time, AOL realized that as rivals moved to unlimited access for a flat fee, it could no longer rely on hourly fees for earnings. It needed a new profit center. Now AOL turned its attention to courting advertisers.

  Enter Bob Pittman, who stepped into the job Razzouk had fled. A media-savvy promoter best k
nown as one of MTV’s founders, he came on board with good news: AOL was not an Internet company. It was a media company. Advertisers would provide the revenue it needed to keep going.

  Pittman slashed AOL’s swollen marketing budget and helped refocus AOL’s strategy. In meeting after meeting with analysts, Pittman “repositioned” AOL as a burgeoning media empire. A Harvard Business Review study praised Pittman for the way he “laid siege at once to analysts and investors specializing in cable TV and other mass media and set out to educate them. He held analyst meetings at AOL’s corporate headquarters every six months, conducted an ongoing road show for the financial community for more than three years, invited key analysts to meet one-on-one with himself and Case, and directed AOL’s investor relations staff to work closely with analysts’ assistants.”

  The case study wound up by congratulating Pittman for his handling of both Wall Street and the media: “During Pittman’s first full year as president…AOL held twice as many analyst conference calls and received ten to 20 times the coverage in media and entertainment publications as any other company in its then peer set, which included Yahoo! and Lycos.”18

  Pittman’s goal was to “brand” AOL. “Pepsi won all the taste tests,” he liked to point out, “but Coke had the brand name.” When asked whether that meant that American consumers could be brainwashed into buying inferior products simply because advertising has reached Orwellian levels of effectiveness, his reply suggested just a tinge of contempt for the consumer: “The consumer is not a scientist. The consumer is not willing to spend the time it takes to do a research project to compare everything feature for feature.”19

  Ergo, the package was all-important. The consumer would not take the time to check the contents. Indeed much of the unique “content” that AOL had to offer the public was, like the Motley Fool’s investment advice, of questionable value. But in an age of supersonic information, a company’s product was like its stock: as things speeded by, appearance was everything. Questions of intrinsic value fell by the wayside.

  Certainly, Pittman was right on the main point: AOL was a media company. It had virtually nothing to do with technology, everything to do with gathering eyeballs and trying to sell them something. Brian Oakes, an analyst for Lehman Brothers, translated the new business model for Wall Street: “In the future, the company will generate the majority of its profits from advertising and transactions. While these revenues make up only 13% to 17% of total revenues, they will contribute 70% of the profits.”20

  How did Oakes know advertising would contribute 70 percent? Why not 60 percent? Or 75 percent? No doubt, it was a “projection.” At this point many of the numbers that passed for “information” were simply judgments—and biased judgments at that.

  As AOL redefined its business model in the third quarter of 1998, Case finally responded to pressure from critics who questioned the company’s bookkeeping. From that point forward, he announced, AOL would deduct its promotion expenses from earnings as it spent the money—“the way a normal company does,” Sloan remarked. It also would take a charge of $385 million to write off a portion of the marketing investments it had already made. The $385 million, Sloan explained, was “the money AOL had spent but hadn’t charged against profits, and [instead] counted as an asset.” In the same press release, AOL announced that it was introducing flat-rate pricing.21

  Incredibly, AOL’s admission that for years it had been, in effect, lying to investors about its profits did not seem to chill their enthusiasm. On the news of the accounting changes, the stock jumped 12 percent in two days. After all, AOL explained to its many admirers, “it’s just bookkeeping.”

  Back at Newsweek, Allan Sloan was rubbing his eyes. He could not quite believe investors’ willingness to forgive and forget the $385 million. That special charge “wiped out most of AOL’s net worth, plus all the profits it claimed to have made in its entire 11-year history,” he wrote. “But guess what? Wall Street loved it. This despite the fact that neither the financial rebooting nor AOL’s hiring of the highly touted Bob Pittman, a cofounder of MTV, solves AOL’s crucial business problem: how to make money online when the Internet offers so much free stuff.”22

  Eventually, Sloan was worn down. It was not just that his bosses objected to his constant carping about AOL’s numbers. In the nineties, few readers appreciated a Woodward and Bernstein approach to financial reporting. Indeed, a year later, Time magazine would be lauding Steve Case’s “visionary” skills in an article headlined “How AOL Lost the Battles but Won the War.”23

  “I knew I was right, but whenever I published one of these stories, everyone would carry on,” Sloan recalled. “Finally I just gave up. I shouldn’t have, but I did. There are only a limited number of swings you can take—eventually you look like a crank.”24

  Nevertheless, Sloan’s view of AOL would prove prophetic: “The bottom line: I think AOL’s stock market value of $6.8 billion is way too high,” he wrote in May of 1996. “Then again, I thought its $4 billion valuation seven months ago was too high. Even Steve Case’s best scrambling can’t prop up AOL’s stock forever. Someday, he’s going to have to score by showing real profits or pull off a financial Hail Mary miracle play by selling AOL. Know a good, hungry phone company?”25

  No, but four years later, Case would find a good, hungry media giant. And in January of 2000 he would pull off his Hail Mary by announcing that he was passing the ball to Time Warner’s shareholders just minutes before the clock ran out. (Actually, he was three months ahead of the clock: the technology meltdown would not begin until March.) Over the next two years, AOL Time Warner shareholders would watch the media marriage of the century crumble while charges of flimflam accounting mounted.

  In 2002, Lise Buyer, the mutual fund manager who had explained that the shorts “just didn’t understand that Wall Street was willing to overlook AOL’s aggressive accounting,” looked back on AOL’s rise. By then, Buyer herself had become disillusioned with Wall Street and had gone west to become a venture capitalist. Yet, she still tried to rationalize the way AOL conjured up profits in the mid-nineties: “Maybe you could say that, by cooking the books, they saved the company?”26 The question mark in her voice belied her words. It seemed that Buyer herself did not truly believe her own halfhearted explanation.

  What some liked to refer to as AOL’s “accounting shenanigans” had represented more than a onetime attempt to paper over an earnings gap until the fledgling company could get on its feet. People who cheat once cheat again. And again—and again. The saga of AOL’s bookkeeping would prove another example of how, in a market driven by momentum rather than value, the more you lie, the more you have to lie, to keep the merry-go-round turning.

  No surprise, then, that in 1997 the SEC once again caught AOL in a compromising position. Just a year after supposedly cleaning up the questions about those marketing expenses, AOL reported that now, at last, it could report true profits. It seemed a key turning point for an embattled company. But within months, AOL had to retroactively erase that quarterly profit. The SEC told AOL that it had prematurely booked millions of dollars of revenue from a major deal.27

  As the next century began, AOL would still be restating its revenues. In 2000, the company agreed to pay a $3.5 million fine to settle charges that it used improper accounting during the mid-1990s to report profits when it was actually losing money. Two years later, AOL Time Warner found itself in the embarrassing position of restating its financial results for the past two years, reducing revenues by $190 million, as the company disclosed it had uncovered more “questionable advertising transactions” at its troubled America Online unit.28 In 2003, the SEC reported that not only had AOL been cooking its own books, it had been helping other companies to cook theirs.29

  But then again, how did you think that AOL “courted” all of those advertisers? This would become yet another subplot in the story of the bull market’s rise and fall.

  —12—

  MUTUAL FUNDS: MOMENTUM VERSUS VAL
UE

  Imagine a country, a fundamentally prosperous country, where a network of brilliant people decides daily how resources get moved around. These people—not a cabal, but a decently spread-out group—determine the nation’s savings, its spending, its capital budgets. They make rational decisions based on what the world will look like far in the future. They work with the tacit approval of government and industry. Though the sometimes brutal decisions they make may not always represent the best possible allocation of the country’s resources, they come pretty close. And, when they make a mistake, they are replaced by abler, more aggressive people. What is this wondrous kingdom?…It’s the United States in the nineties. And the wizards who rule so benevolently are identified by the somewhat banal title “mutual-fund manager.”

  —James Cramer, October 19961

  MOMENTUM PLAYERS

  When James Cramer penned his paean to mutual fund managers in October of 1996, he was exaggerating their power—but not too much. The mutual fund industry now commanded roughly 15 percent of the market, up from 7 percent in 1990. In another two years, the industry would boast assets equal to three times the federal budget.

  The mid-nineties had marked a turning point for the individual investor. In 1995, for the first time in decades, Americans reported that they had more of their savings stashed in the stock market than in their homes.2 But the stampede into mutual funds that invested in stocks was just beginning: that year equity fund sales reached an all-time high of $306.7 billion, up 13 percent from the 1994 record of $270.8 billion.3