Item 1. Business
Time Warner Entertainment Company, L.P. (“TWE”) is engaged principally in three fundamental areas of business:
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Cable, consisting principally of interests in cable television systems and high speed data services;
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Filmed Entertainment, consisting principally of interests in filmed entertainment and television production; and
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Networks, consisting principally of interests in cable television and broadcast network programming.
TWE is a Delaware limited partnership that was formed in 1992. Prior to the completion of a restructuring of the TWE partnership (see below), AOL Time Warner Inc. (“AOL Time Warner”), through its wholly owned subsidiaries, owns general and limited partnership interests in 72.36% of the pro rata priority capital (“Series A Capital”) and residual equity capital of TWE and 100% of the junior priority capital. As a result of the November 2002 merger of Comcast Corporation (“Comcast”) and AT&T Corp.’s (“AT&T”) broadband businesses, including AT&T’s interest in TWE, the remaining 27.64% limited partnership interests in the Series A Capital and residual equity capital of TWE is held by two trusts (the “Comcast Trusts”), all of the beneficial interests of which are owned by a subsidiary of Comcast. See “TWE Restructuring,” below, for a discussion of the equity interests in TWE upon the completion of a restructuring of the partnership.
During the second quarter of 2002, prior to the completion of Comcast’s acquisition of AT&T’s interests, AT&T exercised a one-time option to increase its ownership in the Series A Capital and Residual Capital of TWE. As a result, on May 31, 2002, AT&T’s interest in the Series A Capital and Residual Capital of TWE increased by approximately 2.13% to approximately 27.64% and AOL Time Warner’s corresponding interest in the Series A Capital and Residual Capital of TWE decreased by a like amount, to 72.36%.
TWE Restructuring
In August 2002, AOL Time Warner, Comcast and AT&T announced that they had agreed to restructure TWE. The restructuring (the “TWE Restructuring”) is expected to be completed on March 31, 2003.
The TWE Restructuring will result in the following: (i) AOL Time Warner will acquire complete ownership of TWE’s content assets (including Warner Bros. and Home Box Office, which will become separate, wholly owned subsidiaries of AOL Time Warner); (ii) all of AOL Time Warner’s directly-owned cable television system interests will be contributed to a separate company which will become a majority-owned subsidiary of AOL Time Warner and will be renamed Time Warner Cable Inc. (“TWC Inc.” or “TWC”); (iii) TWE will become a subsidiary of TWC Inc. and will continue to own the cable television system interests previously owned by it; (iv) Comcast will receive $2.1 billion in cash and AOL Time Warner equity securities valued at $1.5 billion; (v) a Comcast Trust will also retain a 21% economic interest in Time Warner Cable, through a 17.9% direct ownership interest in TWC Inc. (representing a 10.7% voting interest) and a limited partnership interest in TWE representing a 4.7% residual equity interest; and (vi) AOL Time Warner will retain an overall 79% economic interest in the cable business, through an 82.1% ownership interest in TWC Inc. (representing an 89.3% voting interest) and a partnership interest in TWE representing a 1% residual equity interest and a $2.4 billion preferred component. For additional information with respect to the TWE Restructuring, see Management’s Discussion and Analysis of Results of Operations and Financial Condition, “Recent Developments.” set forth at pages and herein and Note 1 to TWE’s consolidated financial statements set forth at pages and herein.
The AOLTW General Partners
Prior to the completion of the TWE Restructuring, Warner Communications Inc. (“WCI,” a subsidiary of AOL Time Warner) and American Television and Communications Corporation (“ATC,” a subsidiary of
AOL Time Warner) are the two general partners of TWE (the “AOLTW General Partners”). TWE does not have any ownership interest in the businesses or assets of the AOLTW General Partners.
The principal assets of the AOLTW General Partners currently include, in addition to their interests in TWE: WCI’s ownership of substantially all of the Warner Music Group (“WMG”), which produces and distributes recorded music, owns and administers music copyrights and manufactures and prints CDs and DVDs; WCI’s 50% interest in DC Comics, a New York general partnership which is 50% owned by TWE (“DC Comics”); WCI’s 99.95% aggregate interest in Warner Entertainment Japan Inc., a corporation organized under the laws of Japan (“Warner Japan”); certain securities of Turner Broadcasting System, Inc. (“TBS”) which in the aggregate represent an equity interest of approximately 10.6% in TBS; a 34% aggregate interest in Time Warner Telecom Inc.; and 7.66% of the common stock of Time Warner Companies, Inc., the assets of which consist primarily of investments in its consolidated and unconsolidated subsidiaries, including TWE.
Upon the completion of the TWE Restructuring, TWC Inc. will be the general partner of TWE and WCI and one of the Comcast Trusts will be the limited partners of TWE. For additional information with respect to the changes in TWE’s organization following the completion of the TWE Restructuring, see “Description of Certain Provisions of the TWE Partnership Agreement” at pages 17 through 20 herein.
TWE-A/N Partnership
In 1995, TWE formed a cable television joint venture with the Advance/Newhouse Partnership (“Advance/Newhouse”) known as the Time Warner Entertainment-Advance/Newhouse Partnership (“TWE-A/N”). During 2002, TWE and Advance/Newhouse Partnership (“Advance/Newhouse”) completed the restructuring of the partnership known as the Time Warner Entertainment-Advance/Newhouse Partnership (“TWE-A/N”). As part of the TWE-A/N restructuring (the “TWE-A/N Restructuring”), cable systems and their related assets and liabilities serving 2.1 million subscribers as of December 31, 2002, located primarily in Florida (the “A/N Systems”), were transferred to a subsidiary of TWE-A/N. Advance/Newhouse has authority for the supervision of the day-to-day operations of the subsidiary, subject to some exceptions requiring action by unanimous consent, and TWE will continue to exercise various management functions, including oversight of programming and certain engineering-related services. TWE has deconsolidated the financial position and operating results of the A/N Systems for all periods. Under the new TWE-A/N Partnership Agreement, effective August 1, 2002, Advance/Newhouse’s interest in TWE-A/N tracks only the economic performance of the A/N Systems, while TWE retains the economic interests and associated liabilities in the remaining TWE-A/N cable systems.
Also, in connection with the TWE-A/N Restructuring, AOL Time Warner effectively acquired Advance/Newhouse’s 17% interest in Road Runner, a high speed cable modem Internet service provider. As a result of the termination of Advance/Newhouse’s minority rights in Road Runner, TWE has consolidated the financial position and results of operations of Road Runner with the financial position and results of operations of TWE’s Cable segment, effective January 1, 2002. See Note 4, “Cable-Related Transactions and Investments - Restructuring of TWE-A/N and Road Runner Partnership,” to TWE’s consolidated financial statements set forth at pages through.
For additional information with respect to TWE-A/N, See “Description of Certain Provisions of the TWE-A/N Partnership Agreement” at pages 20 through 22 herein.
AOL-Time Warner Merger
AOL Time Warner was formed in connection with the merger of America Online, Inc (“America Online”) and Time Warner Inc. (“Time Warner”), which was consummated on January 11, 2001 (the “Merger” or the “AOL-Time Warner Merger”). As a result of the Merger, America Online and Time Warner each became wholly owned subsidiaries of AOL Time Warner.
Caution Concerning Forward-Looking Statements
This Annual Report on Form 10-K includes certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s current expectations and are naturally subject to uncertainty and changes in circumstances. Actual results may vary materially from the expectations contained herein due to changes in economic, business, competitive, technological and/or regulatory factors. More detailed information about those factors is set forth on pages F- and F- herein. TWE is under no obligation to (and expressly disclaims any such obligation to) update or alter its forward-looking statements whether as a result of new information, subsequent events or otherwise.
Available Information and Website
TWE’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports filed with the Securities and Exchange Commission (SEC) pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act are available on the SEC’s Website at www.sec.gov. TWE does not have a Website.
CABLE
TWE’s Cable business consists principally of interests in cable television systems that provide video programming and high speed data services to customers under the name Time Warner Cable. As a result of the TWE Restructuring which is expected to be completed on March 31, 2003, Time Warner Cable Inc. (“TWC Inc.”), will become an 82.1%-owned subsidiary of AOL Time Warner and will own or manage all of AOL Time Warner’s and TWE’s cable television systems. Of the 10.9 million basic subscribers served by Time Warner Cable at December 31, 2002, 1.7 million are in systems that will be owned by TWC Inc. directly or through wholly owned subsidiaries of AOL Time Warner and 9.2 million are in systems that will continue to be owned or managed by TWE or TWE-A/N. Following the TWE Restructuring, TWE will become a 94.3%-owned subsidiary of TWC Inc. (with AOL Time Warner holding a partnership interest in TWE representing a 1% residual equity interest and a $2.4 billion preferred component). All of these systems will continue to provide services under the Time Warner Cable brand name.
As a result of the TWE-A/N Restructuring, which was completed on December 31, 2002, cable systems which served 2.1 million subscribers, primarily located in Florida, were transferred to a subsidiary of TWE-A/N, and Advance/Newhouse’s interest in TWE-A/N was converted into an interest that tracks the economic performance of these A/N Systems. Advance/Newhouse has authority for supervision of the day-to-day operations of the subsidiary, subject to some exceptions, including limitations on the incurrence of indebtedness, and TWE will continue to exercise various management functions, including oversight of programming and certain engineering-related matters. Time Warner Cable oversees the management of, and retains the economic interests and associated liabilities in, the remaining systems owned by TWE-A/N. TWE has deconsolidated the financial position and operating results of the A/N Systems for all periods.
Time Warner Cable’s cable systems include systems serving 1.2 million subscribers that are part of Texas Cable Partners (“TCP”), a 50-50 joint venture between Comcast and TWE-A/N, and systems serving 306,000 subscribers that are part of Kansas City Cable Partners (“KCCP”), a 50-50 joint venture between Comcast and TWE. TWE’s investments in these joint ventures are accounted for using the equity method. TWE receives a fee for managing the TCP and KCCP systems.
For additional information with respect to the TWE and TWE-A/N restructurings, see Management’s Description and Analyses of Results of Operations and Financial Condition, “Recent Developments” and Note 4 “Cable-Related Transactions and Investments,” to TWE’s consolidated financial statements set forth at pages through herein.
Systems Operations
Time Warner Cable is the second largest operator of cable television systems in the U.S. As of December 31, 2002, Cable systems owned or managed by Time Warner Cable passed approximately 18.5 million homes, and provided basic cable service to 10.9 million subscribers and high speed data services to 2.5 million residential and commercial subscribers. Time Warner Cable operates large clustered and technologically advanced cable systems. As of December 31, 2002, more than 73% of its subscribers were in 19 geographic clusters, each serving more than 300,000 subscribers, and approximately 99% of its cable systems were capable of carrying two-way broadband services, with approximately 97% having been upgraded to 750MHz or higher. Time Warner Cable is an industry leader in developing and rolling-out new products and services, such as video-on-demand, subscription video-on-demand, high-definition television, home networking and set-top boxes with integrated digital video recorders. See “Advanced Cable Services” below.
Franchises
Cable systems are constructed and operated under non-exclusive franchises granted by state or local governmental authorities. Franchises typically contain many conditions, such as time limitations on commencement or completion of construction; service requirements, including number of channels; provision of free services to schools and other public institutions; and the maintenance of insurance and indemnity bonds. Cable franchises are subject to various federal, state and local regulations. See “Regulation and Legislation” below.
Video Programming
Video programming is generally made available to customers through packages of different programming services provided for prescribed monthly fees. The available analog channel capacity of Time Warner Cable’s systems has expanded as system upgrades are completed, with most systems offering around 70 analog channels. Customers receiving Time Warner Cable’s digital services may elect to receive up to 150 video and audio channels, including expanded pay-per-view and premium channel options as well as other programming products.
Video programming available to customers includes local and distant broadcast television stations, cable programming services like CNN, A&E and ESPN, and premium cable services like HBO, Showtime and Starz! The terms and conditions of carriage of programming services are generally established through affiliation agreements between the programmers and Time Warner Cable. Most programming services impose a monthly license fee per subscriber upon the cable operator and these fees typically increase over time. Time Warner Cable’s programming costs have risen in recent years, see Management’s Discussion and Analysis of Results of Operations, “Business Segment Results - Cable”. Time Warner Cable sometimes has the right to cancel contracts and generally has the right not to renew them. Time Warner Cable may not always be able to renew contracts when it wishes to do so. Time Warner Cable also must periodically obtain retransmission consent for permission to carry local broadcast stations that have so elected. Time Warner Cable cannot be assured that each station will grant such consent on reasonable terms. It is unknown whether the loss of any one popular supplier would have a material adverse effect on Time Warner Cable’s operations.
Video Programming Charges and Advertising
Video subscribers to Time Warner Cable’s cable systems are typically charged monthly subscription fees based on the level of service selected and, in some cases, equipment usage fees. Subscription revenues account for most of Time Warner Cable’s revenues. Although regulation of certain cable programming rates ended in 1999, rates for “basic” programming as well as for equipment rentals and installation services continue to be subject to regulation pursuant to federal law. See “Regulation and Legislation” below.
Video subscribers may also elect to receive premium channels for an additional monthly fee with discounts generally available for the purchase of packages of more than one premium service. Pay-per-view movies and special events are charged on a per-view basis.
Time Warner Cable also generates revenue by selling advertising time to a variety of national, regional and local businesses. Cable television operators receive an allocation of scheduled advertising time on certain cable programming services into which the operator can insert commercials. The clustering of Time Warner Cable’s systems expands the share of viewers that Time Warner Cable reaches within a local DMA (Designated Market Area), which helps local ad sales personnel to compete more effectively with broadcast and other media. In addition, in many locations, contiguous cable system operators have formed advertising interconnects to deliver locally inserted commercials across wider geographic areas, replicating the reach of the broadcast stations as much as possible. As of December 31, 2002, 15 of Time Warner Cable’s 34 divisions participated in local cable advertising interconnects.
A portion of Time Warner Cable’s advertising revenues come from sales to other AOL Time Warner segments and from sales to programming vendors in support of their channel launches. For the past two years, these sales to programming vendors have represented a substantial portion of Time Warner Cable’s total advertising revenues. However, these advertising revenues have decreased in recent periods as the number of new programming service launches has declined. TWE expects this trend to continue and expects sales of advertising to other AOL Time Warner segments to decline significantly in 2003. See Management’s Discussion and Analysis of Results of Operations and Financial Condition Business Segment Results - Cable.”
Local News Channels
Time Warner Cable operates, alone or in partnerships, 24-hour local news channels in New York City (NY1 News), Albany, NY (News 9 Albany), Rochester, NY (R/News), Charlotte and Raleigh, NC (Carolina News 14), Austin (News 8 Austin) and Houston, TX (News 24 Houston). These channels have developed into attractive vehicles for local advertising and provide Time Warner Cable with an important connection to the communities in which the channels operate. Preparations are underway to launch news channels in San Antonio, TX and Syracuse, NY.
Advanced Cable Services
Digital Programming Services
Digital Video Service
As of December 31, 2002, Time Warner Cable had more than 3.7 million digital service subscribers and all of Time Warner Cable’s 34 divisions were upgraded to accommodate digital cable. Digital subscribers receive significantly expanded cable network options, CD-quality audio music services, more pay-per-view choices, more channels of multiplexed premium services and other features such as enhanced parental control options. The digital set-top boxes delivered to subscribing customers also offers a digital interactive program guide and access to Time Warner Cable’s video on demand offerings.
On Demand Services
As of December 31, 2002, Time Warner Cable offered video on demand services in 32 of its 34 divisions. Video on demand enables digital subscribers to instantaneously purchase movies and other programming, and to utilize VCR-like functions (such as pause, rewind and fast-forward) while watching these programs. Subscribers are charged for video on demand on a per-use basis.
As of December 2002, Time Warner Cable offered subscription video on demand in 32 of its 34 divisions. Subscription video on demand provides digital customers the ability to view an array of content associated with a particular content provider. Subscription video on demand uses the same technology and offers the same features as video on demand, but subscriber access is charged on a monthly rather than a per-use basis. Subscription video on demand is currently offered in connection with premium channels such as HBO and it is expected that other programming will be available over time.
HDTV
Pursuant to FCC regulation, television broadcast stations have been granted additional over-the-air spectrum to provide, under a prescribed rollout schedule, high definition and digital television signals to the public. Time Warner Cable believes its upgraded hybrid fiber optic/coaxial cable architecture provides a technologically superior means of distributing HDTV signals. To date, Time Warner Cable has agreed to carry the high definition television signals and other digital signals broadcast by television stations owned and operated by the ABC, CBS, NBC and Fox networks, and also by nearly all public television stations in Time Warner Cable’s operating areas. Time Warner Cable is seeking high definition carriage arrangements with other broadcasters. Time Warner Cable is also carrying the HDTV versions of HBO and Showtime in certain areas.
Digital Video Recorders
Beginning in August, 2002, Time Warner Cable began to offer customers in some of its systems set-top boxes with integrated digital video recorders, or “DVRs,” for an additional monthly charge. DVR users can record programming on a hard drive built into the set-top box through the interactive program guide and view the recorded programing using VCR-like functions such as pause, rewind and fast-forward. Furthermore, DVRs give users the ability to pause even “live” television. Time Warner Cable intends to expand the deployment of DVR-enabled set-top boxes during 2003.
High Speed Data Services
Internet Services
Time Warner Cable’s residential customers can choose from a variety of ISPs, including TWE’s Road Runner and America Online’s AOL For Broadband services. High speed data customers connect their personal computers (PCs) to Time Warner Cable’s two-way hybrid fiber optic/coaxial plant using a cable modem. High speed data customers pay a flat monthly fee for access to their ISP’s features, which typically include Internet access and email. Time Warner Cable also offers a home networking option for an additional monthly fee, which allows a customer to connect multiple PCs to a single cable modem.
As of December 31, 2002, Time Warner Cable had 2.5 million high speed data subscribers. High speed data subscribers include residential subscribers, as well as commercial and bulk (e.g., apartment buildings and universities) subscribers. Due to their nature, commercial and bulk subscribers are charged a different amount than residential subscribers.
Time Warner Cable offers its Road Runner branded, high speed data service to both residential and commercial customers. In connection with the TWE-A/N Restructuring, TWE and an affiliate of AOL Time Warner effectively acquired Advance/Newhouse’s 17% interest in Road Runner thereby increasing AOL Time Warner’s ownership to approximately 82% on a fully attributed basis. As a result of the termination of Advance/Newhouse’s minority rights in Road Runner, TWE consolidated Road Runner with its results retroactive to January 1, 2002. As of December 31, 2002, the Road Runner service was carried in all of Time Warner Cable’s 34 divisions.
Time Warner Cable’s provision of the AOL For Broadband service and its obligation to make multiple ISP services available to its customers are subject to compliance with the terms of the FTC Consent Decree and the FCC Order entered in connection with the regulatory clearance of the AOL-Time Warner Merger. (See “Regulation and Legislation” below, for a description of these terms).
Voice Services
Commencing in 2002, Time Warner Cable has engaged in voice services trials utilizing a technology known as Voice over Internet Protocol or “VoIP.” These trials enable participating Time Warner Cable residential high speed data users to make and receive calls using a traditional telephone handset connected to a cable modem. Time Warner Cable expects to begin the commercial launch of VoIP service in some of its divisions in 2003.
Competition
Time Warner Cable’s video and high speed data services face strong competition from a wide variety of alternative delivery sources. In the future, technological advances will most likely increase the number of alternatives available to its customers. In general, Time Warner Cable’s video and high speed data business faces competition from other information and entertainment providers, as well as competition from other media for advertising dollars.
DBS. Time Warner Cable’s video services face competition from satellite services, such as DirecTV and the Dish Network, which offer satellite-delivered pre-packaged programming services that can be received by relatively small and inexpensive receiving dishes. The video services provided by these satellite providers are comparable, in many respects, with Time Warner Cable’s analog and digital video services. In many metropolitan areas, satellite services now also include local broadcast signals.
“Online” Competition. Time Warner Cable’s high speed data service faces competition from a variety of companies that offer other forms of “online” services, including DSL high speed data service and dial-up services over ordinary telephone lines. Monthly prices of dial-up services are typically less expensive than broadband services. Other developing new technologies, such as Internet service via satellite or wireless connections, also compete with cable and cable modem services.
Overbuilds. Under the Cable Television Consumer Protection and Competition Act of 1992, franchising authorities are prohibited from unreasonably refusing to award additional franchises. As a result, from time to time, Time Warner Cable faces competition from overlapping cable systems operating in its franchise areas, including municipally-owned systems.
SMATV (Satellite master antenna television). Additional competition comes from private cable television systems servicing condominiums, apartment complexes and certain other multiple dwelling units, often on an exclusive basis, with local broadcast signals and many of the same satellite-delivered program services offered by franchised cable television systems. Some SMATV operators now offer voice and high speed Internet services.
MMDS/Wireless Cable (Multichannel microwave distribution services). Time Warner Cable faces competition from wireless cable operators, including digital wireless operators, who use terrestrial microwave technology to distribute video programming. Some MMDS operators now offer voice and high speed Internet services.
Telephone Companies. Time Warner Cable also faces competition from telephone companies. Under the 1996 Telecommunications Act, telephone companies are now free to enter the retail video distribution business within their local exchange service areas, including through satellite, MMDS and SMATV, as traditional franchised cable system operators or as operators of “open video systems” subject to local authorizations and local fees.
Consumer Electronics Manufacturers. To the extent that Time Warner Cable’s products and services converge with theirs, Time Warner Cable may compete with the manufacturers of consumer electronics products.
Additional Competition. In addition to multichannel video providers, cable television systems compete with all other sources of news, information and entertainment, including over-the-air television broadcast reception, live events, movie theaters, home video products and the Internet.
FILMED ENTERTAINMENT
TWE’s Filmed Entertainment businesses produce and distribute theatrical motion pictures, television shows, animation and other programming, distribute home video product and license rights to TWE’s programs and characters. All of the foregoing businesses are principally conducted by Warner Bros., which is a division of TWE. Following the completion of the TWE Restructuring, the Warner Bros. division will become a wholly owned subsidiary of AOL Time Warner.
Warner Bros. Feature Films
Warner Bros. Pictures produces feature films both wholly on its own and under co-financing arrangements with others, and also distributes completed films produced and financed by others. The terms of Warner Bros. Pictures’ agreements with independent producers and other entities are separately negotiated and vary depending upon the production, the amount and type of financing by Warner Bros., the media and territories covered, the distribution term and other factors.
Warner Bros. Pictures’ strategy focuses on offering a diverse slate of films with a mix of genres, talent and budgets that includes four to six “event” movies per year. In response to the rising cost of producing theatrical films, Warner Bros. Pictures has entered into a number of joint venture agreements with other companies to co-finance films, decreasing its financial risk while in most cases retaining substantially all worldwide distribution rights. During 2002, Warner Bros. Pictures released a total of 26 original motion pictures for theatrical exhibition, of which 6 were wholly financed by Warner Bros. Pictures and 20 that were financed with or by others. A total of 25 motion pictures are currently slated to be released during 2003, of which 7 are wholly financed by Warner Bros. Pictures and 18 financed with or by others.
Warner Bros. Pictures’ joint venture arrangements include a joint venture with Village Roadshow Pictures to co-finance the production of motion pictures; and an arrangement with Gaylord Entertainment (“Gaylord”) to co-finance the production of motion pictures with medium to high budgets, and with Gaylord’s wholly owned subsidiary, Pandora Investments SARL, to co-finance the production of lower budget pictures.
Warner Bros. Pictures has distribution servicing agreements with Morgan Creek Productions Inc. (“Morgan Creek”) through December 2003 pursuant to which, among other things, Warner Bros. provides domestic distribution services for all Morgan Creek motion pictures and certain foreign distribution services for selected motion pictures in selected territories. Warner Bros. Pictures has a distribution arrangement with Franchise Entertainment LLC under which, for certain motion pictures, it has domestic distribution rights and foreign distribution rights in selected territories. Additionally, Warner Bros. has an exclusive distribution arrangement with Alcon Entertainment (“Alcon”) for distribution of all of Alcon’s motion pictures in domestic and certain foreign territories, and an exclusive worldwide distribution arrangement with the newly created Shangri-La Entertainment, LLC.
Home Video
Warner Home Video (“WHV”) distributes for home video use DVDs and videocassettes containing filmed entertainment product produced or otherwise acquired by Warner Bros. Pictures, Castle Rock, New Line, Home Box Office, Turner Broadcasting System, Inc. (“TBS”) and WarnerVision.
WHV also distributes other companies’ product, including DVDs and videocassettes for BBC, PBS and National Geographic in the U.S., ICON in the UK and Australia, and France Television and Canal+ in France.
WHV sells and/or licenses its product in the U.S. and in major international territories to retailers and/or wholesalers through its own sales forces, with warehousing and fulfillment handled by divisions of Warner Music Group and third parties. In some countries, WHV’s product is distributed through licensees. DVD product is replicated by Warner Music Group companies and third parties. Video-cassette product is
manufactured under contract with independent duplicators. WHV released 25 titles on DVD and videocassette in the U.S. in 2002 that generated sales of more than one million units each.
Since inception of the DVD format, WHV has released over 1,500 DVD titles in the U.S. and international markets, led by worldwide sales of Harry Potter and the Sorcerer’s Stone, which has sold 23 million DVD units. DVD is the fastest selling consumer electronics product of all time, with an installed base at December 31, 2002 of over 40 million households in the U.S. and an additional 55.4 million households internationally (including China).
Television
Warner Bros. is one of the world’s leading suppliers of television programming, distributing programming in more than 175 countries and in more than 40 languages. Warner Bros. both develops and produces new television series, made-for-television movies, mini-series, reality-based entertainment shows and animation programs and also distributes television programming for exhibition on all media. The distribution library owned or managed by Warner Bros. currently has more than 6,500 feature films, approximately 38,000 television titles, and 14,000 animated titles (including 1,500 classic animated shorts).
Warner Bros.’ television programming is primarily produced by Warner Bros. Television (“WBTV”), which produces primetime dramatic and comedy programming for the major networks, and Telepictures Productions (“Telepictures”), which specializes in reality-based and talk/variety series for the syndication and primetime markets. During the 2002-03 season, WBTV produced hits such as Smallville, Gilmore Girls and Everwood for The WB Network and ER, Friends, The West Wing, The Drew Carey Show, George Lopez, Third Watch and Without a Trace. Telepictures has primetime hits The Bachelor and The Bachelorette as well as first-run syndication staples such as Extra.
Warner Bros. Animation is responsible for the creation, development and production of contemporary television and feature film animation, as well as for the creative use and production of classic animated characters from Warner Bros.’, TBS’s and DC Comics’ libraries, including Looney Tunes and the Hanna-Barbera libraries.
Backlog
Backlog represents the future revenue not yet recorded from cash contracts for the licensing of theatrical and television programming for pay cable, network, basic cable and syndicated television exhibition. Backlog for all of TWE’s filmed entertainment companies amounted to $3.2 billion at December 31, 2002, compared to $3.5 billion at December 31, 2001 (including amounts relating to the intercompany licensing of film product to TWE’s cable television networks of $405 million and $433 million as of December 31, 2002 and December 31, 2001, respectively). The backlog excludes advertising barter contracts.
Consumer Products
Warner Bros. Consumer Products licenses rights in both domestic and international markets to the names, likenesses, images, logos and other representations of characters and copyrighted material from the films and television series produced or distributed by Warner Bros., including the superhero characters of DC Comics, Hanna-Barbera characters, classic films and the literary and feature film phenomenon, Harry Potter.
Competition
The production and distribution of theatrical motion pictures, television and animation product and videocassettes/DVDs are highly competitive businesses, as each vies with the other, as well as with other forms of entertainment and leisure time activities, including video games, the Internet and other computer-related activities for consumers’ attention. Furthermore, there is increased competition in the television industry evidenced by the increasing number and variety of broadcast networks and basic cable and pay television services now available. Despite this increasing variety of networks and services, access to primetime and syndicated television slots has actually tightened as networks and owned and operated stations increasingly
source programming from content producers aligned with or owned by their parent companies. There is active competition among all production companies in these industries for the services of producers, directors, writers, actors and others and for the acquisition of literary properties. With respect to the distribution of television product, there is significant competition from independent distributors as well as major studios. Piracy and unauthorized recording, transmission and distribution of content are increasing challenges. Revenues for filmed entertainment product depend in part upon general economic conditions, but the competitive position of a producer or distributor is still greatly affected by the quality of, and public response to, the entertainment product it makes available to the marketplace.
Warner Bros. also competes in its character merchandising and other licensing activities with other licensors of character, brand and celebrity names.
NETWORKS
TWE’s Networks business consists principally of the multichannel HBO and Cinemax pay television programming services (collectively, the “Home Box Office Services”), operated by the Home Box Office division of TWE (“Home Box Office”). The WB Television Network (“The WB”), a broadcast television network, is operated as a limited partnership in which WB Communications (currently a subsidiary of TWE) holds a 77% interest in the network and is the network’s managing general partner. Upon the completion of the TWE Restructuring, both Home Box Office and WB Communications will become wholly owned subsidiaries of AOL Time Warner.
Home Box Office
HBO, operated by the Home Box Office division of TWE, is the nation’s most widely distributed pay television service, which together with its sister service, Cinemax, had approximately 39 million subscriptions as of December 31, 2002. Both HBO and Cinemax are made available in a multichannel format and through the newly introduced subscription video on demand enhancement, which enables participating digital cable subscribers to choose programs at a time of their choice with VCR-like functionality. Through various joint ventures, HBO-branded services are distributed in Latin America, Asia and Eastern Europe.
The Home Box Office Services distribute their programming via cable and other distribution technologies, including satellite distribution and generally enter into separate multi-year agreements, known as affiliation agreements, with distributors that have agreed to carry them. Distributors that have agreed to carry a cable network or service are known as affiliates. The Home Box Office Services are commercial-free and generate revenue principally from monthly subscriptions paid by affiliates for subscribers who are generally free to cancel their subscriptions at any time. The Home Box Office Services and their affiliates engage in ongoing marketing and promotional activities to retain existing subscribers and acquire new subscribers. Although the Home Box Office Services believe prospects of continued carriage and marketing of their respective Networks by the larger affiliates are good, the loss of one or more of them as distributors of any individual network or service could have a material adverse effect on their respective businesses. The recent combination of Comcast and AT&T Broadband, two of the largest multiple-system cable operators that distribute the Home Box Office Services, reflects a growing consolidation among the Services’ distributors. In addition, one of the larger DBS services has been seeking a buyer. This trend towards consolidation could impact the Home Box Office Services’ prospects for securing carriage agreements on favorable terms.
A major portion of the programming on HBO and Cinemax consists of recently released, uncut and uncensored theatrical motion pictures. Home Box Office’s practice has been to negotiate licensing agreements of varying duration for such programming with major motion picture studios, and independent producers and distributors in order to ensure continuing access to theatrical motion pictures. These agreements typically grant pay television exhibition rights to recently released and certain older films owned by the particular studio, producer or distributor in exchange for a negotiated fee, which may be a function of, among other things, the films’ box office performances.
HBO also defines itself by the exhibition of award-winning original movies and mini-series, dramatic and comedy series, such as The Sopranos, Sex and the City, and Six Feet Under and boxing matches, sports documentaries and sports news programs, as well as concerts, comedy specials, family programming and documentaries. HBO received 24 Primetime Emmy Awards® in 2002 in a variety of categories, including Best Miniseries, Best Made for Television Movie and Best Directing for both Drama and Comedy Series.
Home Box Office has also increased its involvement in the financing and production of theatrical motion pictures, including the surprise hit My Big Fat Greek Wedding and the critically praised Real Women Have Curves.
A division of Home Box Office produces Everybody Loves Raymond, now in its seventh season on CBS and its first syndication cycle. Home Box Office also develops and produces programming for other networks. HBO Sports, a division of Home Box Office, operates HBO Pay-Per-View, an entity that distributes pay-per-view prize fights and other pay-per-view events. HBO Video, also a division of Home Box Office, distributes videocassettes and DVDs of a number of HBO’s original movies, miniseries and dramatic and comedy series, including Band of Brothers, The Sopranos and Sex and the City.
The WB Television Network
The WB provides a national group of affiliated television stations with 13 hours of prime time plus 2 additional hours of Sunday access programming during six days of the week (Sunday through Friday). The WB’s programming is primarily aimed at teens and young adults. The network’s line-up of programs includes established series such as 7th Heaven, Everwood, Dawson’s Creek, Charmed, Reba, Smallville and Gilmore Girls. As of December 31, 2002, Kids’ WB!, a programming service for young viewers, presented 14 hours of animated programming per week, including Yu-Gih-Oh and Pokemon.
As of December 31, 2002, 84 primary and 8 secondary affiliates provide coverage for The WB in the top 100 television markets. Additional coverage reaching approximately 8.5 million homes in smaller markets is provided by The WB 100+ Station Group, a venture between The WB and local broadcasters under which WB programming is disseminated over the facilities of local cable operators.
Advertising revenue on The WB is comprised of consumer advertising, which is sold exclusively on a national basis, with local affiliates of The WB selling local advertising. Advertising contracts generally have terms of one year or less. Advertising revenue is generated from a wide variety of categories, including financial and business services, food and beverages, automotive, entertainment and office supplies and equipment. Advertising revenue is a function of the size and demographics of the audience delivered, the “CPM,” which is the cost per thousand viewers delivered, and the number of units of time sold. Units sold and CPM’s are influenced by the quantitative and qualitative characteristics of the audience of each network as well as overall advertiser demand in the marketplace.
Tribune Broadcasting owns a 22.25% interest in The WB and the balance is held by WB Communications, a division of TWE. Following the completion of the TWE Restructuring, WB Communications will be a wholly owned subsidiary of AOL Time Warner.
Other Network Interests
TWE has held a 50% interest in Comedy Central, an advertiser-supported basic cable television service that provides comedy programming. Following the completion of the TWE Restructuring, such interest will be held by a wholly owned subsidiary of AOL Time Warner. Comedy Central was available in approximately 81 million homes as of December 31, 2002.
TWE has held a 50% interest in Court TV, which was available in approximately 75 million homes as of December 31, 2002. Following the completion of the TWE Restructuring, such interest will be held by a wholly owned subsidiary of AOL Time Warner. Court TV is an advertiser-supported basic cable television service whose programming aims to provide an informative and entertaining view of the American system of
justice. Focusing on “investigative television,” Court TV broadcasts trials by day and original programs such as Forensic Files and popular off-network series such as NYPD Blue in the evening.
Competition
Each of TWE’s networks competes with other television programming services for marketing and distribution by cable and other distribution systems. All of the networks compete for viewers’ attention and audience share with all other forms of programming provided to viewers, including broadcast networks, local over-the-air television stations, other pay and basic cable television services, home video, pay-per-view services, online activities and other forms of news, information and entertainment. In addition, the networks face competition for programming with those same commercial television networks, independent stations, and pay and basic cable television services, some of which have exclusive contracts with motion picture studios and independent motion picture distributors. The WB competes for advertising with numerous direct competitors and other media.
REGULATION AND LEGISLATION
TWE’s cable television system, cable and broadcast television network and original programming businesses are subject, in part, to regulation by the Federal Communications Commission (“FCC”), and the cable television system business is also subject to regulation by some state governments and substantially all local governments where TWE has cable systems. In addition, in connection with regulatory clearance of the AOL-Time Warner merger, AOL Time Warner and its subsidiaries, including TWE’s cable system and Internet businesses are subject to compliance with the terms of the Consent Decree (the “Consent Decree”) issued by the Federal Trade Commission (“FTC”), the Order to Hold Separate issued by the FTC, the Memorandum Opinion and Order (“Order”) issued by the FCC. TWE is also subject to an FTC consent decree (the “Turner Consent Decree”) as a result of the FTC’s approval of Time Warner’s acquisition of Turner Broadcasting System, Inc. in 1996. The terms of the Order to Hold Separate entered by the FTC in connection with the AOL-Time Warner Merger (which terms were described in TWE’s Annual Report on Form 10-K for the year ended December 31, 2000) have been satisfied.
The following is a summary of the terms of these orders as well as current significant federal, state and local laws and regulations affecting the growth and operation of these businesses. In addition, various legislative and regulatory proposals under consideration from time to time by Congress and various federal agencies have in the past materially affected, and may in the future materially affect, TWE.
FTC Consent Decree
On December 14, 2000, the FTC issued a consent decree in connection with the AOL Time Warner Merger. The consent decree provided that, with the exception of Road Runner, Time Warner Cable is not permitted to launch an affiliated ISP, like the AOL Broadband service, in its 20 largest divisions, until it launched the EarthLink service, an unaffiliated ISP, on those systems. The consent decree also provided that Time Warner Cable had to enter into agreements with two additional unaffiliated ISPs within 90 days after launching an affiliated ISP. In addition, the consent decree required that, in its remaining divisions, Time Warner Cable had to enter into agreements with three unaffiliated providers within 90 days after launching an affiliated ISP. Each of these agreements had to be approved by the FTC.
Time Warner Cable has now entered into, and received FTC approval for, agreements with the required number of unaffiliated ISPs in all covered divisions. If any of the required agreements expires or is terminated during the term of the consent decree, Time Warner Cable will be required to replace it with another approved agreement. Although offering multiple ISPs was required by the terms of the consent decree, Time Warner Cable has entered into agreements with unaffiliated ISPs beyond the number required by the consent decree.
The consent decree also requires that Time Warner Cable’s FTC-approved agreements contain a provision that requires Time Warner Cable to give notice to the unaffiliated ISPs whenever AOL Time
Warner enters into an AOL For Broadband affiliation agreement with any one of six specified cable operators. In that event, Time Warner Cable is required to give each unaffiliated ISP the option to adopt all terms and conditions of the relevant AOL For Broadband affiliation agreement. In addition, the consent decree requires that AOL Time Warner continue to offer and promote DSL service in areas served by Time Warner Cable to the same extent and on terms similar to the terms offered in areas not served by Time Warner Cable. TWE’s obligations under the consent decree expire on April 17, 2006.
FCC Memorandum Opinion and Order
On January 11, 2001, the FCC issued an Order imposing certain requirements over a five-year period regarding Time Warner Cable’s provision of multiple ISPs. Specifically, the Order requires Time Warner Cable to provide ISP customers with a list of available ISPs upon request, to allow ISPs to determine the content on their first screen, and to allow ISPs to have direct billing arrangements with the subscribers they obtain. The Order prohibits Time Warner Cable from requiring customers to go through an affiliated ISP to reach an unaffiliated ISP, from requiring ISPs to include particular content, and from discriminating on the basis of affiliation with regard to technical system performance.
The FCC’s Order also imposes conditions regarding possible future enhancements to America Online’s instant messaging service. The Order prohibits America Online from offering “advanced” instant messaging services (which are defined as streaming video applications that are not upgrades to America Online’s current instant messaging products) that utilize a names and presence database (“NPD”) over Time Warner Cable broadband facilities unless America Online satisfies one of three conditions: (i) America Online implements an industry-wide standard for server-to-server interoperability; (ii) America Online contracts with at least one unaffiliated provider of NPD based instant messaging services before offering “advanced” instant messaging and, within 180 days thereafter, enters into two additional such contracts; or (iii) America Online demonstrates that these conditions no longer serve the public interest due to materially changed circumstances. AOL Time Warner must also report to the FCC, every 180 days, its progress toward Instant Messaging interoperability. Conditions relating to AOL’s instant messaging expire January 22, 2006.
In addition, the FCC’s Order prohibits TWE from entering into any agreement with Comcast (formerly AT&T) that gives any ISP affiliated with AOL Time Warner exclusive carriage rights on any former AT&T cable system for broadband ISP services or that affects Comcast’s ability to offer rates or other carriage terms to ISPs that are not affiliated with AOL Time Warner.
Turner FTC Consent Decree
TWE is also subject to the terms of a consent decree (the “Turner Consent Decree”) entered in connection with the FTC’s approval of the acquisition of Turner Broadcasting System, Inc. (“TBS”) by Time Warner in 1996. Certain requirements imposed by the Turner Consent Decree, such as carriage commitments for Time Warner Cable for the rollout of at least one independent national news video programming service, have been fully satisfied by TWE. Various other conditions remain in effect, including certain restrictions which prohibit TWE from offering programming upon terms that (1) condition the availability of, or the carriage terms for, the HBO service upon whether a multichannel video programming distributor carries a video programming service affiliated with TBS; and (2) condition the availability of, or the carriage terms for, CNN, TBS Superstation and TNT upon whether a multichannel video programming distributor carries any video programming service affiliated with TWE. The Turner Consent Decree also imposes certain restrictions on the terms by which a Turner video programming service may be offered to an unaffiliated programming distributor that competes in areas served by Time Warner Cable.
Other conditions of the Turner Consent Decree prohibit Time Warner Cable from requiring, as a condition of carriage, that any national video programming vendor provide a financial interest in its programming service or that such programming vendor provide exclusive rights against any other multichannel programming distributor. In addition, Time Warner Cable may not discriminate on the basis of affiliation in the selection, terms or conditions of carriage for national video programming vendors.
The Turner Consent Decree also requires that any AOL Time Warner stock held by Liberty Media Corporation (“Liberty Media”), its former corporate parent, Tele-Communications, Inc. (“TCI”), which was merged with AT&T in 1999, as well as by the late Bob Magness and John C. Malone as individuals, be non-voting except that such securities are entitled to a vote of one-one hundredth (1/100) of a vote per share owned when voting with the outstanding common stock on the election of directors and a vote equal to the vote of the common stock with respect to corporate matters that would adversely change the rights or terms of these non-voting securities. Upon the sale of these non-voting securities to any independent third party, the securities may be converted into voting stock of AOL Time Warner. The Turner Consent Decree also prohibits Liberty Media, TCI (now Comcast), the late Bob Magness and John C. Malone as individuals, from holding ownership interests, collectively, of more than 9.2% of the fully diluted equity of AOL Time Warner. In 2002, Liberty Media sought to eliminate these restrictions from the Turner Consent Decree; the petition was denied by the FTC without prejudice on July 17, 2002. The Turner Consent Decree will expire in February 2007.
Cable System Regulation
Communications Act and FCC Regulation.
The Communications Act and the regulations and policies of the FCC affect significant aspects of Time Warner Cable’s cable system operations, including subscriber rates; carriage of broadcast television stations, as well as the way Time Warner Cable sells its program packages to subscribers; the use of cable systems by franchising authorities and other third parties; cable system ownership; and use of utility poles and conduits.
Subscriber Rates. The Communications Act and the FCC’s rules regulate rates for basic cable service and equipment in communities that are not subject to “effective competition,” as defined by federal law. Where there is no effective competition, federal law authorizes franchising authorities to regulate the monthly rates charged by the operator for the minimum level of video programming service, referred to as basic service, which generally includes local broadcast channels and public access or governmental channels required by the franchise. This kind of regulation also applies to the installation, sale and lease of equipment used by subscribers to receive basic service, such as set-top boxes and remote control units. In many localities, Time Warner Cable is no longer subject to this rate regulation, either because the local franchising authority has not asked the FCC for permission to regulate or because the FCC has found that there is effective competition.
Carriage of Broadcast Television Stations and Other Programming Regulation. The Communications Act and the FCC’s regulations contain broadcast signal carriage requirements that allow local commercial television broadcast stations to elect once every three years to require a cable system to carry their stations, subject to some exceptions, or to negotiate with cable systems the terms by which the cable systems may carry their stations, commonly called “retransmission consent.” The most recent election by broadcasters was due on October 1, 2002 and became effective on January 1, 2003.
The Communications Act and the FCC’s regulations require a cable operator to devote up to one-third of its activated channel capacity for the mandatory carriage of local commercial television stations. The Communications Act and the FCC’s regulations give local non-commercial television stations mandatory carriage rights, but non-commercial stations do not have the option to negotiate retransmission consent for the carriage of their signals by cable systems. Additionally, cable systems must obtain retransmission consent for all “distant” commercial television stations except for commercial satellite-delivered independent “superstations,” commercial radio stations, and some low-power television stations.
FCC regulations require Time Warner Cable to carry the signals of both commercial and non-commercial local digital-only broadcast stations and the digital signals of local broadcast stations that return their analog spectrum to the government and convert to a digital broadcast format. The FCC’s rules give digital-only broadcast stations discretion to elect whether the operator will carry the station’s signal in a digital or converted analog format, and the rules also permit broadcasters with both analog and digital signals to tie the carriage of their digital signals to the carriage of their analog signals as a retransmission consent condition. The FCC is continuing to consider further modifications to its digital broadcast signal carriage requirements.
The Communications Act also permits franchising authorities to require cable operators to set aside channels for public, educational and governmental access programming. Moreover, it requires a cable system with 36 or more activated channels to designate a significant portion of its channel capacity for commercial leased access by third parties to provide programming that may compete with services offered by the cable operator. The FCC regulates various aspects of such third-party commercial use of channel capacity on our cable systems, including the rates and some terms and conditions of the commercial use.
High Speed Internet Access. From time to time, industry groups, telephone companies, and ISPs have sought local, state and federal regulations that would require cable operators to sell capacity on their systems to ISPs under a common carrier regulatory scheme. Cable operators have successfully challenged regulations requiring this “forced access,” although courts that have considered these cases have employed varying legal rationales in rejecting these regulations.
On March 15, 2002, the FCC released an order in which it determined that cable-modem service constitutes an “information service” rather than a “cable service” or a “telecommunications service,” as those terms are used in the Communications Act. According to the FCC, this conclusion may permit but does not require it to impose “multiple ISP” requirements. The FCC has begun a rulemaking proceeding to consider whether it may and should do so and whether local franchising authorities should be permitted to do so. Several ISPs have appealed the FCC’s order in federal court. If the ISPs prevail, cable operators may become subject to a requirement that they carry any ISP desiring carriage.
In the wake of the FCC’s March 2002 order, Time Warner Cable, along with most other multiple system operators, stopped collecting and paying franchise fees on cable-modem revenues. However, the FCC has initiated a rulemaking to explore the consequences of its March 2002 order. In addition, several local franchising authorities have appealed the order in federal court, arguing that the FCC should have held that cable-modem service is a “cable service.” Some local franchising authorities have also claimed that cable operators’ failure to pay franchise fees on cable-modem services revenue constitutes a breach of their franchise agreement. To date, only a few local franchising authorities have filed lawsuits. Time Warner Cable is a defendant in one such lawsuit.
Ownership Limitations. There are various rules prohibiting joint ownership of cable systems and other kinds of communications facilities. Local telephone companies generally may not acquire more than a small equity interest in an existing cable system in the telephone company’s service area. In addition, cable operators may not have more than a small interest in “multichannel multipoint distribution services” facilities or “satellite master antenna television” systems in their service areas. Finally, the FCC has been exploring whether it should prohibit cable operators from holding ownership interests in satellite operators.
The Communications Act also required the FCC to adopt “reasonable limits” on the number of subscribers a cable operator may reach through systems in which it holds an ownership interest. In September 1993, the FCC adopted a rule that was later amended to prohibit any cable operator from serving more than 30% of all cable, satellite and other multi-channel subscribers nationwide. The Communications Act also required the FCC to adopt “reasonable limits” on the number of channels that cable operators may fill with programming services in which they hold an ownership interest. In September 1993, the FCC imposed a limit of 40% of a cable operator’s first 75 activated channels. In March 2001, a federal appeals court struck down both limits. The FCC is currently exploring whether it should re-impose any limits. Time Warner Cable believes that it is unlikely that the FCC will adopt limits as stringent as those struck down.
Pole Attachment Regulation. The Communications Act requires that utilities provide cable systems and telecommunications carriers with nondiscriminatory access to any pole, conduit or right-of-way controlled by the utility. The Communications Act also requires the FCC to regulate the rates, terms and conditions imposed by public utilities for cable systems’ use of utility pole and conduit space unless state authorities demonstrate to the FCC that they adequately regulate pole attachment rates, as is the case in some states in which Time Warner Cable operates. In the absence of state regulation, the FCC administers pole attachment rates on a formula basis. The FCC’s original rate formula governs the maximum rate utilities may charge for attachments to their poles and conduit by cable operators providing only cable services. The FCC also adopted a second rate formula that became effective in February 2001 and governs the maximum rate utilities may
charge for attachments to their poles and conduit by companies providing telecommunications services, including cable operators. Any increase in attachment rates resulting from the FCC’s new rate formula is being phased in (in equal annual installments) over a five-year period that began in February 2001. The U.S. Supreme Court has upheld the FCC’s jurisdiction to regulate the rates, terms and conditions of cable operators’ pole attachments that are being used to provide both cable service and high speed data service.
Other Regulatory Requirements of the Communications Act and the FCC. The Communications Act also includes provisions regulating customer service, subscriber privacy, marketing practices, equal employment opportunity, technical standards and equipment compatibility, antenna structure notification, marking, lighting, emergency alert system requirements and the collection from cable operators of annual regulatory fees, which are calculated based on the number of subscribers served and the types of FCC licenses held.
There are also some regulatory requirements applicable to set-top boxes. Currently, many cable subscribers rent from their cable operator a set-top box that performs both signal-reception functions and conditional-access security functions. The lease rates cable operators charge for this equipment are subject to rate regulation to the same extent as basic cable service. In 1996, Congress enacted a statute seeking to allow subscribers to use set-top boxes obtained from third-party retailers. The most important of the FCC’s implementing regulations requires cable operators to offer separate equipment providing only the conditional-access security function, so that subscribers can purchase boxes providing other functions from other sources and to cease placing into service new set-top boxes that have integrated conditional-access security. These regulations are scheduled to go into effect on January 1, 2005. Cable operators and consumer-electronics companies recently entered into a standard-setting agreement relating to interoperability between cable systems and reception equipment. Among other things, the agreement envisions consumer electronics devices with a slot for a conditional-access security card provided by the cable operator. The FCC has invited comment on whether it should issue regulations to implement that agreement. Meanwhile, industry groups are in the process of negotiating additional agreements.
Compulsory Copyright Licenses for Carriage of Broadcast Stations, Music Performance Licenses. Time Warner Cable’s cable systems provide subscribers with, among other things, local and distant television broadcast stations. Time Warner Cable generally does not obtain a license to use this programming directly from program owners. Instead, it obtains this programming pursuant to a compulsory license provided by federal law, which requires it to make payments to a copyright pool. The elimination or substantial modification of the cable compulsory license could adversely affect Time Warner Cable’s ability to obtain suitable programming and could substantially increase the cost of programming that remains available for distribution to its subscribers.
When Time Warner Cable obtains programming from third parties, it generally obtains licenses that include any necessary authorizations to transmit the music included in it. When Time Warner Cable creates its own programming and provides various other programming or related content, including local origination programming and advertising that it inserts into cable-programming networks, it is required to obtain any necessary music performance licenses directly from the rights holders. These rights are generally controlled by three music performance rights organizations, each with rights to the music of various artists. Time Warner Cable generally has obtained the necessary licenses, either through executed licenses or through procedures established by consent decrees entered into by some of the music performance rights organizations.
State and Local Regulation
Cable operators operate their systems under non-exclusive franchises. Franchises are awarded, and cable operators are regulated, by municipal or other local franchising authorities. In some states, there is cable regulation at the state level as well. Time Warner Cable believes it generally has good relations with state and local cable regulators.
Franchise agreements typically require payment of franchise fees and contain regulatory provisions addressing, among other things, upgrades, service quality, cable service to schools and other public institutions, insurance and indemnity bonds. The terms and conditions of cable franchises vary from jurisdiction to jurisdiction. The Communications Act provides protections against many unreasonable terms. In particular,
the Communications Act imposes a ceiling on franchise fees of five percent of revenues derived from cable service. Time Warner Cable generally passes the franchise fee on to its subscribers, listing it as a separate item on the bill.
Franchise agreements usually have a term of ten to 15 years from the date of grant, although some renewals may be for shorter terms. Franchises usually are terminable only if the cable operator fails to comply with material provisions. Time Warner Cable has not had a franchise terminated due to breach. After a franchise agreement expires, a franchising authority may seek to impose new and more onerous requirements, including requirements to upgrade facilities, to increase channel capacity and to provide various new services. Federal law, however, provides significant substantive and procedural protections for cable operators seeking renewal of their franchises. In addition, although Time Warner Cable occasionally reaches the expiration date of a franchise agreement without having a written renewal or extension, it generally has the right to continue to operate, either by agreement with the franchising authority or by law, while continuing to negotiate a renewal. In the past, substantially all of the material franchises relating to its systems have been renewed by the relevant local franchising authority, though sometimes only after significant time and effort. Despite its efforts and the protections of federal law, some Time Warner Cable franchises may not be renewed, and it may be required to make significant additional investments in its cable systems in response to requirements imposed in the course of the franchise renewal process.
Franchises usually require the consent of franchising authorities prior to the sale, assignment, transfer or change of control of a cable system. Federal law imposes various limitations on the conditions local authorities may impose and requires localities to act on such requests within 120 days.
Regulation of Telephony
As of March 1, 2003, it was unclear whether and to what extent regulators will subject Voice over Internet Protocol (“VoIP”) service provided by cable operators to the same regulations that apply to regular telephone service provided by regular telephone companies. In particular, it is unclear whether and to what extent the “access charge” and “universal service” rules that apply to regular telephone service will also apply to VoIP service. Finally, it is possible that regulators will allow utility pole owners to charge cable operators offering VoIP service higher rates for pole rental than for traditional cable service and cable-modem service.
Network Regulation
Under the Act and its implementing regulations, vertically integrated cable programmers like the Turner Networks and the Home Box Office Services, are generally prohibited from offering different prices, terms, or conditions to competing unaffiliated multichannel video programming distributors unless the differential is justified by certain permissible factors set forth in the regulations. The rules also place certain restrictions on the ability of vertically integrated programmers to enter into exclusive distribution arrangements with cable operators. Certain other federal laws also contain provisions relating to violent and sexually explicit programming, including relating to the voluntary promulgation of ratings by the industry and requiring manufacturers to build television sets with the capability of blocking certain coded programming (the so-called “V-chip”).
DESCRIPTION OF CERTAIN PROVISIONS OF THE
TWE PARTNERSHIP AGREEMENT
In August 2002, AOL Time Warner, AT&T and Comcast, which in November 2002 acquired AT&T’s broadband business, including AT&T’s interest in TWE, entered into an agreement with respect to the TWE Restructuring, which is expected to be completed on March 31, 2003. The TWE Partnership Agreement will be amended in connection with the TWE Restructuring (as amended, the “New TWE Partnership Agreement”). The following description summarizes certain provisions of the TWE Partnership Agreement relating to the ongoing operations of TWE both before and after the completion of the TWE Restructuring. Such description does not purport to be complete and is subject to, and is qualified in its entirety by reference
to, the provisions of the TWE Partnership Agreement as in effect immediately prior to the completion of the TWE Restructuring (hereinafter referred to as the “original TWE Partnership Agreement”) and the New TWE Partnership, as applicable.
Management and Operations of TWE
Partners. Under the original TWE Partnership Agreement, the limited partnership interests in TWE are held by the Class A Partners, consisting of two Comcast Trusts and two wholly owned subsidiaries of AOL Time Warner. The general partnership interests in TWE are held by the Class B Partners, consisting of wholly owned subsidiaries of AOL Time Warner (the “AOLTW General Partners”).
Following the TWE Restructuring, the partnership interests in TWE will be recapitalized with one of the Comcast Trusts holding a partnership interest representing a 4.7% residual equity interest in TWE, with a subsidiary of AOL Time Warner holding a partnership interest consisting of a $2.4 billion preferred component and a 1% residual equity interest in TWE and with TWC Inc. holding a partnership interest representing a 94.3% residual equity interest in TWE.
Upon the completion of the TWE Restructuring, TWC Inc. will be the general partner of TWE and a subsidiary of AOL Time Warner and one of the Comcast Trusts will be the limited partners of TWE. The designations “Class A Partner” and “Class B Partner” will no longer apply.
Board of Representatives. Under the original TWE Partnership Agreement, the business and affairs of TWE are managed under the direction of a board of representatives (the “Board of Representatives” or the “Board”). Both AOL Time Warner and the Comcast Trusts are entitled to appoint representatives to the Board. The AOL Time Warner representatives control all Board decisions except for certain limited, significant matters affecting TWE as a whole, which matters also require the approval of the Comcast Trusts’ representatives. The managing general partners, both of which are wholly owned subsidiaries of AOL Time Warner, may take any action without the approval or consent of the Board if such action otherwise may be authorized by the AOL Time Warner representatives without the approval of the Comcast Trusts’ representatives.
Following the completion of the TWE Restructuring, TWC Inc., as the general partner of TWE, will have the exclusive authority to manage the business and affairs of TWE, subject to certain protections over extraordinary actions afforded the Comcast Trust under the New TWE Partnership Agreement. These protections consist of consent rights over the dissolution or liquidation of TWE and the transfer of control of TWE to a third party, in each case, prior to the second anniversary of the closing of the TWE Restructuring, and the right to approve of certain amendments to the New TWE Partnership Agreement.
Day-to-Day Operations. TWE is, and will continue to be following the closing of the TWE Restructuring, managed on a day-to-day basis by the officers of TWE.
Certain Covenants
Covenant Not to Compete. Under the original TWE Partnership Agreement, AOL Time Warner and its controlled affiliates are prohibited from competing or owning an interest in the principal lines of business of TWE - cable television systems, pay cable programming networks and filmed entertainment, subject to certain exceptions (which include TBS and its businesses). The New TWE Partnership Agreement does not contain such prohibitions.
Transactions with Affiliates. Under the original TWE Partnership Agreement, subject to agreed upon exceptions for certain types of arrangements, TWE has agreed not to enter into transactions with any partner or any of its affiliates other than on an arm’s-length basis. The New TWE Partnership Agreement will require that transactions between TWC Inc., as the managing partner, and TWE be conducted on an arm’s-length basis, with management, corporate or similar services being provided by TWC Inc. on a no mark-up basis with fair allocations of administrative costs and general overhead.
Registration Rights and Other Exit Rights
Registration Rights under TWE Partnership Agreement. Both AOL Time Warner and the Comcast Trusts have registration rights under the original TWE Partnership Agreement. The parties have agreed not to exercise any of their registration rights pending the closing of the TWE Restructuring. Following the closing of the TWE Restructuring, the New TWE Partnership Agreement will not provide for registration rights in respect of their interests in TWE.
Sale and Appraisal Rights of Comcast Trust. Under a partnership interest sale agreement (the “Partnership Interest Sale Agreement”) to be entered in connection with the closing of the TWE Restructuring, at any time following the second anniversary of the closing of the TWE Restructuring, the Comcast Trust holding a limited partnership interest in TWE has the right to require TWC Inc. to purchase all or a portion of its partnership interest in TWE at an appraised fair market value, subject to a right of first refusal in favor of AOL Time Warner. The fair market value of the interest will be determined separately by two investment banks, one appointed by the Comcast Trust and one appointed by TWC Inc. If the higher of the two valuations presented by the investment banks is within 110% of the lower valuation, then the fair market value of the offered partnership interest will be the average of the two valuations. If the higher valuation is not within 110% of the lower valuation, a third investment bank selected by the other two investment banks, or, if they are unable to agree on a third investment bank, an investment bank selected by the American Arbitration Association will choose one of the two valuations to be the fair market value of the offered partnership interest, and that determination will be final and binding.
Following the second anniversary of the closing of the TWE Restructuring, the Comcast Trust also has the right, at any time, to sell all or a portion of its interest in TWE to a third party in a bona fide transaction, subject to a right of first refusal, first, in favor of AOL Time Warner and, second, in favor of TWC Inc. If TWC Inc. and AOL Time Warner do not collectively elect to purchase all of the Comcast Trust’s offered partnership interest, the Comcast Trust may proceed with the sale of the offered partnership interest to that third party on terms no more favorable than those offered to TWC Inc. and AOL Time Warner, if that third party agrees to be bound by the same terms and conditions applicable to the Comcast Trust as a limited partner in TWE and under the Partnership Interest Sale Agreement.
The purchase price payable by TWC Inc. or AOL Time Warner as consideration for the Comcast Trust’s partnership interest may be cash; common stock, if the common stock of the purchaser is then publicly traded, or a combination of both. Any AOL Time Warner or TWC Inc. common stock issued to purchase the Comcast Trust’s partnership interests will be valued based on the average of the volume-weighted trading price of the common stock for a period of time prior to issuance and will be entitled to registration rights.
Redemption of Preferred Component. The preferred component of AOL Time Warner’s partnership interest must be redeemed by TWE following the 20th anniversary of the closing of the TWE Restructuring.
Certain Put Rights of the Class A Partners
The put rights held by the TWE Class A Partners under the original TWE Partnership Agreement that are triggered upon a change of control of AOL Time Warner will terminate upon the closing of the TWE Restructuring.
Restrictions on Transfer
The original TWE Partnership Agreement prevents the general partners and limited partners of TWE from transferring their partnership interests, subject to a variety of exceptions.
Following the TWE Restructuring, the New TWE Partnership Agreement will provide that TWC Inc. and AOL Time Warner may generally transfer their partnership interests in TWE at any time, except that TWC Inc. may not transfer control of TWE before the third anniversary of the TWE Restructuring.
The New TWE Partnership Agreement will provide that the Comcast Trust may not transfer its partnership interest in TWE at any time prior to the second anniversary of the closing of the TWE
Restructuring and, after that, the Comcast Trust may only transfer its partnership interest pursuant to the Partnership Interest Sale Agreement.
Following the TWE Restructuring, no transfer of partnership interests may be made by any partner through securities markets, and no transfer may be made by any partner if the transfer causes TWE to have more than 100 partners or would result in, or have a material risk of, TWE being treated as a corporation for federal income tax purposes.
DESCRIPTION OF CERTAIN PROVISIONS OF THE
TWE-A/N PARTNERSHIP AGREEMENT
The following description summarizes certain provisions of the TWE-A/N Partnership Agreement relating to the ongoing operations of TWE-A/N. Such description does not purport to be complete and is subject to, and is qualified in its entirety by reference to, the provisions of the TWE-A/N Partnership Agreement.
Partners of TWE-A/N
As of March 1, 2003, the general partnership interests in TWE-A/N are held by TWE, Paragon Communications, an indirect wholly owned subsidiary of AOL Time Warner (“Paragon” and, together with TWE, the “AOLTW Partners”), and Advance/Newhouse Partnership, a wholly owned subsidiary of Advance Publications Inc. and Newhouse Broadcasting Corporation (“A/N”). The AOLTW Partners also hold preferred partnership interests. As part of the TWE Restructuring, expected to be completed on March 31, 2003, the interests held by Paragon will be transferred to TWC Inc.
Recent Restructuring of TWE-A/N
The TWE-A/N cable television joint venture was formed by TWE and Advance/Newhouse in December, 1995. A restructuring of the partnership was completed during 2002. As a result of this restructuring, cable systems and their related assets and liabilities serving 2.1 million subscribers as of December 31, 2002, located primarily in Florida (the “A/N Systems”), were transferred to a subsidiary of TWE-A/N (the “A/N Subsidiary”). As part of the restructuring, effective August 1, 2002, A/N’s interest in TWE-A/N was converted into an interest that tracks the economic performance of the A/N Systems, while AOL Time Warner and TWE retain the economic interests and associated liabilities in the remaining TWE-A/N cable systems. Also, in connection with the restructuring, AOL Time Warner effectively acquired A/N’s interest in Road Runner. All of the systems owned by TWE-A/N and the A/N Subsidiary continue to support multiple ISPs, including AOL for Broadband, Road Runner and EarthLink. TWE-A/N’s financial results, other than the results of the A/N Systems, are consolidated with TWE’s. (For additional information, see Management’s Discussion and Analysis of Results of Operations and Financial Condition, “Recent Developments - Restructuring of TWE-A/N and Road Runner Partnerships” at pages through).
Management and Operations of TWE-A/N
Management Powers and Services Agreement. Subject to the requirement to act by unanimous consent with respect to some actions as described below, TWE is the managing partner, with exclusive management rights of TWE-A/N, other than with respect to the A/N Systems. As managing partner, TWE manages TWE-A/N, other than the A/N Systems, on a day-to-day basis. Also, subject to the requirement to act by unanimous consent with respect to some actions as described below, A/N has authority for the supervision of the day-to-day operations of the A/N Subsidiary and the A/N systems. TWE entered into a services agreement with A/N and the A/N Subsidiary under which TWE agreed to exercise various management functions, including oversight of programming and certain engineering-related services. TWE and A/N also agreed to periodically discuss cooperation with respect to new product development.
Actions Requiring Unanimous Consent. Some actions cannot be taken by TWE-A/N, TWE or A/N without the unanimous consent of the AOLTW Partners and A/N or the unanimous consent of an executive committee consisting of members designated by the AOLTW Partners and A/N. These actions include, among other things:
•
any merger, consolidation or disposition of all or substantially all of the assets of TWE-A/N (excluding the A/N Subsidiary) or the A/N Subsidiary;
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any liquidation or dissolution of TWE-A/N or the A/N Subsidiary;
•
specified incurrences of debt by TWE-A/N or by the A/N Subsidiary; and
•
admission of a new partner or other issuances of equity interests in TWE-A/N or the A/N Subsidiary.
Restrictions on Transfer
AOLTW Partners. Any AOLTW Partner is generally permitted to directly or indirectly dispose of its entire partnership interest at any time so long as the transferee is a wholly owned affiliate of TWE (in the case of transfers by TWE) or TWE, AOL Time Warner or a wholly owned affiliate of TWE or AOL Time Warner (in the case of transfers by Paragon). In addition, the partnership interests of TWE-A/N held by Paragon may be transferred directly or indirectly to any permitted transferee of partnership interests of TWE-A/N held by TWE so long as AOL Time Warner controls such transferee and continues to own, directly or indirectly, at least (a) 43.75% of the residual equity capital of TWE, if such disposition occurs prior to the date on which TWE’s Class A Partners have received cash distributions of $500 million per $1 billion of investment, or (b) 35% of the residual equity capital of TWE if such disposition occurs after such date (the “AOLTW Minimum Interest”). The AOLTW Partners are also allowed to transfer their partnership interests in TWE-A/N pursuant to certain types of restructurings or liquidations of TWE. AOL Time Warner and its subsidiaries, including TWE, are generally allowed to issue equity interests so long as AOL Time Warner continues to own, directly or indirectly, at least the AOLTW Minimum Interest.
A/N Partner. A/N is generally permitted to directly or indirectly dispose of its entire partnership interest at any time so long as the transfer is to certain members of the Newhouse family or certain affiliates of A/N. A/N is also allowed to transfer its partnership interest pursuant to certain restructurings of A/N.
Restructuring Rights of the Partners
TWE and A/N each have the right to cause TWE-A/N to be restructured at any time. Upon a restructuring, TWE-A/N would be required to distribute the A/N Subsidiary with all of the A/N Systems to A/N in complete redemption of A/N’s interests in TWE-A/N, and A/N would be required to assume all liabilities of the A/N Subsidiary and the A/N Systems. Following such a restructuring, TWE’s obligations to provide management services would terminate. As of the date of this annual report, neither TWE nor A/N has delivered notice of the intent to cause a restructuring of TWE-A/N.
Rights of First Offer
TWE’s Regular Right of First Offer. Subject to exceptions, A/N and its affiliates are obligated to grant TWE a right of first offer with respect to any sale of assets of the A/N systems.
TWE’s Special Right of First Offer. Within a specified time period following the first, seventh, thirteenth and nineteenth anniversaries of the deaths of two specified members of the Newhouse family (those deaths have not yet occurred), A/N has the right to deliver notice to TWE stating that it wishes to transfer some or all of the assets of the A/N systems, thereby granting TWE the right of first offer to purchase the specified assets. Following delivery of this notice, an appraiser will determine the value of the assets proposed to be transferred. Once the value of the assets has been determined, A/N has the right to terminate its offer to sell the specified assets. If A/N does not terminate its offer, TWE will have the right to purchase the specified assets at a price equal to the value of the specified assets determined by the appraiser. If TWE does not
exercise its right to purchase the specified assets, A/N has the right to sell the specified assets to an unrelated third party within 180 days on substantially the same terms as were available to TWE.
DESCRIPTION OF CERTAIN PROVISIONS OF AGREEMENTS
RELATED TO TWC INC.
The following description summarizes certain provisions of agreements related to, and constituent documents of, TWC that will affect and govern the ongoing operations of TWC following the TWE Restructuring. Such description does not purport to be complete and is subject to, and is qualified in its entirety by reference to, the provisions of such agreements and constituent documents.
Management and Operation of TWC
Stockholders of TWC. In the TWE Restructuring, AOL Time Warner and its subsidiaries will receive shares of Class A common stock of TWC, which generally has one vote per share, and shares of Class B common stock of TWC, which generally has ten votes per share, which together will represent 89.3% of the voting power of TWC and 82.1% of the equity of TWC. A Comcast Trust will receive shares of Class A common stock of TWC representing the remaining 10.7% of the voting power and 17.9% of the equity of TWC. The Class B common stock will not be convertible into Class A common stock. The Class A common stock and the Class B common stock will vote together as a single class on all matters, except with respect to the election of directors and certain matters described below.
Board of Directors of TWC. Following the TWE Restructuring, the Class A common stock will vote, as a separate class, with respect to the election of the Class A directors of TWC (the “Class A Directors”), and the Class B common stock will vote, as a separate class, with respect to the election of the Class B directors of TWC (the “Class B Directors”). Pursuant to the restated certificate of incorporation of TWC (the “Restated Certificate of Incorporation”) to be filed at the closing of the TWE Restructuring, the Class A Directors must represent not less than one-sixth and not more than one-fifth of the directors of TWC, and the Class B Directors must represent not less than four-fifths of the directors of TWC. Because of its share holdings, AOL Time Warner will be able to cause the election of all Class A Directors and Class B Directors, subject to certain restrictions on the identity of these directors discussed below.
Following the TWE Restructuring but prior to any initial public offering of TWC, the Restated Certificate of Incorporation will require that there be at least two independent directors on the board of directors of TWC. In addition, a parent agreement (the “Parent Agreement”) among AOL Time Warner, TWC and Comcast will provide that, prior to the initial public offering of TWC, at least 50% of the independent directors be, at the time of their nomination, reasonably satisfactory to the Comcast Trust. To the extent possible, all such independent directors will be Class A Directors. For three years following the initial public offering of TWC, the Restated Certificate of Incorporation will require that at least 50% of the board of directors of TWC consist of independent directors.
Protections of Minority Class A Common Stockholders. Following the TWE Restructuring, the approval of the holders of a majority of the voting power of the then outstanding shares of Class A common stock held by persons other than AOL Time Warner will be necessary in connection with:
•
any merger, consolidation or business combination of TWC in which the holders of Class A common stock do not receive per share consideration identical to that received by the holders of Class B common stock (other than with respect to voting power) or which would adversely affect the Class A common stock relative to the Class B common stock;
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any change to the Restated Certificate of Incorporation that would have a material adverse effect on the rights of the holders of the Class A common stock in a manner different from the effect on the holders of the Class B common stock;
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any change to the provisions of the Restated Certificate of Incorporation that would affect the right of the Class A common stock to vote as a class in connection with any merger as discussed above;
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any change to the Restated Certificate of Incorporation that would alter the number of independent directors required on the TWC board of directors; and
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through and until the fifth anniversary of the completion of any initial public offering of TWC, any change to provisions of TWC’s by-laws concerning restrictions on transactions between TWC and AOL Time Warner and its affiliates.
Matters Affecting the Relationship between AOL Time Warner and TWC
Indebtedness Approval Right. For so long as the indebtedness of TWC is attributable to AOL Time Warner, in AOL Time Warner’s reasonable judgment, TWC, its subsidiaries and entities that it manages will not, without the consent of AOL Time Warner, create, incur or guarantee any indebtedness, including preferred equity, or rental obligations if its ratio of indebtedness plus six times its annual rental expense to EBITDA plus rental expense, or “EBITDAR,” then exceeds or would exceed 3:1.
Other AOL Time Warner Rights. Under the Parent Agreement, as long as AOL Time Warner has the right to elect more than a majority of the directors of TWC, TWC must obtain AOL Time Warner’s consent before it enters into any agreement that binds or purports to bind AOL Time Warner or its affiliates or that would subject TWC to significant penalties or restrictions as a result of any action or omission of AOL Time Warner; or adopts a stockholder rights plan, becomes subject to Section 203 of the Delaware General Corporation Law, adopts a “fair price” provision or takes any similar action.
AOL Time Warner Standstill. Under the Parent Agreement, AOL Time Warner has agreed that for three years following the completion of any initial public offering of TWC, AOL Time Warner will not make or announce a tender offer or exchange offer for the Class A common stock of TWC without the approval of a majority of the independent directors of TWC; and for ten years following any initial public offering of TWC, AOL Time Warner will not enter into any business combination with TWC, including a short-form merger, without the approval of a majority of the independent directors of TWC.
Transactions between AOL Time Warner and TWC. The by-laws of TWC will provide that AOL Time Warner may only enter into transactions with TWC and its subsidiaries, including TWE, that are on terms that, at the time of entering into such transaction, are substantially as favorable to TWC or its subsidiaries as they would be able to receive in a comparable arm’s-length transaction with a third party. Any such transaction involving reasonably anticipated payments or other consideration of $50 million or greater will also require the prior approval of a majority of the independent directors of TWC.
TWC Registration Rights Agreements
TWC Registration Rights Agreement with Comcast Trust. At the closing of the TWE Restructuring, a Comcast Trust will enter into a registration rights agreement with TWC relating to its shares of Class A common stock, as well as any common stock of TWC that it or another Comcast Trust may receive in connection with any sale of a partnership interest in TWE under the Partnership Interest Sale Agreement (see “Description of Certain Provisions of the TWE Partnership Agreement - Registration Rights and Other Exit Rights,” above).
Subject to several exceptions, including TWC’s right to defer a demand registration under some circumstances, the Comcast Trust may require that TWC register for public resale under the Securities Act of 1933 all shares of Class A common stock it requests be registered. The Comcast Trust may demand five registrations so long as the securities being registered in each registration statement are reasonably expected to produce aggregate proceeds of $250 million or more. TWC will not be obligated to effect more than one demand registration on behalf of the Comcast Trust in any 270-day period, nor will TWC be obligated to effect a demand registration on behalf of the Comcast Trust if it has received proceeds in excess of $250 million (or 10% of TWC’s market capitalization) from private placements of and hedging transactions relating to TWC’s common stock in the preceding 270-day period. Any registered hedging transaction or other monetization with respect to TWC common stock will be deemed to constitute a demand registration. In addition, the Comcast Trust will have “piggyback” registration rights subject to customary restrictions on any
registration for TWC’s account or the account of another stockholder, and TWC and AOL Time Warner will be permitted to piggyback on the Comcast Trust’s demand registrations. Under the registration rights agreement, the Comcast Trust may not engage in any private placement or hedging transaction until the earlier of the first anniversary of the closing of the TWE Restructuring and the date upon which TWC shall have sold at least $2.1 billion worth of common stock.
If any registration requested by the Comcast Trust or AOL Time Warner is in the form of a firm underwritten offering, and if the managing underwriter of the offering determines that the number of securities to be offered would jeopardize the success of the offering, the number of shares included in the offering shall be determined as follows:
•
first, securities to be offered for TWC’s account must be included until TWC has sold $2.1 billion worth of securities, whether through public offerings, private placements or hedging transactions;
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second, securities to be offered for the account of the Comcast Trust must be included until it has sold $3.0 billion worth of securities; and
•
third, TWC and the Comcast Trust will have equal priority, and AOL Time Warner will have last priority until the earlier of (x) the fifth anniversary of the closing of the TWE Restructuring and (y) the date the Comcast Trust holds less than $250 million of TWC common stock. After that date, TWC, the Comcast Trust and AOL Time Warner will have equal priority.
Registration Rights Agreement between TWC and AOL Time Warner. At the closing of the TWE Restructuring, AOL Time Warner and TWC will enter into a registration rights agreement relating to AOL Time Warner’s shares of TWC common stock. Subject to several exceptions, including TWC’s right to defer a demand registration under some circumstances, AOL Time Warner may, under that agreement, require that TWC register for public resale under the Securities Act of 1933 all shares of common stock that AOL Time Warner requests be registered. AOL Time Warner may demand an unlimited number of registrations. In addition, AOL Time Warner will be granted “piggyback” registration rights subject to customary restrictions, and TWC will be permitted to piggyback on AOL Time Warner’s registrations. Any registration statement filed under the agreement is subject to the cut-back priority discussed above. AOL Time Warner will not, until the fifth anniversary of the closing of the TWE Restructuring, dispose of its shares of TWC common stock other than in registered offerings.
In connection with the registrations described above under both registration rights agreements, TWC will indemnify the selling stockholders and bear all fees, costs and expenses, except underwriting discounts and selling commissions.
CURRENCY RATES AND REGULATIONS
TWE’s foreign operations are subject to the risk of fluctuation in currency exchange rates and to exchange controls. TWE cannot predict the extent to which such controls and fluctuations in currency exchange rates may affect its operations in the future or its ability to remit dollars from abroad. See Note 1, “Organization and Summary of Significant Accounting Policies - Foreign Currency Translation” and Note 12, “Derivative Financial Instruments - Foreign Currency Risk Management” to TWE’s consolidated financial statements set forth at pages and through, respectively, herein. For a discussion of revenues of international operations, see Note 13, “Segment Information” to TWE’s consolidated financial statements set forth on page herein.
EMPLOYEES
At December 31, 2002, TWE employed a total of approximately 31,200 persons.
BUSINESSES OF THE AOL TIME WARNER GENERAL PARTNERS
Prior to the completion of the TWE Restructuring, WCI and ATC are the General Partners of TWE. WCI conducts substantially all of AOL Time Warner’s vertically integrated worldwide recorded music business and worldwide music publishing business under the umbrella name Warner Music Group. ATC does not conduct operations independent of its ownership in TWE and certain other investments.
MUSIC
In the United States and around the world, WCI, through its wholly owned Warner Music Group division (“WMG”), is in the business of discovering and signing musical artists and manufacturing, packaging, distributing and marketing their recorded music, and also in the DVD manufacturing and printing businesses.
Recorded Music
In the United States, WMG’s recorded music business is principally conducted through WMG’s Warner Bros. Records Inc., Atlantic Recording Corporation, Elektra Entertainment Group Inc. and Word Entertainment and their affiliated labels, as well as through the WEA Inc. companies. WMG’s recorded music activities are also conducted through its Warner Music International division in over 70 countries outside the United States through various subsidiaries, affiliates and non-affiliated licensees.
The WEA Inc. companies include WEA Manufacturing Inc., which manufactures compact discs (CDs), CD-ROMs and DVDs principally for WMG’s record labels and Warner Home Video, but also for other outside companies; Ivy Hill Corporation, which produces printed material and packaging for WMG’s recorded music products as well as for a wide variety of other consumer products; and Warner-Elektra-Atlantic Corporation (“WEA Corp.”), which markets and distributes WMG’s and third-party recorded music products to retailers and wholesale distributors. WMG also owns a majority interest in Alternative Distribution Alliance (“ADA”), an independent distribution company specializing in alternative rock, metal, hip hop and dance music with a focus on new or developing artists.
Domestic
WMG’s major record labels in the United States-Warner Bros., Atlantic, Elektra and Word-each with a distinct identity, discover, sign and develop recording artists. The labels scout and sign talent in many different musical genres, including pop, rock, jazz, country, R&B, hip hop, rap, reggae, Latin, alternative, folk, blues, gospel and Christian music. The January 2002 acquisition of Word Entertainment, a major Christian music company, has significantly expanded the division’s presence in that genre. In July 2002, Word Entertainment became 20% owned by an affiliate of Curb Records, a prominent Nashville-based independent record label, as part of a transaction in which Curb entered into a long-term multi-territory distribution arrangement with various WMG affiliates. Among the artists that resulted in significant United States sales for WMG during 2002 were: Josh Groban, Enya, Kid Rock, Faith Hill, Red Hot Chili Peppers, Linkin Park, Missy Elliott, P.O.D., Michelle Branch and Nappy Roots.
WMG is a vertically integrated music company. After an artist has entered into a contract with a WMG label, a master recording of the artist’s music is produced and provided to WMG’s manufacturing operation, WEA Manufacturing, which replicates the music primarily on CDs. WEA Manufacturing also manufactures a significant number of DVDs worldwide. Ivy Hill prints material that is included with CDs, DVDs and audio cassettes and creates packaging for them. WEA Corp. and ADA, WMG’s United States distribution arms, market and sell product and deliver it, either directly or through sub-distributors and wholesalers, to thousands of record stores, mass merchants and other retailers throughout the country. Product is also increasingly being sold directly to consumers through Internet retailers such as Amazon.com. Sales by WMG labels, as well as by the music industry generally, have been adversely affected by piracy and parallel imports and also by Internet sites and technologies that allow consumers to download quality sound reproductions from the Internet without authorization from the rights owner.
WMG’s Warner Strategic Marketing division (which includes Warner Special Products, Warner Television Marketing, Warner Music Group Soundtracks and Rhino Entertainment Company) specializes in marketing WMG’s catalog through compilations and reissues of previously released music and video titles; licensing tracks to third parties for various uses and through coordinating film and television soundtrack opportunities between WMG record labels and the film and television studios of both Warner Bros. and third parties.
WMG also has entered into joint venture arrangements pursuant to which WMG companies manufacture, distribute and market (in most cases, domestically and internationally) recordings owned by joint ventures, such as Maverick Records and Lava Records. Since 1991, WMG and Sony Music Entertainment Inc. have operated The Columbia House Company, a direct marketer of CDs, DVDs and audio and videocassettes in North America, through a 50/50 joint venture. In June 2002, WMG and Sony Music each sold 85% of their ownership interests in Columbia House to an affiliate of The Blackstone Group as part of a leveraged buyout, thereby reducing WMG’s interest to 7.5%.
WMG has continued to actively pursue new media opportunities and to license new business models in the digital arena. In 2001, Bertelsmann and EMI joined WMG and RealNetworks as shareholders in MusicNet, an online subscription music distribution platform that functions as a wholesaler and is implemented by online services that interface with individual consumers. As of November 2002, MusicNet had obtained licenses from all five major music companies, enabling it to offer a broad musical repertoire. In addition to the subscription service licenses granted by WMG in 2001 to Echo Networks, MusicNet, OD2 and Listen.com, in 2002 WMG entered into subscription service licenses with FullAudio, Streamwaves.com and pressplay.
In late 2002, WMG and AT&T Wireless announced that AT&T Wireless would be selling ring tones featuring the music of WMG artists to certain AT&T Wireless subscribers that use cellular handsets supporting such functionality. As part of such arrangement, WMG is hosting a wireless website that allows such subscribers to access certain WMG artists’ promotional content. WMG entered into a similar arrangement with Sprint PCS in early 2003 and expects to enter into additional arrangements with a goal of developing new wireless promotional and commercial opportunities for WMG and its artists. WMG has also been a driving force in establishing the DVD Audio format, launched in fall 2000, which improves on the CD by providing higher fidelity and six-channel surround sound. As of the end of 2002, WMG has released more than 80 titles in this format.
WMG’s Giant Merchandising is a leading supplier of screen printed and embellished apparel focusing on music entertainment merchandising, retail licenses and private label marketing and distribution. Among Giant’s major customers in 2002 were Paul McCartney, Cher, Aerosmith, Harley Davidson, Hard Rock Cafe, Nike and Reebok.
International
The Warner Music International (“WMI”) division of WMG operates through various subsidiaries and affiliates and their non-affiliated licensees in over 70 countries around the world. WMI engages in the same activities as WMG’s domestic labels, discovering and signing artists and manufacturing, packaging, distributing and marketing their recorded music. The artists signed to WMI and its affiliates number more than a thousand. Significant album sales for WMI in 2002 were generated by the following artists and soundtracks: Alanis Morissette, Linkin Park, David Gray, Phil Collins, Laura Pausini, Mana, Rip Slyme, Red Hot Chili Peppers and Lord of the Rings.
In most cases, WMI also markets and distributes the records of those artists for whom WMG’s domestic record labels have international rights. In certain countries, WMI licenses to unaffiliated third-party record labels the right to distribute its records. WMI operates a plant in Germany that manufactures CDs and DVDs for its affiliated companies, as well as for outside companies and, as part of a joint venture, operates a plant in Australia that manufactures CDs.
Music Publishing
WMG’s music publishing division, Warner/Chappell, owns or controls the rights to more than one million musical compositions, including numerous pop music hits, American standards, folk songs and motion picture and theatrical compositions. Its catalog includes works from a diverse range of artists and composers including Madonna, Staind, Nickelback, India.Arie, Barry Gibb, Dido, Moby, George and Ira Gershwin and Cole Porter. Warner/Chappell also administers the music of several television and motion picture companies, including Lucasfilm, Ltd. and Hallmark Entertainment.
Warner/Chappell also owns Warner Bros. Publications, one of the world’s largest publishers of printed music. Warner Bros. Publications markets publications throughout the world containing works of such artists as Shania Twain, The Grateful Dead and Led Zeppelin and containing works from the Zomba and Universal music publishing catalogs.
The principal sources of revenues to Warner/Chappell are royalties for the use of its compositions on CDs, DVDs, ring tones, music videos, the Internet and in television commercials; license fees paid for the use of its musical compositions on radio, television, in motion pictures and in other public performances; and sales of published sheet music and song books.
Competition
The revenues of a company in the recording industry depend upon public acceptance of a company’s recording artists and their music. Although WMG is one of the largest recorded music companies in the world, its competitive position is dependent on its continuing ability to attract and develop talent that can achieve a high degree of public acceptance. The competition among record companies for such talent is intense, as is the competition among companies to sell the recordings created by these artists. The recorded music business continues to be adversely affected by the bankruptcies of record wholesalers and retailers, counterfeiting of CDs, piracy and parallel imports and also by Internet sites and technologies that allow consumers to download quality sound reproductions from the Internet without authorization from the rights owner. In response, the recorded music industry has engaged in efforts to develop secure technologies for digital music delivery, to battle piracy through litigation and legislation and to establish legitimate new media business models.
Competition in the music publishing business is also intense. Although WMG’s music publishing business is one of the largest on a worldwide basis, it competes with every other music publishing company in acquiring musical compositions and in having them recorded and performed. In addition, the vast majority of WMG’s music publishing revenues are subject to rate regulation either by government entities or by collecting societies throughout the world. WMG also competes for consumer attention with other non-musical media such as home video and video games.
OTHER
Time Warner Telecom
Time Warner Telecom Inc. (“Time Warner Telecom”) is a fiber facilities-based integrated communications provider that sells last-mile bandwidth and telecommunications services on its own fiber optic network to medium and large businesses in selected metropolitan areas across the United States. Time Warner Telecom was formed in 1998 through a restructuring of the business telephony operations of Time Warner Cable. The AOLTW General Partners’ aggregate equity interest in Time Warner Telecom as of December 31, 2002 was 34%.
DC Comics and Mad Magazine
DC Comics, which has been owned 50-50 by TWE and WCI, publishes more than 50 regularly issued comics magazines featuring such popular characters as Superman, Batman, Wonder Woman and The Sandman. DC Comics also derives revenues from motion pictures, television, product licensing and books.
Following completion of the TWE Restructuring, DC Comics will be 100% owned by WCI and a subsidiary of WCI.
WCI owns 100% of E.C. Publications, Inc., the publisher of MAD, a humor and satirical magazine which is regularly published 12 times a year and also in periodic special editions.
Turner Broadcasting System, Inc.
In October 1996, Time Warner consummated the acquisition of TBS by acquiring the remaining approximately 80% interest in TBS not already owned by Time Warner. The AOLTW General Partners collectively own a 10.6% economic interest in TBS. Through its subsidiaries, TBS owns and operates domestic and international entertainment networks, including TBS Superstation, Turner Network Television (TNT), Cartoon Network and Turner Classic Movies; and news networks, including CNN, Headline News, CNN International (CNNI) and CNN en Español. TBS also has interests in sports franchises and motion picture operations.
Warner Japan
WCI currently owns, directly and indirectly, an aggregate 99.95% interest in Warner Japan, which conducts a number of businesses in Japan, including home video distribution, theatrical film and television distribution and merchandising businesses, as well as recorded music production, promotion and distribution. Pursuant to distribution and merchandising agreements entered into between TWE and Warner Japan, Warner Japan receives distribution fees generally comparable to those currently received by TWE for performing distribution services for unaffiliated third parties.
Item 2.
Item 2.
Properties
Networks - HBO, Filmed Entertainment and Cable
The following table sets forth certain information as of December 31, 2002 with respect to principal properties (over 250,000 square feet in area) owned or leased by TWE’s Networks - HBO, Filmed Entertainment and Cable businesses, all of which TWE considers adequate for its present needs, and all of which were substantially used by TWE.
(a)
Ten acres consist of various parcels adjoining The Warner Bros. Studio, with mixed commercial, office and residential uses.
AOL Time Warner General Partners
The following table sets forth certain information as of December 31, 2002 with respect to the principal properties of WCI and its subsidiaries (over 250,000 square feet in area), all of which WCI considers adequate for its present needs, and all of which were substantially used by WCI. ATC, the other AOL Time Warner General Partner, does not own or lease any properties material to its business.
Item 3.
Item 3. Legal Proceedings
TWE or the AOLTW General Partners are parties to various litigation matters, including:
On June 24, 1997, plaintiffs in Six Flags Over Georgia LLC et al. v. Time Warner Entertainment Company, L.P. et al., filed an amended complaint in the Superior Court of Gwinnett County, Georgia, claiming that, inter alia, defendants, which include TWE, violated their fiduciary duties in operating the Six Flags Over Georgia theme park. On December 18, 1998, following a trial, a jury returned a verdict in favor of plaintiffs. The total awarded to plaintiffs was approximately $454 million in compensatory and punitive damages. The case was appealed to the Georgia Court of Appeals, which affirmed the trial court’s judgment, and denied reconsideration. The Supreme Court of Georgia denied certiorari on January 18, 2001. On February 28, 2001, the compensatory damages portion of the award plus accrued interest was paid to plaintiffs. On March 1, 2001, the United States Supreme Court granted a stay as to payment of the punitive damages part of the jury’s original award, pending the resolution of a petition for certiorari to be filed by TWE, which was filed on June 15, 2001. On October 1, 2001, the United States Supreme Court granted certiorari, vacated the opinion of the Georgia Court of Appeals and remanded the case for further consideration as to punitive damages. On March 29, 2002, the Georgia Court of Appeals affirmed and reinstated its earlier decision regarding the punitive damage award. On April 18, 2002, TWE filed a petition for certiorari to the Georgia Supreme Court seeking review of the decision of the Georgia Court of Appeals, which was denied on September 16, 2002. The Georgia Supreme Court subsequently denied TWE’s motion for reconsideration of its September 16th ruling. Plaintiffs have agreed not to pursue payment of the punitive damages award and accrued interest until the resolution of TWE’s petition for writ of certiorari to the United States Supreme Court, which TWE filed on December 23, 2002. The petition is pending.
On April 8, 2002, three former employees of certain subsidiaries of WMG filed Henry Spann et al. v. AOL Time Warner Inc. et al., a purported class action, in the U. S. District Court for the Central District of California. Plaintiffs have named as defendants AOL Time Warner, TWE., WEA Corp., WEA Manufacturing Inc., Warner Bros. Records, Atlantic Recording Corporation, various pension plans sponsored by the companies and the administrative committees of those plans. Plaintiffs allege that defendants miscalculated the proper amount of pension benefits owed to them and other class members as required under the plans in violation of ERISA. The lawsuit has been transferred to the U. S. District Court for the Southern District of New York. The AOLTW General Partners intend to defend against this lawsuit vigorously. The AOLTW General Partners are unable to predict the outcome of this suit or reasonably estimate a range of possible loss.
The costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgements and investigations,
claims and changes in those matters (including those matters described above), and developments or assertions by or against TWE or the AOLTW General Partners relating to intellectual property rights and intellectual property licenses, could have a material adverse effect such company’s business, financial condition and operating results.
Item 4.
Item 4.
Submission of Matters to a Vote of Security Holders.
Not applicable.
PART II
Item 5.
Item 5.
Market For Registrant’s Common Equity and Related Stockholder Matters.
Not applicable.
Item 6.
Item 6.
Selected Financial Data.
The selected financial information of TWE and the AOLTW General Partners for the five years ended December 31, 2003 is set forth at pages and herein and is incorporated herein by reference.
Item 7.
Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
The information set forth under the caption “Management’s Discussion and Analysis” at pages through and at pages through herein is incorporated herein by reference.
Item 7A.
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk.
The information set forth under the caption “Market Risk Management” at pages through and page through herein is incorporated herein by reference.
Item 8.
Item 8.
Financial Statements and Supplementary Data.
The consolidated financial statements and supplementary data at pages through of TWE and the report of independent auditors thereon set forth at page herein, and the consolidated financial statements set forth at pages through of the AOLTW General Partners and the report of independent auditors thereon set forth at page herein, are incorporated herein by reference.
Quarterly Financial Information set forth at page herein is incorporated herein by reference.
Item 9.
Item 9.
Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Representatives and Directors
Set forth below is the name and age of each member of the Board of Representatives of TWE and each person who is a director of one or both of the AOLTW General Partners, such person’s present principal occupation or employment, the name of the corporation or other organization in which such occupation or employment is conducted and the name and principal business of any corporation or other organization in which such person held a material position or office or engaged in a material occupation or employment during the last five years and such position, office, occupation or employment. Mr. Parsons became a member of the Board of Representatives of TWE on February 1, 1995, Messrs. Case and Novack became members of the Board of Representatives of TWE as of January 12, 2001 and Messrs. Bewkes and Logan became members of
the Board of Representatives of TWE on July 18, 2002. The selection of TWE’s Board of Representatives prior to the completion of the TWE Restructuring is governed by the TWE Partnership Agreement. Comcast, through the Comcast Trusts, has elected not to appoint any representatives to the Board of Representatives of TWE and will not do so prior to the completion of the TWE Restructuring. After the TWE Restructuring, TWC Inc., as the general partner of TWE, will manage the business and affairs of TWE. See “Description of Certain Provisions of the TWE Partnership Agreement - Management and Operations of TWE.” Mr. Parsons became a director of each AOLTW General Partner on February 1, 1995. Messrs. Bewkes and Logan became directors of each AOLTW General Partner on July 31, 2002.
For a general discussion of the duties of the executive officers and representatives of TWE, see “Description of Certain Provisions of the TWE Partnership Agreement - Management and Operations of TWE.”
Director and/or
Principal Occupations or Positions
Name
Representative of
Age
During the Past Five Years
Stephen M. Case
TWE
Chairman of the Board of TWE and AOL Time Warner since the consummation of the Merger. Mr. Case has announced that he will step down as Chairman of the Board of TWE and AOL Time Warner in May 2003. A co-founder of America Online, Mr. Case had been Chairman of the Board of America Online from October 1995 and CEO of America Online from April 1993, having served in other executive positions at America Online since 1985. Mr. Case is also a director of AOL Time Warner.
Richard D. Parsons
TWE, WCI and ATC
Chief Executive Officer of TWE and AOL Time Warner since May 2002 and will also become Chairman of the Board of TWE and AOL Time Warner in May 2003; prior to May 2002, he was Co-Chief Operating Officer of both companies from the consummation of the Merger. Prior to the Merger, Mr. Parsons was President of TWE and Time Warner from February 1995. He served as a director of ATC, then an 82%-owned subsidiary of Time Warner, from 1989 until 1991 and is currently also a director of AOL Time Warner, Citigroup Inc. and Estee Lauder Companies, Inc.
Kenneth J. Novack
TWE
Vice Chairman of TWE and AOL Time Warner since the consummation of the Merger; prior to that, he served as Vice Chairman of America Online from May 1998. Mr. Novack served as Of Counsel to the Boston-based law firm of Mintz, Levin, Cohn, Ferris, Glovsky and Popeo, PC after his retirement as a member of that firm in August 1998 through March 2001. Mr. Novack joined Mintz Levin in 1966 and served on its executive committee from 1970 until his retirement. Mr. Novack is also a director of AOL Time Warner.
Director and/or
Principal Occupations or Positions
Name
Representative of
Age
During the Past Five Years
Jeffrey L. Bewkes
TWE, WCI and ATC
Chairman, Entertainment & Networks Group of TWE and AOL Time Warner since July 2002; prior to that, Mr. Bewkes served as Chief Executive Officer of the Home Box Office division of TWE from May 1995 and President and Chief Operating Officer for the preceding five years.
Don Logan
TWE, WCI and ATC
Chairman, Media & Communications Group of TWE and AOL Time Warner since July 2002; prior to that, Mr. Logan served as Chairman and Chief Executive Officer of Time Inc., AOL Time Warner’s publishing subsidiary, from August 1994, and as its President and Chief Operating Officer from June 1992. Prior to that, he held various executive positions with Southern Progress Corporation, which was acquired by Time Inc. in 1985.
Executive Officers
Set forth below is the name and age of the executive officers of TWE and each of the AOLTW General Partners, such person’s present principal occupation or employment, the name of the corporation or other organization in which such occupation or employment is conducted and the name and principal business of any corporation or other organization in which such person held a material position or office or engaged in a material occupation or employment during the last five years and such position, office, occupation or employment. Mr. Parsons became an executive officer of the AOLTW General Partners on February 1, 1995. The remaining executive officers of TWE became executive officers of ATC as of January 12, 2001 and of WCI as of February 2, 2001 or, if later, on the date they became executive officers of TWE.
Principal Occupations or
Name
Age
Positions During the Past Five Years
Stephen M. Case
See “- Representatives and Directors.”
Richard D. Parsons
See “- Representatives and Directors.”
Kenneth J. Novack
See “- Representatives and Directors.”
Jeffrey L. Bewkes
See “- Representatives and Directors.”
Don Logan
See “- Representatives and Directors.”
Paul T. Cappuccio
Executive Vice President, General Counsel and Secretary of TWE and AOL Time Warner since the consummation of the Merger; prior to that, he served as Senior Vice President and General Counsel of America Online from August 1999. Before joining America Online, from 1993 to 1999, Mr. Cappuccio was a partner at the Washington, D.C. office of the law firm of Kirkland & Ellis. Mr. Cappuccio was also an Associate Deputy Attorney General at the U.S. Department of Justice from 1991 to 1993.
Adolf DiBiasio
Executive Vice President of Strategy and Investments of TWE and AOL Time Warner since May 2001; prior to that, Mr. DiBiasio was a Senior Director at McKinsey & Company, management consultants, for more than 30 years.
Compliance with Section 16(a) of the Exchange Act.
Not Applicable.
Item 11.
Item 11. Executive Compensation
In 2002, the executive officers of TWE and the AOLTW General Partners were compensated by AOL Time Warner for services provided in most cases to AOL Time Warner pursuant to employment agreements with AOL Time Warner and received no additional compensation from TWE or any of the AOLTW General Partners. AOL Time Warner provided the services of such executive officers to TWE and was reimbursed for such services pursuant to arrangements set forth in the TWE Partnership Agreement. See Item 13 “Certain Relationships and Related Transactions - Corporate Services.” Members of the Board of Representatives of TWE and directors of the AOLTW General Partners are not additionally compensated for such activities.
Executive Compensation Summary Table
The following table presents information concerning total compensation paid to the two individuals who served as Chief Executive Officer during 2002, each of the four most highly compensated executive officers of AOL Time Warner and TWE who served in such capacities on December 31, 2002 and Mr. Pittman, who served as an executive officer during 2002 (collectively, the “named executive officers”). Prior to the consummation of the Merger on January 11, 2001 (the “Merger Date”), certain of these executive officers functioned as executive officers of, and were compensated by, America Online or Time Warner, as the case may be. Prior to the Merger, America Online’s fiscal year ended on June 30. In connection with the Merger, America Online changed its fiscal year to a calendar year. As a result, the compensation shown for Messrs. Case, Novack and Pittman prior to 2001 is that paid with respect to America Online’s prior fiscal year and the last six months of 2000 (the “Transition Period”). All information related to common stock has been adjusted to reflect the exchange ratios of common stock of Time Warner and America Online for common stock of AOL Time Warner (“AOL Time Warner Common Stock”) in the Merger and AOL Time Warner’s assumption of the relevant America Online and Time Warner stock-based benefit plans in connection with the Merger.
SUMMARY COMPENSATION TABLE
*
Transition Period - July 1, 2000 through December 31, 2000
(1)
Mr. Case became Chairman of the Board of AOL Time Warner on the Merger Date. Prior to that, he served as Chairman of the Board and Chief Executive Officer of America Online.
(2)
Mr. Parsons became Chief Executive Officer of AOL Time Warner on May 16, 2002, having served as Co-Chief Operating Officer of AOL Time Warner from the Merger Date. Prior to that, he served as President of Time Warner.
(3)
Mr. Novack became Vice Chairman of AOL Time Warner on the Merger Date. Prior to that, he served as Vice Chairman of America Online.
(4)
Mr. Bewkes became Chairman, Entertainment & Networks Group of AOL Time Warner on July 18, 2002. Prior to that, Mr. Bewkes was Chief Executive Officer of AOL Time Warner’s Home Box Office division (not an executive officer of AOL Time Warner). The compensation shown in the table includes compensation received from Home Box Office.
(5)
Mr. Logan became Chairman, Media & Communications Group of AOL Time Warner on July 18, 2002. Prior to that, Mr. Logan was Chairman and Chief Executive Officer of AOL Time Warner’s Time Inc. subsidiary (not an executive officer of AOL Time Warner). The compensation shown in the table includes compensation received from Time Inc.
(6)
Mr. Levin served as Chief Executive Officer of AOL Time Warner from February 2000 until his retirement from the position of Chief Executive Officer in May 2002. He continues to serve as an employee in an advisory capacity. He served as Chairman of the Board and Chief Executive Officer of Time Warner from January 1993 to the Merger Date.
(7)
Mr. Pittman served as Co-Chief Operating Officer of AOL Time Warner from the Merger Date and served as Chief Operating Officer of AOL Time Warner from May 16, 2002 until his resignation in July 2002. Prior to that, he served as President and Chief Operating Officer of America Online.
(8)
One quarter of the stock option award of each named executive officer in 2001, other than Messrs. Bewkes and Logan, was made in lieu of a cash bonus for 2002.
(9)
In accordance with SEC rules, amounts totaling less than $50,000 have been omitted. The amounts of personal benefits shown in this column for 2002 that represent more than 25% of the applicable executive’s total Other Annual Compensation include financial services of $100,000 to each of Messrs. Parsons, Novack, Levin and Pittman, $99,213 to Mr. Case and $39,186 to Mr. Bewkes; transportation-related benefits of $178,342 to Mr. Case, $74,768 to Mr. Parsons, $47,374 to Mr. Bewkes, $371,029 to Mr. Logan and $172,656 to Mr. Levin; $50,880 to Mr. Novack for insurance coverage (see Note 11(b)); and $167,192 to Mr. Pittman as reimbursement for the payment of taxes related to life insurance coverage provided in 2001. For security reasons, certain executive officers are subject to mandated transportation procedures.
(10)
None of the stock options reflected was awarded with tandem stock appreciation rights. None of such executive officers was awarded restricted stock during the relevant period and, as of December 31, 2002, no named executive officer held any such shares.
(11)
The amounts shown in this column for 2002 include the following:
(a) Pursuant to the AOL Time Warner Savings Plan (the “Savings Plan”), a defined contribution plan available generally to employees of AOL Time Warner, for the 2002 plan year, each of the named executive officers deferred a portion of his annual compensation and AOL Time Warner contributed $2,000 for the first $3,000 so deferred by the executive (“Matching Contribution”). These Matching Contributions were invested under the Savings Plan in an AOL Time Warner Common Stock fund.
(b) AOL Time Warner maintains a program of life and disability insurance generally available to all salaried employees on the same basis. This group term life insurance coverage was reduced to $50,000 for each of Messrs. Parsons, Novack, Logan and Levin, who were given a cash payment equal to the cost of replacing such reduced coverage under a voluntary group program available to employees generally. Such payments are included in the “Other Annual Compensation” column. In addition, during 2002, AOL Time Warner maintained for certain members of senior management, including the named executive officers, certain supplemental life insurance benefits and paid premiums for this supplemental coverage of approximately $250 each. AOL Time Warner also maintained split-dollar life insurance policies on the lives of Messrs. Parsons, Bewkes, Logan and Levin and paid the following
amounts allocated to the term portion of the split-dollar coverage for 2002: Mr. Parsons, $5,242; Mr. Bewkes, $3,227; Mr. Logan, $4,811; and Mr. Levin, $25,846. The actuarial equivalent of the value of the premiums paid by AOL Time Warner for 2002 based on certain assumptions regarding interest rates and periods of coverage are: Mr. Parsons, $82,933; Mr. Bewkes, $59,047; Mr. Logan, $33,889; and Mr. Levin, $32,752. The premium on one of two policies for Mr. Logan was not paid in 2002 pursuant to an extended grace period. It is anticipated that AOL Time Warner will recover the net after-tax cost of the premiums on these policies or the cash surrender value thereof. For a description of life insurance coverage for certain executive officers provided pursuant to the terms of their employment agreements, see “Employment Arrangements.”
Stock Option Grants During 2002
The following table sets forth certain information with respect to employee options to purchase shares of AOL Time Warner Common Stock (“options”) awarded during 2002 to the named executive officers. All such options were nonqualified options. No stock appreciation rights, alone or in tandem with such stock options, were awarded in 2002.
STOCK OPTION GRANTS IN 2002
(1)
Options for executive officers have been awarded pursuant to plans approved by the stockholders, except for the awards made to Messrs. Bewkes and Logan in February 2002 before they became executive officers of AOL Time Warner. The terms are governed by the plans and the recipient’s option agreement. The option exercise price is the fair market value of AOL Time Warner Common Stock on the date of grant. The options shown in the table become exercisable in installments of 25% on the first four anniversaries of the date of grant, subject to acceleration upon the occurrence of certain events. Payment of the exercise price of an option may be made in cash and/or full shares of AOL Time Warner Common Stock already owned by the holder of the option. The payment of withholding taxes due upon exercise of an option may generally be made in cash and/or full shares of AOL Time Warner Common Stock.
(2)
These amounts represent the estimated present value of stock options at the respective date of grant, calculated using the Black-Scholes option pricing model, based upon the following assumptions used in developing the grant valuations: an expected volatility of 52.9% based on the historical volatility of AOL Time Warner Common Stock; an expected term to exercise of .47 years after vesting; a risk-free rate of return of 4.20% for the first awards listed for Messrs. Bewkes and Logan and 3.70% for the other awards; and a dividend yield of 0%. The actual value of the options, if any, realized by an officer will depend on the extent to which the market value of the AOL Time Warner Common Stock exceeds the exercise price of the option on the date the option is exercised. Consequently, there is no assurance that the value
realized by an officer will be at or near the value estimated above. These amounts should not be used to predict stock performance.
Option Exercises and Values in 2002
The following table sets forth as to each of the named executive officers information on option exercises during 2002 and the status of his options on December 31, 2002: (i) the number of shares of AOL Time Warner Common Stock underlying options exercised during 2002; (ii) the aggregate dollar value realized upon exercise of such options; (iii) the total number of shares of AOL Time Warner Common Stock underlying exercisable and nonexercisable stock options held on December 31, 2002; and (iv) the aggregate dollar value of in-the-money exercisable and nonexercisable stock options on December 31, 2002. The number of shares covered and the option exercise prices have been adjusted to reflect the exchange ratios of common stock of America Online and Time Warner for AOL Time Warner Common Stock on the Merger Date and AOL Time Warner’s assumption on the Merger Date of the option plans and agreements under which the options were awarded.
AGGREGATE OPTION EXERCISES DURING
and
OPTION VALUES ON DECEMBER 31, 2002
*
Calculated using the fair market value of $13.10 per share of AOL Time Warner Common Stock on December 31, 2002 minus the option exercise price.
(1)
The options exercised by each of Messrs. Case and Levin would have expired in 2003. In connection with the exercise of these options, Mr. Levin used AOL Time Warner Common Stock to pay the taxes due and retained the remainder of the shares received upon exercise and Mr. Case retained, and continues to hold, all of the shares received upon exercise.
(2)
Includes 855,812 exercisable options that Mr. Novack transferred to grantor retained annuity trusts for the benefit of members of his family. At December 31, 2002, these options had a value of $1,150,813.
(3)
Includes 144,996 exercisable options that Mr. Logan transferred to a family-owned limited partnership. At December 31, 2002, these options had a value of $159,496.
(4)
All of the options exercised by Mr. Pittman were held by a family-owned limited partnership. His year-end holdings include 797,255 exercisable options that Mr. Pittman transferred to a family-owned limited partnership. At December 31, 2002, these options had a value of $9,169,121.
(5)
All options awarded prior to 2000 held by Messrs. Parsons, Bewkes, Logan and Levin became immediately exercisable in full upon the approval by Time Warner’s board of directors of the Merger on January 9, 2000. All options awarded prior to 2000 held by Messrs. Case and Novack became immediately exercisable in full on the Merger Date and all such options held by Mr. Pittman became immediately exercisable on the first anniversary of the Merger Date. All options awarded to Mr. Pittman in or after 2000 became immediately exercisable in full in September 2002.
The option exercise price of all the options held by the named executive officers is the fair market value of the AOL Time Warner Common Stock on the date of grant except for (1) half of the regular annual options awarded to Messrs. Parsons and Levin in 1996 through 2000, half of the options awarded to each of the named executive officers, except Messrs. Bewkes and Logan, in 2001 and 1,500,000 of Mr. Levin’s options awarded in 1993, half of which have an exercise price 25% above the fair market value of the common stock on the date of grant and the other half of which have an exercise price 50% above such fair market value and (2) options awarded to Messrs. Case and Pittman in 1997 which have an exercise price 30% above the fair market value of the common stock on the date of grant. All such nonqualified options permit a portion of each award to be transferred by gift directly or indirectly to members of the holder’s immediate family. The stock option agreements may permit optionees to defer receipt of the shares of AOL Time Warner Common Stock receivable upon exercise of options governed by such stock option agreements to a future date elected by the optionee, thereby deferring the recognition of income by the optionee (and AOL Time Warner’s tax deduction) until such future date. During the deferral period, the shares are not outstanding, do not vote and do not pay dividends; however, AOL Time Warner has agreed to pay the optionee dividend equivalents during the deferral period, to the extent dividends are paid.
The options held by the named executive officers remain exercisable for three months to five years in the event their employment is terminated without cause or as a result of AOL Time Warner’s breach of an employment agreement. For some executive officers, some of their options remain exercisable for the full term of the options if their employment is terminated for any reason other than for cause, including death. Otherwise, options may generally be exercised for one or three years after death or total disability (depending on their date of grant) and some options may be exercised for five years after retirement. All options terminate either immediately or one month after the holder’s employment is terminated for cause. The terms of the options shown in the chart are generally ten years, although 960,000 options held by Mr. Levin and 188,592 options held by Mr. Bewkes have a term of 15 years from the date of their award in 1989.
Employment Arrangements
AOL Time Warner is a party to employment agreements with Messrs. Parsons, Novack, Bewkes, Logan and Levin. The expiration dates of these agreements are: Mr. Parsons - January 31, 2005; Mr. Novack - December 31, 2003; Mr. Bewkes - December 31, 2003; Mr. Logan - December 31, 2004; and Mr. Levin - December 31, 2005. AOL Time Warner also was a party to an employment agreement with Mr. Pittman that did not have a fixed term.
Among other things, the agreements with Messrs. Parsons and Novack each provide for a fixed term of employment in a specified executive post; minimum annual salary of $1 million and participation in AOL Time Warner stock option and other compensation and benefit plans, including $50,000 of group term life insurance. These agreements do not provide for the payment of an annual cash bonus. The agreements with Messrs. Bewkes and Logan were entered into with the divisions for which they served as Chairman and Chief Executive Officer prior to their election as executive officers of AOL Time Warner in July 2002. These agreements, which have been assumed by AOL Time Warner, provide for a minimum annual salary of $1 million, an annual cash bonus of not less than $2.75 million with respect to Mr. Bewkes and a discretionary cash bonus in a target amount of $3 million with respect to Mr. Logan, and participation in AOL Time Warner stock option and other compensation and benefit plans, including group life insurance. In addition, the agreements with Messrs. Parsons, Bewkes, Logan and Levin provide for (1) life insurance benefits in the amount of $5 million, $4 million, $4 million and $6 million, respectively, to be provided by split-dollar policies for the life of the executive under which AOL Time Warner recovers an amount equal to the net after-tax cost of the premiums paid by AOL Time Warner or the policies’ cash surrender value, (2) for Messrs. Parsons and Levin, a cash payment equal to the premium for coverage under a Group Universal Life (“GUL”) insurance program made available by AOL Time Warner in an amount equal to twice the executive’s salary, minus $50,000 and (3) for Mr. Logan, a cash payment equal to two times the premium he would have to pay to obtain life insurance under AOL Time Warner’s GUL insurance program in an amount equal to twice his salary. Mr. Novack’s agreement provides for a cash payment equal to two times the premium for $4 million of GUL insurance coverage.
The agreements with Messrs. Parsons, Novack, Bewkes, Logan and Levin include a narrow definition of the “cause” for which an executive’s employment may be terminated and in that event, the executive will only receive earned and unpaid base salary accrued through such date of termination.
These agreements provide that in the event of AOL Time Warner’s material breach or termination of the executive’s employment without cause, the executive will be entitled to elect either (a) to receive a lump-sum payment equal to the present value of the compensation otherwise payable during the remaining portion of the executive’s term of employment or a specified minimum period of time if less than such remains in the term of the agreement or (b) to remain an employee of AOL Time Warner through the end of such period and, without having to perform any services, receive such compensation as if there had been no breach or termination. These executives are not required to mitigate damages after such a termination, other than as necessary to prevent AOL Time Warner from losing any tax deductions to which it otherwise would have been entitled for any payments deemed to be “contingent on a change” of control under the Internal Revenue Code. These agreements also provide that in the event of AOL Time Warner’s material breach or termination of the executive’s employment without cause, a portion or all of the unvested stock options granted to such executive will vest and vested stock options will remain exercisable for a period of time longer than would generally apply to stock options awarded by AOL Time Warner.
Mr. Parsons’ agreement allows him, effective on or after January 1, 2002 and with not less than six months’ prior notice to AOL Time Warner, to terminate his executive position and become an advisor to AOL Time Warner for the remainder of the agreement term. In that case his advisory compensation would be equal to $500,000 per year.
Mr. Logan’s agreement allows him to elect in September 2003 to terminate his active employment with AOL Time Warner effective as of January 1, 2004 and become an advisor to AOL Time Warner through June 30, 2007 at an annual salary equal to $1.25 million, but with no bonus. If he remains with AOL Time Warner through the December 31, 2004 term of the agreement, Mr. Logan can elect to become an advisor to AOL Time Warner thereafter through December 31, 2009 at an annual salary equal to $1.25 million.
Mr. Bewkes’ agreement also provides that if he and AOL Time Warner have not reached written agreement regarding his employment with AOL Time Warner by the end of the term, then Mr. Bewkes may elect to (a) leave AOL Time Warner with a lump sum payment in exchange for additional limits on his ability to accept employment with competitors of AOL Time Warner following his departure, (b) leave AOL Time Warner without a lump sum payment and without being subject to such additional limits on his ability to compete with AOL Time Warner, or (c) remain an employee of AOL Time Warner for an additional 6 or 12 months.
If Messrs. Parsons, Novack, Bewkes, Logan or Levin should become disabled during the term of his employment agreement, the executive will receive full salary for six months and then 75% thereof through the end of the employment term. Any such payments will be reduced by amounts received from Worker’s Compensation, Social Security and disability insurance policies maintained by AOL Time Warner.
If an executive dies during the term of an employment agreement, the executive’s beneficiaries will receive the executive’s earned and unpaid salary to the last day of the month in which the death occurs.
Mr. Levin’s agreement allowed him, effective on or after May 1, 2002 and with not less than five months’ prior notice to AOL Time Warner, to terminate his position as Chief Executive Officer and become an advisor to AOL Time Warner through December 31, 2005. His advisory compensation will be $1 million per year, which was equal to his annual salary. Mr. Levin delivered this notice to AOL Time Warner in December 2001, stepped down as Chief Executive Officer in May 2002 and is currently serving as an advisor to AOL Time Warner.
In October 1996, America Online entered into an employment agreement with Mr. Pittman which did not have a fixed term and which AOL Time Warner assumed. This agreement provided that, in the event Mr. Pittman’s employment agreement were terminated under certain circumstances, including by him for a good reason or by AOL Time Warner other than for cause, he would become a consultant of AOL Time Warner for a term of two years, subject to the terms and conditions of a consulting agreement. Pursuant to the
terms of this agreement, Mr. Pittman will be a consultant to AOL Time Warner for the two years ending September 30, 2004. As part of an agreement entered into in connection with his departure, Mr. Pittman agreed to forego the $1 million annual consulting fee he would have received under the consulting agreement and AOL Time Warner agreed that stock options granted to him after September 1, 1998 will remain exercisable through September 30, 2007. Mr. Pittman is subject to the terms of a confidentiality/non-competition/proprietary rights agreement that remains in effect for the term of the consulting agreement.
In addition, prior to 2001, pursuant to their employment agreements then in place, Time Warner made contributions for each of Messrs. Parsons, Bewkes, Logan and Levin to separate non-current compensation accounts in a grantor trust or under its deferred compensation plan. Effective beginning January 2001, AOL Time Warner terminated these contributions, but existing accounts will continue to be invested and paid out following termination of employment in accordance with their terms.
Time Warner Pension Plan - AOLTW
The Time Warner Employees’ Pension Plan, as amended (the “Old Pension Plan”), which provides benefits to eligible employees, including officers, of AOL Time Warner and certain of its subsidiaries, was amended effective as of January 1, 2000, as described below, and was renamed and assumed by AOL Time Warner in connection with the Merger (the “Amended Pension Plan” and, together with the Old Pension Plan, the “Pension Plans”). Because of certain grandfathering provisions, the benefit of participants with a minimum of ten years of benefit service whose age and years of benefit service equal or exceed 65 years as of January 1, 2000, including Messrs. Bewkes and Levin, will be determined under either the provisions of the Old Pension Plan or the Amended Pension Plan, whichever produces the greater benefit.
Under the Amended Pension Plan, a participant accrues benefits equal to the sum of 1.25% of a participant’s average annual compensation (defined as the highest average annual compensation for any five consecutive full calendar years of employment, which includes regular salary, overtime and shift differential payments, and non-deferred bonuses paid according to a regular program) not in excess of his covered compensation up to the applicable average Social Security wage base and 1.67% of his average annual compensation in excess of such covered compensation multiplied by his years of benefit service (not in excess of 30). Compensation for purposes of calculating average annual compensation under the Pension Plans is limited to $200,000 per year for 1988 through 1993, $150,000 per year for 1994 through 2001 and $200,000 per year for 2002 and thereafter (each subject to adjustments provided in the Internal Revenue Code of 1986, as amended). Eligible employees become vested in all benefits under the Pension Plans on the earlier of five years of service or certain other events.
Under the Old Pension Plan, a participant accrues benefits on the basis of 1 2/3% of the average annual compensation (defined as the highest average annual compensation for any five consecutive full and partial calendar years of employment, which includes regular salary, overtime and shift differential payments, and non-deferred bonuses paid according to a regular program) for each year of service up to 30 years and 1/2% for each year of service over 30. Annual pension benefits under the Old Pension Plan are reduced by a Social Security offset determined by a formula that takes into account benefit service up to 35 years, covered compensation up to the average Social Security wage base and a disparity factor based on the age at which Social Security benefits are payable (the “Social Security Offset”). Under both of the Pension Plans, the pension benefit of participants on December 31, 1977 in the former Time Employees’ Profit-Sharing Savings Plan (the “Profit Sharing Plan”) is further reduced by a fixed amount attributable to a portion of the employer contributions and investment earnings credited to such employees’ account balances in the Profit Sharing Plan as of such date (the “Profit Sharing Plan Offset”).
Under the Amended Pension Plan, employees who are at least 62 years old and have completed at least ten years of service may elect early retirement and receive the full amount of their annual pension. Under the Old Pension Plan, employees who are at least 60 years old and have completed at least ten years of service may elect early retirement and receive the full amount of their annual pension (“early retirement”). An early retirement supplement is payable to an employee terminating employment at age 55 and before age 60, after 20 years of service, equal to the actuarial equivalent of such person’s accrued benefit, or, if greater, an annual
amount equal to the lesser of 35% of such person’s average compensation determined under the Old Pension Plan or such person’s accrued benefit at age 60 plus Social Security benefits at age 65. The supplement ceases when the regular pension commences at age 60.
Federal law limits both the amount of compensation that is eligible for the calculation of benefits and the amount of benefits derived from employer contributions that may be paid to participants under both of the Pension Plans. However, as permitted by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), AOL Time Warner has adopted the Time Warner Excess Benefit Pension Plan - AOLTW (the “Excess Plan”). The Excess Plan provides for payments by AOL Time Warner of certain amounts which employees of AOL Time Warner would have received under the Pension Plans if eligible compensation were limited to $250,000 in 1994 (increased 5% per year thereafter, to a maximum of $350,000) and there were no payment restrictions. For purposes of the Excess Plan, the $200,000 limit (as indexed for years after 1989) on eligible compensation will only apply to compensation received in 1988 through 1993; the $250,000 limit (as adjusted) will apply to compensation received in 1994 and thereafter.
The following table shows the estimated annual pension payable upon retirement to employees in specified remuneration and years-of-service classifications under the Amended Pension Plan. The amount of the estimated annual pension is based upon a pension formula which applies to all participants in both the Amended Pension Plan and the Excess Plan. The amounts shown in the table do not reflect the effect of the previously-described Profit Sharing Plan Offset. The estimated amounts are based on the assumption that payments under the Amended Pension Plan will commence upon normal retirement (generally age 65) or early retirement, that the Amended Pension Plan will continue in force in its present form, that the maximum compensation is $350,000 and that no joint and survivor annuity will be payable (which would on an actuarial basis reduce benefits to the employee but provide benefits to a surviving beneficiary). Amounts calculated under the pension formula which exceed ERISA limits will be paid under the Excess Plan from AOL Time Warner’s assets and are included in the amounts shown in the following table.
The amount of covered compensation that would be considered in the determination of the highest five consecutive full or partial years of compensation under the Pension Plans and the Excess Plan for each of Messrs. Case, Parsons, Novack, Bewkes, Logan and Levin is limited as a result of the imposition of the limitations on eligible compensation. However, because combined payments under the Pension Plans and the Excess Plan are based on the highest average annual compensation for any five consecutive full or partial calendar years of employment (taking into account the compensation limits only for 1988 and thereafter), the compensation used for determining benefits under such Plans for Mr. Levin (and employees who participated in the Pension Plan prior to 1988) will include eligible compensation in years prior to 1988 which exceeded these limits. The estimated annual benefits payable under the Amended Pension Plan and the Excess Plan, as of February 1, 2003, would be based on average compensation of $350,000 for Mr. Case; $331,394 for Mr. Parsons; $350,000 for Mr. Novack; $331,394 for Mr. Bewkes; $331,394 for Mr. Logan; and $729,248 for Mr. Levin, with 2.1, 8.2, 2.1, 22.9, 32.8 and 30.8 years of benefit service, respectively. In addition, pursuant to his employment agreement, Mr. Parsons will be entitled to receive supplemental payments from AOL Time Warner that will achieve a total retirement benefit equal to what he would have received if he had five additional years of benefit service under the Amended Pension Plan. Mr. Pittman is not eligible to participate in the Pension Plans. However, as a result of Mr. Pittman’s previous employment by Time Warner, at age 65, he is entitled to start receiving an annual benefit of $21,978 under the Amended Pension Plan and the Excess Plan. The estimated annual pension payable to each Mr. Levin and Mr. Bewkes under the Old Pension Plan and the Excess Plan upon retirement based on the indicated remuneration and years of service would be
$361,891 and $177,302, respectively. These amounts are greater than the estimated annual benefit payable under the Amended Pension Plan and the Excess Plan.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Ownership by Partners of TWE
The table below sets forth, as of March 15, 2003, the pro rata priority capital and residual equity interests of each AOLTW General Partner and each Limited Partner in TWE. Subsidiaries of AOL Time Warner and the AOLTW General Partners collectively own 72.36% of the pro rata priority capital and residual equity capital and 100% of the priority capital interests junior to the pro rata priority capital interests. Each AOLTW General Partner is a direct or indirect wholly owned subsidiary of AOL Time Warner. The TWE Holdings Trusts are Delaware statutory trusts all of the beneficial interests of which are held indirectly by Comcast Corporation.
The address of the principal executive offices of each of the companies listed above is as follows: Warner Communications Inc.: 75 Rockefeller Plaza, New York, New York 10019; American Television and Communications Corporation: 290 Harbor Drive, Stamford, Connecticut 06902; and TWE Holdings Trusts, c/o Edith H. Holiday, Operating Trustee, 801 West Street, 2nd Floor, Wilmington, Delaware 19801.
Security Ownership of Certain Beneficial Owners
Set forth below is the name, address, stock ownership and voting power of each person or group of persons known by TWE to own beneficially securities of AOL Time Warner having more than 5% of the voting power of any class of AOL Time Warner’s voting securities and, unless otherwise indicated, is based on information provided to AOL Time Warner as of January 31, 2003 by the beneficial owner. Subsidiaries of AOL Time Warner collectively own 72.36% of the pro rata priority capital and residual equity partnership interests in TWE.
*
Less than 1%
(1)
Beneficial ownership is as of December 31, 2002. Capital Research and Management Company, an investment adviser, has filed with the SEC a statement on Schedule 13G dated February 10, 2003 to the effect that (a) it (directly or indirectly) has sole dispositive power over all these shares, (b) it has voting power over none of these shares and (c) all of the reported shares are held for the benefit of its clients.
(2)
Beneficial ownership is as of December 31, 2002. FMR Corp., a holding company, has filed with the SEC a statement on Schedule 13G dated February 14, 2003 to the effect that (a) it (directly or indirectly) has sole dispositive power over all these shares, (b) it has sole voting power over 15,315,805 of these shares and no shared voting power, (c) these shares are held principally by Fidelity Management & Research Company, a wholly-owned investment adviser, (d) the shares of AOL Time Warner Common Stock reported as beneficially owned include 114,926 shares of AOL Time Warner Common Stock reported as issuable upon the conversion of $19,700,000 principal amount of 3% Convertible Subordinated Notes due 2019 of America Online and 1,311,440 shares of AOL Time Warner Common Stock issuable upon conversion of securities of other issuers (these shares have been excluded from the calculation of voting power), (e) these shares are, for the most part, held by investment companies and institutional accounts managed by subsidiaries of FMR Corp. and (f) the family of Edward C. Johnson 3d, including Mr. Johnson, the Chairman of FMR Corp., and his daughter Abigail Johnson, a director, and trusts for the family members’ benefit may be deemed to form a controlling group with respect to FMR Corp.
(3)
Consists of shares beneficially owned by Liberty Media Corporation through its direct and indirect subsidiaries. Under certain circumstances, each share of Series LMCN-V Stock is convertible into one share of AOL Time Warner Common Stock; such circumstances are not currently present. Each share of Series LMCN-V Stock currently has 1/100 of a vote with respect to the election of directors and class voting rights on limited other matters.
Security Ownership of Management
The following table sets forth as of January 31, 2003 information concerning the beneficial ownership of AOL Time Warner Common Stock for each current representative of TWE and each current member of the
board of directors of one or more of the AOLTW General Partners, each of the persons named in the Summary Compensation Table above and for all current representatives, directors and executive officers of TWE and the AOLTW General Partners as a group.
*
Represents beneficial ownership of less than one percent of the issued and outstanding AOL Time Warner Common Stock on January 31, 2003.
(1)
Beneficial ownership as reported in the above table has been determined in accordance with Rule 13d-3 of the Securities Exchange Act of 1934. Unless otherwise indicated, beneficial ownership represents both sole voting and sole investment power. This table does not include, unless otherwise indicated, any shares of AOL Time Warner Common Stock or other equity securities of AOL Time Warner which may be held by pension and profit-sharing plans of other corporations or endowment funds of educational and charitable institutions for which various representatives, directors and officers serve as directors or trustees. As of January 31, 2003, the only equity securities of AOL Time Warner beneficially owned by the named persons or group were shares of AOL Time Warner Common Stock and options to purchase AOL Time Warner Common Stock.
(2)
Reflects shares of AOL Time Warner Common Stock subject to options to purchase AOL Time Warner Common Stock issued by AOL Time Warner which, on January 31, 2003, were unexercised but were exercisable on or within 60 days after that date. These shares are excluded from the column headed “Number of Shares.” 144,996 of the stock options shown for Mr. Logan have been transferred to a limited partnership owned by members of his family and 211,700 of the stock options shown for Mr. Novack have been transferred to grantor retained annuity trusts for the benefit of members of his family.
(3)
Includes 243,752 shares of AOL Time Warner Common Stock held by Mr. Case’s wife and 1,199,550 shares of AOL Time Warner Common Stock held by the Stephen M. Case Foundation. Mr. Case and his wife are the sole directors of this Foundation but do not exercise day-to-day investment authority. Mr. Case disclaims beneficial ownership of shares held by his wife and the Stephen M. Case Foundation.
(4)
Includes 45,000 shares of AOL Time Warner Common Stock held by Mr. Levin’s wife and approximately 33,877 shares of AOL Time Warner Common Stock held by a trust under the AOL Time Warner Savings Plan for his benefit. Mr. Levin disclaims beneficial ownership of shares held by his wife.
(5)
Includes 375 shares of AOL Time Warner Common Stock held by an irrevocable trust for the benefit of Mr. Novack’s children, one of whom is a minor, and 525 shares of AOL Time Warner Common Stock held by the Novack Family Foundation of which Mr. Novack and his wife are two of nine trustees. Mr. Novack disclaims beneficial ownership of shares held by the trust and the Novack Family Foundation.
(6)
Includes 200 shares of AOL Time Warner Common Stock held by Mr. Parsons’ wife and 2,000 shares of AOL Time Warner Common Stock held by The Parsons Family Foundation, Inc. of which Mr. Parsons
is one of six directors. Mr. Parsons disclaims beneficial ownership of shares held by his wife and The Parsons Family Foundation, Inc.
(7)
Includes 1,920 shares of AOL Time Warner Common Stock held by the Pittman Family Foundation of which Mr. Pittman and his wife are the sole trustees and approximately 106 shares of AOL Time Warner Common Stock held by a trust under the AOL Time Warner Savings Plan for his benefit. Mr. Pittman disclaims beneficial ownership of the shares held by the Pittman Family Foundation.
(8)
Includes (a) an aggregate of approximately 42,720 shares of AOL Time Warner Common Stock held by a trust under the AOL Time Warner Savings Plan for the benefit of current directors and executive officers of AOL Time Warner (including 462 shares for Mr. Case, 24,825 shares for Mr. Bewkes, 14,529 shares for Mr. Logan, 417 shares for Mr. Novack, and 946 shares for Mr. Parsons), (b) an aggregate of 243,952 shares of AOL Time Warner Common Stock beneficially owned by certain relatives of such persons and (c) an aggregate of 356,696 stock options that have been transferred to entities for the benefit of relatives of such persons.
Item 13.
Item 13. Certain Relationships and Related Transactions
Corporate Services
AOL Time Warner provides TWE with corporate support services and facilities (including, without limitation, internal accounting, financial, tax, legal and similar administrative and other services) as may be necessary or appropriate for TWE to conduct the businesses that were contributed to TWE in the manner that such businesses were conducted by Time Warner and its subsidiaries prior to the capitalization of TWE on June 30, 1992 (the “TWE Capitalization”). As compensation and reimbursement for the cost of providing such services and facilities, TWE paid AOL Time Warner fees in the amount of $105 million, $77 million and $74 million in 2002, 2001 and 2000, respectively.
Option Reimbursement
Upon the exercise of options to purchase securities of AOL Time Warner by any officer or other employee of TWE or of any “strategic venture” of TWE, including, without limitation, Warner Japan, or of AOL Time Warner or any of its subsidiaries who in such capacity performs substantially all of his or her duties on behalf of TWE or any such “strategic venture,” TWE or such “strategic venture” must reimburse AOL Time Warner for the amount by which the market price of such securities on the exercise date exceeds the exercise price, or with respect to options granted prior to the TWE Capitalization, the greater of the exercise price and the market price of such securities as of the TWE Capitalization (such reimbursement is hereinafter called a “Stock Option Distribution”). At December 31, 2002, TWE had accrued $8 million of Stock Option Distributions payable to AOL Time Warner. Such amount, which is not payable until the underlying options are exercised and then only subject to limitations on cash distributions in accordance with the TWE credit agreement, will be adjusted in subsequent accounting periods based on changes in the quoted market prices for the underlying securities. Such amount would increase (decrease) by approximately $54 million for each one dollar increase (decrease) in the closing price of AOL Time Warner AOL Time Warner Common Stock. See Notes 10 and 11 to the TWE consolidated financial statements included herein.
Warner Japan Distribution Agreements
Concurrently with the closing of the Warner Japan transaction, TWE and Warner Japan entered into distribution and merchandising agreements pursuant to which TWE granted to Warner Japan the right to engage in theatrical and non-theatrical, television and home video distribution in Japan as well as the right to engage in the licensing and merchandising of TWE’s copyrights and trademarks in Japan. Such agreements provide that Warner Japan will receive distribution fees generally comparable to those currently received by TWE for performing distribution services for unaffiliated third parties.
Other Arrangements and Transactions
The TWE Partnership Agreement expressly permits Time Warner and TWE to continue certain arrangements and transactions that prior to the TWE Capitalization existed between Time Warner and certain of the subsidiaries of Time Warner that contributed assets to TWE at the TWE Capitalization, to the extent that such arrangements and transactions relate to the businesses that were contributed. The TWE Partnership Agreement also permits Time Warner to enter into additional similar arrangements and transactions with TWE in the ordinary course of business consistent with past practice as well as any new arrangements and transactions with TWE on an arm’s-length basis. For additional information regarding such arrangements, see Note 15 to TWE’s consolidated financial statements included herein and Note 16 to the AOLTW General Partners’ consolidated financial statements included herein.
For information with respect to the revolving credit agreements between the General Partners and Time Warner Companies, Inc., see Note 8 to the AOLTW General Partners’ consolidated financial statements included herein.
Item 14.
Item 14. Controls and Procedures
Within the 90-day period prior to the filing of this report, each of the General Partners, under the supervision and with the participation of its management, including the Chief Executive Officer and Chief
TWE GENERAL PARTNERS
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION - (Continued)
Financial Officer of such General Partner, evaluated the effectiveness of the design and operation of such General Partner’s “disclosure controls and procedures” (as defined in Rule 13a-14(c)) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer of each General Partner concluded that such General Partner’s disclosure controls and procedures are effective in timely making known to them material information relating to such General Partner and such General Partner’s consolidated subsidiaries required to be disclosed in the General Partners’ reports filed or submitted under the Exchange Act. The General Partners have investments in certain unconsolidated entities. As the General Partners do not control or manage these entities, their disclosure controls and procedures with respect to such entities are necessarily substantially more limited than those maintained with respect to consolidated subsidiaries. There have been no significant changes in the General Partners’ internal controls or in other factors that could significantly affect the internal controls subsequent to the date the General Partners completed their respective evaluations.
TWE GENERAL PARTNERS
CONSOLIDATED BALANCE SHEETS
December 31,
(millions)
See accompanying notes.
TWE GENERAL PARTNERS
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
(millions)
(a)
Includes the following income (expenses) resulting from transactions with AOL Time Warner, TW Companies, TWE or equity investees of the General Partners:
See accompanying notes.
TWE GENERAL PARTNERS
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
(millions)
See accompanying notes.
WCI
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(millions)
See accompanying notes.
ATC
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY
(millions)
See accompanying notes.
TWE GENERAL PARTNERS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business and Basis of Presentation
Description of Business
On June 30, 1992, thirteen direct or indirect subsidiaries of Time Warner Companies, Inc. (“TW Companies”) contributed the assets and liabilities or the rights to the cash flows of substantially all of TW Companies’ Filmed Entertainment, Networks and Cable businesses to Time Warner Entertainment Company, L.P., a Delaware limited partnership (“TWE”), for general partnership interests, and each general partner guaranteed a pro rata portion of substantially all of TWE’s debt and accrued interest based on the relative fair value of the net assets each contributed to TWE (the “General Partner Guarantees,” see Note 9). Since then, eleven of the thirteen original general partners have been merged or dissolved into the other two. Warner Communications Inc. (“WCI”) and American Television and Communications Corporation (“ATC”) are the two remaining general partners of TWE. They have succeeded to the general partnership interests and have assumed the General Partner Guarantees of the eleven former general partners. WCI, ATC and, where appropriate, the former general partners are referred to herein as the “General Partners.”
WCI conducts substantially all of TW Companies’ music operations, including interests in recorded music, music publishing and CD and DVD manufacturing. These music operations include copyrighted music from many of the world’s leading recording artists that is produced and distributed by a family of established record labels such as Warner Bros. Records, Atlantic Records, Elektra Entertainment and Warner Music International. In addition, WCI has investments in TWE, TW Companies, IPC Group Limited, Turner Broadcasting System, Inc. (“TBS”) and Time Warner Telecom Inc. (“Time Warner Telecom”). ATC does not conduct operations independent of its ownership interests in TWE and certain other investments, including investments in TW Companies, TBS and Time Warner Telecom.
On January 11, 2001, America Online, Inc. (“America Online”) and Time Warner Inc. (“Time Warner”) merged to form AOL Time Warner Inc. (“AOL Time Warner”), the world’s leading media and entertainment company (the “Merger”). As a result of the Merger, America Online and Time Warner each became a wholly owned subsidiary of AOL Time Warner, and WCI and ATC each became an indirect, wholly owned subsidiary of AOL Time Warner.
Basis of Presentation
America Online-Time Warner Merger
The Merger has been accounted for by AOL Time Warner as an acquisition of Time Warner under the purchase method of accounting for business combinations. Under the purchase method of accounting, the cost of approximately $147 billion to acquire Time Warner, including transaction costs, was allocated to its underlying net assets, including the net assets of the General Partners, based on their respective estimated fair values. The excess of the purchase price over the estimated fair values of the net assets acquired was recorded as goodwill. This allocation includes intangible assets for WCI, such as music catalogues and copyrights and brands and trademarks.
As a result of the Merger, WCI’s 2000 historical operating results reflect reclassifications to conform to AOL Time Warner’s financial statement presentation, as follows:
•
Digital media results have been allocated to the business segments now responsible for managing those operations, including WCI’s music operations;
•
Income and losses related to investments accounted for using the equity method of accounting and gains and losses on the sale of investments have been reclassified from operating income (loss) to other income (expense), net; and
TWE GENERAL PARTNERS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
•
Corporate services have been reclassified to selling, general and administrative costs as a reduction of operating income.
Investment in TWE
Prior to the change in ownership relating to the exercise of an option by AT&T Corp. (“AT&T”) which is discussed below, the General Partners in the aggregate held 63.27% of the pro rata priority capital (“Series A Capital”) and residual equity capital (“Residual Capital”) of TWE and 100% of the junior priority capital (“Series B Capital”) of TWE. TW Companies held, directly or indirectly, 11.22% of the Series A Capital and Residual Capital limited partnership interests. The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE were held by MediaOne TWE Holdings, Inc., a subsidiary of AT&T. AT&T’s interest in TWE was recently acquired by Comcast Corp. (“Comcast”) upon consummation of the merger of Comcast and AT&T’s broadband business in November 2002.
During the second quarter of 2002, AT&T exercised a one-time option to increase its ownership in the Series A Capital and Residual Capital of TWE. As a result, on May 31, 2002, AT&T’s interest in the Series A Capital and Residual Capital of TWE increased by approximately 2.13% to approximately 27.64%. This resulted in a decrease in WCI’s and ATC’s corresponding interest in the Series A Capital and Residual Capital of TWE of approximately 1.07% and 0.74%, respectively, to approximately 36.43% and 25.03%, respectively. Similarly, TW Companies’ interest in the Series A Capital and Residual Capital of TWE decreased by approximately 0.32% to approximately 10.90%. In accordance with Staff Accounting Bulletin No. 51, “Accounting For Sales of Stock of a Subsidiary,” WCI and ATC have reflected the pretax impact of the dilution of their interests in TWE of approximately $365 million and $240 million, respectively, as an adjustment to paid-in-capital (Note 5). During the third quarter of 2002, TW Companies’ 10.90% interest in TWE was transferred to WCI and ATC, increasing WCI’s and ATC’s interests in the Series A and Residual Capital of TWE to 41.88% and 30.48%, respectively. In August 2002, AOL Time Warner and AT&T announced that they had agreed to restructure TWE. See Note 5 for additional discussion.
New Accounting Principles
Revenue Classification Changes
Reimbursement of “Out-of-Pocket” Expenses
In January 2002, the Financial Accounting Standards Board’s (“FASB”) Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 01-14, “Income Statement Characterization of Reimbursements Received for ‘Out-of-Pocket’ Expenses Incurred” (“EITF 01-14”). EITF 01-14 requires that reimbursements received for out-of-pocket expenses be classified as revenue on the income statement. EITF 01-14 was effective for the General Partners in the first quarter of 2002 and requires retroactive restatement of all periods presented to reflect the new accounting provisions. This change in revenue classification only impacts WCI. As a result of applying the guidance of EITF 01-14, WCI’s revenues and costs presented herein were retroactively increased by an equal amount of approximately $152 million in 2001 and approximately $155 million in 2000.
Emerging Issues Task Force Issue No. 01-09
In April 2001, the EITF reached a final consensus on EITF Issue No. 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products,” which was later codified along with other similar issues, into EITF Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products” (“EITF 01-09”). EITF 01-09 was effective for the General Partners in the first quarter of 2002 and requires retroactive restatement of all periods presented to reflect the new accounting provisions. EITF 01-09 clarifies the income statement classification of costs incurred by a vendor in connection with the reseller’s purchase or promotion of the vendor’s products, resulting in certain
TWE GENERAL PARTNERS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
cooperative advertising and product placement costs previously classified as selling expenses to be reflected as a reduction of revenues earned from that activity. This change in revenue classification only impacts WCI. As a result of applying the provisions of EITF 01-09, WCI’s revenues and costs presented herein were retroactively reduced by an equal amount of $45 million in 2001 and approximately $35 million in 2000.
Securities and Exchange Commission Staff Accounting Bulletin No. 101
In the fourth quarter of 2000, WCI adopted Securities and Exchange Commission Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements” (“SAB 101”). SAB 101 clarifies certain existing accounting principles for the timing of revenue recognition and the classification of revenues in financial statements. While WCI’s existing revenue recognition policies were consistent with the provisions of SAB 101, the new rules resulted in changes as to how revenues from certain transactions are classified. As a result of applying the provisions of SAB 101, WCI’s revenues and costs were increased by an equal amount of $135 million for 2000.
New Accounting Standard for Goodwill and Other Intangible Assets
In July 2001, the FASB issued Statement of Financial Accounting Standards (“Statement”) No. 141, “Business Combinations” and Statement No. 142 “Goodwill and Other Intangible Assets” (“FAS 142”). These standards change the accounting for business combinations by, among other things, prohibiting the prospective use of pooling-of-interests accounting. In addition, FAS 142 requires that, effective January 1, 2002, goodwill, including the goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have an indefinite useful life, cease amortizing. The new rules also require that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. During the first quarter of 2002, WCI and ATC completed its initial impairment review and recorded non-cash pretax charges of $18.962 billion and $9.603 billion, respectively, for the impairment of goodwill, substantially all of which was generated in the Merger. The charge reflects overall market declines since the Merger was announced in January 2000, is non-operational in nature and is reflected as a cumulative effect of an accounting change in the accompanying consolidated financial statements.
During the fourth quarter of 2002, WCI and ATC performed their annual impairment reviews for goodwill and other intangible assets. As a result, WCI recorded an additional non-cash charge of $1.499 billion which is recorded as a component of operating income in the accompanying consolidated statement of operations. The impairment charges are non-cash in nature and do not affect the General Partners’ liquidity. See Note 3 to the accompanying consolidated financial statements for additional discussion.
Variable Interest Entities
In January 2003, the FASB issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which requires variable interest entities (commonly referred to as SPEs) to be consolidated by the primary beneficiary of the entity if certain criteria are met. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 become effective for the General Partners’ during the third quarter of 2003. Although the General Partners have not completed their review, the General Partners anticipate that the adoption of FIN 46 will not have a significant impact on their consolidated financial statements.
Stock-Based Compensation
In December 2002, the FASB issued Statement No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure” (“FAS 148”). FAS 148 provides alternative methods of transition for a voluntary
TWE GENERAL PARTNERS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
change to the fair value based method of accounting for stock-based employee compensation. FAS 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, FAS 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of FAS 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements of FAS 148 are effective for interim periods beginning after December 15, 2002. The adoption of the provisions of FAS 148 did not have an impact on the General Partners’ consolidated financial statements. However, the General Partners have modified its disclosures as required.
Exit and Disposal Activities
In July 2002, the FASB issued Statement No. 146, “Accounting for Costs Associated with Exit or Disposal Activities” (“FAS 146”). FAS 146 nullifies the accounting for restructuring costs provided in EITF Issue No. 94-3 “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring).” FAS 146 requires that a liability associated with an exit or disposal activity be recognized and measured at fair value only when incurred. In addition, one-time termination benefits should be recognized over the period employees will render service, if the service period required is beyond a minimum retention period. FAS 146 is effective for exit or disposal activities initiated after December 31, 2002. Management does not expect that the application of the provisions of FAS 146 will have a material impact on the General Partners’ consolidated financial statements.
Multiple Element Arrangements
In November 2002, the EITF reached a consensus on EITF No. 00-21, “Revenue Arrangements with Multiple Deliverables” (“EITF 00-21”). EITF 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The General Partners believe that its current accounting is consistent with the provisions of EITF 00-21 and therefore does not expect that the application of the provisions of EITF 00-21 will have a material impact on the General Partners’ consolidated financial statements.
Consideration Received from a Vendor by a Customer
In November 2002, the EITF reached a consensus on EITF No. 02-16, “Accounting for Consideration Received from a Vendor by a Customer” (“EITF 02-16”). EITF 02-16 provides guidance as to how customers should account for cash consideration received from a vendor. EITF 02-16 presumes that cash received from a vendor represents a reduction of the prices of the vendor’s products or services, unless the cash received represents a payment for assets or services provided to the vendor or a reimbursement of costs incurred by the customer to sell the vendor’s products. The provisions of EITF 02-16 will apply to all agreements entered into or modified after December 31, 2002. Management does not expect the provisions of EITF 02-16 to have a material impact on the General Partners’ consolidated financial statements.
Guarantees
In November 2002, the FASB issued Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others” (“FIN 45”). FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. As the General Partners’ guarantee of $3.3 billion of TWE’s debt (which is discussed in further detail in Note 9) was issued prior to December 31, 2002, the initial
TWE GENERAL PARTNERS
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
recognition and initial measurement provisions of FIN 45 are not expected to have a material impact on the General Partners’ consolidated financial statements. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002; therefore, the General Partners have modified its disclosures herein as required.
Asset Retirement Obligations
In July 2001, the FASB issued Statement No. 143, “Accounting for Asset Retirement Obligation” (“FAS 143”). FAS 143 addresses the accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. FAS 143 became effective for the General Partners in the first quarter of 2002. The provisions of FAS 143 did not have a material impact on WCI’s or ATC’s consolidated financial statements.
Impairment or Disposal of Long-Lived Assets
In August 2001, the FASB issued Statement No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“FAS 144”). FAS 144 clarifies the accounting for the impairment of long-lived assets and for long-lived assets to be disposed of, including the disposal of business segments and major lines of business. FAS 144 became effective for the General Partners in the first quarter of 2002. The provisions of FAS 144 did not have a material impact on the General Partners’ consolidated financial statements.
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities
In September 2000, the FASB issued Statement No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities - a Replacement of FASB Statement No. 125” (“FAS 140”). FAS 140 revises the criteria for accounting for securitizations and other transfers of financial assets and collateral. In addition, FAS 140 requires certain additional disclosures. Except for the new disclosure provisions, which were effective for the year ended December 31, 2000, FAS 140 was effective for the transfer of financial assets occurring after March 31, 2001. The provisions of FAS 140 did not have a material impact on General Partners’ consolidated financial statements.
Summary of Significant Accounting Policies
Basis of Consolidation and Accounting for Investments
The consolidated financial statements include 100% of the assets, liabilities, revenues, expenses, income, loss and cash flows of each General Partner and all companies in which the General Partner has a controlling voting interest (“subsidiaries”), as if the General Partner and its subsidiaries were a single company. Intercompany accounts and transactions between the consolidated companies have been eliminated.
WCI’s fiscal year-end is December 31, however certain foreign locations are on a month lag. In addition, during 2002, WCI’s domestic music operations changed its fiscal year end from December 31 to November 30 in order to be consistent with its foreign operations which had previously been operating under a November fiscal year end. The impact of this change was not material to WCI’s overall financial results. To the extent a significant and or unusual transaction or event occurs during the one month lag period, it would be accounted for within WCI’s year-end financial statements (See Note 4).
Investments in TWE, and certain other companies in which the General Partners individually have significant influence, but less than a controlling voting interest, are accounted for using the equity method of accounting. This is generally presumed to exist when the General Partners individually own between 20% and 50% of the investee. Under the equity method, only the General Partners’ investment in and amounts due to and from the equity investee are included in the consolidated balance sheet; only its share of the investee’s earnings is included in the consolidated operating results; and only the dividends, cash distributions, loans or
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other cash received from the investee, additional cash investments, loan repayments or other cash paid to the investee, are included in the consolidated cash flows. In circumstances where the General Partner’s ownership in an investee is in the form of a preferred security or otherwise senior security, WCI’s and ATC’s share in the investee’s income or loss is determined by applying the equity method of accounting using the “hypothetical-liquidation-at-book-value” method. WCI and ATC use the hypothetical-liquidation-at-book-value method to determine the earnings or losses attributable to its investment in TWE. Under the hypothetical-liquidation-at-book-value method, the investor’s share of earnings or losses is determined based on changes in the investor’s claim in the net book value of the investee. Additionally, the carrying value of investments accounted for using the equity method of accounting are adjusted downward to reflect any other-than-temporary declines in value.
Investments in companies in which the General Partners do not have a controlling interest, or an ownership and voting interest so large as to exert significant influence, are accounted for as available-for-sale securities at market value if the investments are publicly traded and there are no resale restrictions greater than one year. If there are resale restrictions greater than one year, or if the investment is not publicly traded, then the investment is accounted for at cost. Unrealized gains and losses on investments accounted for at market value are reported, net of tax, in the accompanying consolidated statement of shareholders’ equity as a component of accumulated other comprehensive income (loss) until the investment is sold, at which time the realized gain or loss is included in income. Dividends and other distributions of earnings from both market-value investments and investments accounted for at cost are included in income when declared.
The effect of any changes in each General Partner’s ownership interests resulting from the issuance of equity capital by consolidated subsidiaries or equity investees to unaffiliated parties is included as a component of shareholders’ equity.
WCI, through AOL Time Warner has certain accounts receivable facilities that provide for the accelerated receipt of cash on available accounts receivables and licensing contracts. These securitization transactions are accounted for as a sale in accordance with FAS 140 because WCI relinquished control of the receivables. Since WCI has relinquished control over these receivables and does not control the Qualifying SPE that holds the receivables, the amounts held in these securitization facilities are not included in the consolidated financial statements of WCI.
Investment Impairments
The General Partners’ investments are comprised of fair value investments, including available-for-sale investments, investments accounted for using the cost method of accounting and investments accounted for using the equity method of accounting. A judgmental aspect of accounting for investments involves determining whether an other-than-temporary decline in value of the investment has been sustained. If it has been determined that an investment has sustained an other-than-temporary decline in its value, the investment is written down to its fair value, by a charge to earnings. Such evaluation is dependent on the specific facts and circumstances. Factors that are considered by the General Partners in determining whether an other-than-temporary decline in value has occurred include: the market value of the security in relation to its cost basis; the financial condition of the investee; and the intent and ability to retain the investment for a sufficient period of time to allow for recovery in the market value of the investment.
In evaluating the factors above for available-for-sale securities, management presumes a decline in value to be other-than-temporary if the quoted market price of the security is 20% or more below the investment’s cost basis for a period of six months or more (the “20% criteria”) or the quoted market price of the security is 50% or more below the security’s cost basis at any quarter end (the “50% criteria”). However, the presumption of an other-than-temporary decline in these instances may be overcome if there is persuasive evidence indicating that the decline is temporary in nature (e.g., strong operating performance of investee, historical volatility of investee, etc.). Additionally, there may be instances where impairment losses are
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recognized even if the 20% and 50% criteria are not satisfied (e.g., plan to sell the security in the near term and the fair value is below WCI’s or ATC’s cost basis).
For investments accounted for using the cost or equity method of accounting, management evaluates information (e.g., budgets, business plans, financial statements, etc.) in addition to quoted market price, if any, in determining whether an other-than-temporary decline in value exists. Factors indicative of an other-than- temporary decline include recurring operating losses, credit defaults and subsequent rounds of financings at an amount below the cost basis of the investment. This list is not all inclusive and management weighs all quantitative and qualitative factors in determining if an other-than-temporary decline in value of an investment has occurred.
Business Combinations
Business combinations have been accounted for using the purchase method of accounting. Business combinations which have been accounted for under the purchase method of accounting include the results of operations of the acquired business from the effective date of acquisition. The cost to acquire companies, including transaction costs, have been allocated to the underlying net assets of the acquired company in proportion to their respective fair values. Any excess of the purchase price over estimated fair values of the net assets acquired has been recorded as goodwill. In certain purchase business combinations, the General Partners may review the operations of the acquired company and implement plans to restructure its operations. As a result, the General Partners may accrue a liability related to these restructuring plans using the criteria prescribed in EITF Issue No. 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination.” The impact of accruing these liabilities in connection with a purchase business combination is that the related cost is reflected as a liability assumed in the acquisition and results in additional goodwill as opposed to being included as a charge in the current period determination of income (Note 4). The application of the purchase method of accounting requires significant judgments and assumptions, which is further discussed in Critical Accounting Policies.
Foreign Currency Translation
The financial position and operating results of substantially all foreign operations are consolidated using the local currency as the functional currency. Local currency assets and liabilities are translated at the rates of exchange on the balance sheet date, and local currency revenues and expenses are translated at average rates of exchange during the period. Resulting translation gains or losses, which have not been material, are included in the accompanying consolidated statement of shareholders’ equity as a component of accumulated other comprehensive income (loss).
Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. requires management to make estimates and assumptions that affect the amounts reported in the financial statements and footnotes thereto. Actual results could differ from those estimates.
Significant estimates inherent in the preparation of the accompanying consolidated financial statements include management’s forecast of anticipated revenues and cash flows from investments and the sale of future and existing music-related products in order to evaluate the ultimate recoverability of accounts receivable, artist advances and investments recorded as assets in the WCI consolidated balance sheet. Accounts receivable and sales in the music industry are subject to customers’ rights to return unsold items. In addition, significant estimates have been used in accounting for business combinations accounted for using the purchase method of accounting.
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Management periodically reviews such estimates and it is reasonably possible that management’s assessment of recoverability of accounts receivable, individual artist advances and investments may change based on actual results and other factors.
Revenues and Costs
In accordance with industry practice, certain products (such as compact discs, DVDs and cassettes) are sold to customers with the right to return unsold items. Revenues from such sales are recognized when the products are shipped based on gross sales less a provision for future estimated returns.
Inventories of WCI consist of cassettes, DVDs, compact discs and related music and music publishing products. Inventories of cassettes, DVDs and compact discs are stated at the lower of cost or estimated realizable value. Cost is determined using first-in, first-out and average cost methods. Returned goods included in inventory are valued at estimated realizable value, but not in excess of cost.
Multiple-Element Arrangements
WCI or TWE enters into transactions where it is purchasing a product, service or making an investment in a vendor and at the same time it is negotiating a contract for the sale of advertising to the vendor. For example, when negotiating programming arrangements with cable networks, TWE will, at times, simultaneously negotiate for the sale of advertising to the cable network. This arrangement may be documented in one contract or may be documented in two separate contracts; whether there are one or two contracts, these arrangements are negotiated simultaneously. In accounting for these arrangements, WCI or TWE looks to the guidance contained in the following authoritative literature.
•
APB Opinion No. 29, “Accounting for Nonmonetary Transactions” (APB 29); and
•
EITF 01-09, “Accounting for Consideration Given by a Vendor to a Customer” (EITF 01-09).
WCI or TWE measures these transactions based on the respective fair values of the goods or services purchased and the goods or services sold. If WCI or TWE is unable to determine the fair value of one or more of the element(s) being purchased, then revenue recognition is limited to the total consideration received for the products or services sold less amounts paid. The accounting for these transactions requires significant judgments and estimates, which are further discussed in Critical Accounting Policies.
Advertising
In accordance with AICPA SOP 93-7, “Reporting on Advertising Costs,” advertising costs are expensed upon the first exhibition of the advertisement, except for certain direct-response advertising, for which the costs are capitalized and amortized over the expected period of future benefits. Direct-response advertising principally consists of product promotional mailings, catalogues and other promotional costs incurred in WCI’s direct-marketing businesses. Deferred advertising costs are generally amortized using the straight-line method over a period of twelve months or less subsequent to the promotional event. Deferred advertising costs for WCI amounted to $5 million at December 31, 2002 and $3 million at December 31, 2001. Advertising expense for WCI amounted to $259 million in 2002, $257 million in 2001 and $244 million in 2000.
Cash Equivalents
Cash equivalents consist of commercial paper and other investments that are readily convertible into cash and have original maturities of three months or less. Cash equivalents are carried at cost, which approximates fair value.
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Derivative and Financial Instruments
Effective January 1, 2001, WCI adopted FASB Statement No. 133, as amended by FASB Statement No. 138, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”). FAS 133 requires that all derivative instruments be recognized on the balance sheet at fair value. In addition, FAS 133 provides that for derivative instruments that qualify for hedge accounting, changes in the fair value will either be offset against the change in fair value of the hedged assets, liabilities, or firm commitments through earnings or recognized in shareholders’ equity as a component of accumulated other comprehensive income (loss) until the hedged item is recognized in earnings, depending on whether the derivative is being used to hedge changes in fair value or cash flows. The ineffective portion of a derivative’s change in fair value will be immediately recognized in earnings. The adoption of FAS 133 did not have a material effect on WCI’s financial statements (Note 13).
The carrying value of WCI’s financial instruments approximates fair value, except for certain differences relating to investments accounted for at cost and other financial instruments that are not significant. The fair value of financial instruments, such as investments, is generally determined by reference to market values resulting from trading on a national securities exchange or in an over-the-counter market. In cases where quoted market prices are not available, fair value is based on estimates using present value or other valuation techniques.
Property, Plant and Equipment
Property, plant and equipment are stated at cost. Depreciation is provided generally on the straight-line method over useful lives ranging up to thirty years for buildings and improvements and up to fifteen years for furniture, fixtures and other equipment.
The General Partners periodically review the carrying value of their long-lived assets, including property, plant and equipment, whenever events or changes in circumstances indicate that the carrying value may not be recoverable. To the extent fair value of a long-lived asset, determined based upon the estimated future cash inflows attributable to the assets, less estimated future cash outflows, are less than the carrying amount, an impairment loss is recognized.
Goodwill and Other Intangible Assets
As a creator and distributor of entertainment copyrights, WCI has a significant and growing number of intangible assets, including goodwill, music catalogues, contracts and copyrights. In accordance with generally accepted accounting principles, WCI does not recognize the fair value of internally generated intangible assets. Costs incurred to create and produce copyrighted product, such as compact discs, DVDs and cassettes, generally are either expensed as incurred, or capitalized as tangible assets as in the case of cash advances and inventoriable product costs. However, accounting recognition is not given to any increasing asset value that may be associated with the collection of the underlying copyrighted material. Additionally, costs incurred to create or extend brands generally result in losses over an extended development period and are recognized as a reduction of income as incurred, while any corresponding brand value created is not recognized as an intangible asset in the consolidated balance sheet. However, intangible assets acquired in business combinations accounted for under the purchase method of accounting are recorded at fair value on the General Partners’ consolidated balance sheet. As of January 1, 2001, in connection with the Merger, the intangible assets of WCI, including the significant value of intentionally generated intangible assets, were recorded at fair value on WCI’s consolidated balance sheet. However, increases in the fair value, if any, or the creation of intangible assets related to WCI businesses subsequent to the consummation of the Merger, are not reflected on WCI’s consolidated balance sheet.
As discussed previously, FAS 142, which became effective on January 1, 2002, required that goodwill and certain other intangible assets deemed to have an indefinite useful life cease amortizing. As a result, a
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substantial portion of the General Partners’ goodwill and intangible assets, ceased amortizing. However, WCI continues to amortize intangible assets that are deemed to have a finite useful life, including music catalogues and copyrights, which are amortized over periods up to 20 years. Amortization of goodwill and intangible assets for WCI was $175 million in 2002, $836 million in 2001 and $241 million in 2000. Accumulated amortization of goodwill and intangible assets for WCI was $396 billion at December 31, 2002 and $836 million at December 31, 2001. Amortization of goodwill and intangible assets for ATC amounted to $11 million in 2001, all of which related to the amortization of goodwill resulting from the Merger. There was no amortization of goodwill and intangible assets for ATC in 2002 and 2000. Accumulated amortization of goodwill and intangible assets for ATC at was $11 million at December 31, 2002 and 2001.
The General Partners periodically review the carrying value of acquired intangible assets, including goodwill, to determine whether impairment may exist. FAS 142 requires that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. Specifically, goodwill impairment is determined using a two-step process. The first step of the goodwill impairment test is used to identify potential impairment by comparing the fair value of a reporting unit with its carrying amount, including goodwill. If the fair value of a reporting unit exceeds its carrying amount, goodwill of the reporting unit is considered not impaired and the second step of the impairment test is unnecessary. If the carrying amount of a reporting unit exceeds its fair value, the second step of the goodwill impairment test is performed to measure the amount of impairment loss, if any. The second of the goodwill impairment test compares the implied fair value of the reporting unit’s goodwill with the carrying amount of that goodwill. If the carrying amount of the reporting unit’s goodwill exceeds the implied fair value of that goodwill, an impairment loss is recognized in an amount equal to that excess. The implied fair value of goodwill is determined in the same manner as the amount of goodwill recognized in a business combination. That is, the fair value of the reporting unit is allocated to all of the assets and liabilities of that unit (including any unrecognized intangible assets) as if the reporting unit had been acquired in a business combination and the fair value of the reporting unit was the purchase price paid to acquire the reporting unit. The impairment test for other intangible assets not subject to amortization consists of a comparison of the fair value of the intangible asset with its carrying value. If the carrying value of the intangible asset exceeds its fair value, an impairment loss is recognized in an amount equal to that excess. For intangible assets subject to amortization, to the extent the fair value of the intangible asset, determined based upon the estimated future cash inflows attributable to the asset, less estimated future cash outflows, are less than carrying amount, an impairment loss is recognized. The determination of impairment of goodwill and other intangible assets requires significant judgments and estimates, which is further discussed under Critical Accounting Policies.
Income Taxes
The domestic operating results of the General Partners are included in the consolidated U.S. federal, state and local income tax returns of WCI or subsidiaries of AOL Time Warner Inc. The foreign operations of WCI are subject to taxation by foreign jurisdictions. Both domestic and foreign income tax provisions are reflected in the consolidated statements of operations of the General Partners on a stand-alone basis consistent with the liability method prescribed by FASB Statement No. 109, “Accounting for Income Taxes.” Under the liability method, deferred income taxes reflect the tax effect of net operating loss and investment carryforwards and the net tax effects of temporary differences between the carrying amount of assets and liabilities for financial statement and income tax purposes, as determined under enacted tax laws and rates. The financial effect of changes in tax laws or rates is accounted for in the period of enactment. The subsequent realization of tax carryforwards acquired in acquisitions is accounted for as a reduction of goodwill.
Under a tax-sharing agreement between the General Partners and AOL Time Warner, each General Partner pays to, or receives from, AOL Time Warner amounts equal to the total domestic income taxes, or tax benefits, provided by, or attributable to, the partner. Accordingly, no domestic income tax balances are reflected in the consolidated balance sheets of the General Partners, except for amounts related to certain
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book/tax differences created as a result of purchase accounting, and for certain items reflected in shareholders’ equity.
As a Delaware limited partnership, TWE is generally not subject to U.S. federal and state income taxation. However, certain of TWE’s operations are conducted by subsidiary corporations that are subject to domestic or foreign taxation. Income tax expense for each of the General Partners includes all income taxes related to its allocable share of partnership income and its equity in the income tax expense of corporate subsidiaries of TWE.
Stock-Based Compensation
AOL Time Warner has various stock option plans under which it may grant options to purchase AOL Time Warner common stock to employees of AOL Time Warner and WCI, both of which follow the provisions of FASB Statement No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”). The provisions of FAS 123 allow companies to either expense the estimated fair value of stock options or to continue to follow the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”), but disclose the pro forma effects on net income (loss) had the fair value of the options been expensed. AOL Time Warner and WCI have elected to continue to apply APB 25 in accounting for stock option plans (Note 11).
In accordance with APB 25 and related interpretations, compensation expense for stock options is recognized in income based on the excess, if any, of the quoted market price of the stock at the grant date of the award or other measurement date over the amount an employee must pay to acquire the stock. Generally, the exercise price for stock options granted to employees of WCI equals or exceeds the fair market value of AOL Time Warner common stock at the date of grant, thereby resulting in no recognition of compensation expense by AOL Time Warner, nor charged to WCI. For awards that generate compensation expense as defined under APB 25, WCI calculates the amount of compensation expense and recognizes the expense over the vesting period of the awards.
As previously discussed, in 2002 the FASB issued FAS 148. FAS 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. FAS 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, FAS 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of FAS 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements of FAS 148 are effective for interim periods beginning after December 15, 2002.
Had compensation cost for AOL Time Warner’s stock option plans been determined based on the fair value method set forth under FAS 123, WCI’s net income (loss) would have been changed to the pro forma amounts indicated below:
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Comprehensive Income (Loss)
Comprehensive income (loss), which is reported on the accompanying consolidated statement of shareholders’ equity as a component of accumulated other comprehensive income (loss), consists of net income and other gains and losses affecting shareholders’ equity that, under accounting principles generally accepted in the U.S., are excluded from net income (loss). For the General Partners, such items consist primarily of unrealized gains and losses on marketable equity investments, gains and losses on certain derivative financial instruments, changes in the unfunded accumulated benefit obligation of the General Partners’ pension plan and foreign currency translation gains and losses.
The following summary sets forth the components of WCI’s other comprehensive income (loss) accumulated in shareholders’ equity:
Reclassifications
Certain reclassifications have been made to the prior years’ consolidated financial information to conform to the 2002 presentation.
2. WORD ENTERTAINMENT ACQUISITION
In January 2002, WCI completed its purchase of Word Entertainment (“Word”) from Gaylord Entertainment Company for approximately $84 million in cash. Word is a leader in the multi-faceted contemporary Christian music industry with over 30 active artists on several record labels, approximately 45 songwriters under contract and a catalog containing more than 75,000 masters. The acquisition was accounted for using the purchase method of accounting for business combinations. As a result of the subsequent purchase price allocation, approximately $10 million has been allocated to copyrights, approximately $20 million has been allocated to music catalogues, $30 million to goodwill and the remaining $24 million of the purchase price has been allocated to the underlying tangible net assets of Word. As discussed in further detail in Note 3, during the fourth quarter of 2002, WCI recorded a non-cash, pretax charge of $646 million related to goodwill impairment.
During the third quarter of 2002, WCI exchanged 20% of its interest in Word to Curb Records for non-cash consideration of equal value.
3. GOODWILL AND INTANGIBLE ASSETS
As discussed in Note 1, in January 2002, the General Partners adopted FAS 142, which requires companies to stop amortizing goodwill and certain intangible assets with an indefinite useful life. Instead, FAS 142 requires that goodwill and intangible assets deemed to have an indefinite useful life be reviewed for impairment upon adoption of FAS 142 (January 1, 2002) and annually thereafter.
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Under FAS 142, goodwill impairment is deemed to exist if the net book value of a reporting unit exceeds its estimated fair value. For purposes of applying the provisions of FAS 142, both WCI and ATC are considered one reporting unit. This methodology differs from the General Partners’ previous policy, as provided under accounting standards existing at that time, of using undiscounted cash flows on an enterprise-wide basis to determine if goodwill is recoverable.
Upon adoption of FAS 142 in the first quarter of 2002, WCI recorded an approximate $18.962 billion non-cash charge and ATC recorded an approximate $9.603 billion non-cash charge to reduce the carrying value of goodwill. Approximately $5 billion of WCI’s charge related to its wholly owned music business, while the remaining approximate $14 billion of WCI’s charge and all of ATC’s charge were the result of goodwill impairment charges recorded at TWE and other AOL Time Warner consolidated subsidiaries, which are accounted for by the General Partners under the equity method of accounting. Such charges are nonoperational in nature and are reflected as a cumulative effect of accounting change in the accompanying consolidated statement of operations. In calculating the impairment charge, the fair value of WCI’s music business and the reporting units underlying the General Partners’ investments in TWE and certain AOL Time Warner consolidated subsidiaries accounted for under the equity method of accounting, were estimated using either a discounted cash flow methodology, market comparisons, recent comparable transactions or a combination thereof.
The FAS 142 goodwill impairment is associated entirely with goodwill resulting from the Merger. The amount of the impairment primarily reflects the overall market declines since the Merger was announced and valued for accounting purposes in January of 2000. Prior to performing the review for impairment, FAS 142 required that all goodwill deemed to be related to AOL Time Warner as a whole be assigned to all of AOL Time Warner’s reporting units, including the reporting units of the acquirer. This differs from the previous accounting rules where goodwill was assigned only to the businesses of the company acquired. As a result, a portion of the goodwill generated in the Merger has been reallocated from WCI’s music business and the reporting units underlying the General Partners’ investments in TWE and certain AOL Time Warner consolidated subsidiaries accounted for under the equity method of accounting to other segments of AOL Time Warner.
During the fourth quarter of 2002, WCI and ATC performed their annual impairment reviews for goodwill and other intangible assets. As a result, WCI recorded an additional non-cash charge of approximately $1.499 billion which is recorded as a component of operating income in the accompanying consolidated statement of operations. The $1.499 billion charge at WCI includes a $646 million charge to reduce the carrying value of goodwill and a $853 million charge to reduce the carrying value of other intangible assets at WCI’s music operations which reflects declining valuations in the music industry, primarily due to the negative effects of piracy.
In addition, the General Partners recognized a $1.572 billion charge at WCI and $1.146 billion charge at ATC relating to goodwill impairment charges at TWE due to decreasing valuations of TWE’s cable systems as evidenced by the decline in the stock prices of comparable cable television companies. These charges are included in equity in pretax income (loss) of TWE in the accompanying consolidated statement of operations.
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A summary of changes in WCI’s goodwill during the year ended December 31, 2002 is as follows (millions):
(1)
Reflects the reallocation of $5.942 billion of goodwill to other segments of AOL Time Warner under FAS 142.
(2)
Acquisitions relate to WCI’s purchase price allocation for the acquisition of Word Entertainment.
(3)
The impairment charge does not include approximately $14.2 billion related to goodwill impairments associated with investments accounted for under the equity method of accounting.
(4)
The impairment charge does not include approximately $1.572 billion related to WCI’s investment in TWE.
The impairment charges are non-cash in nature and do not affect the General Partners’ liquidity.
WCI’s intangible assets and related accumulated amortization consisted of the following (millions):
(1)
Accumulated amortization for intangible assets not subject to amortization relates to amortization expense recognized prior to the adoption of FAS 142.
(2)
Amount represents intangible assets related to WCI’s music operations.
(3)
The decrease in brands, trademarks and other intangible assets primarily relates to the impairment of brands and trademarks of WCI’s music operations.
WCI recorded amortization expense of $175 million in 2002 compared to $836 million in 2001. Based on the current amount of intangible assets subject to amortization, the estimated amortization expense for each of the succeeding 5 years are as follows: 2003: $172 million; 2004: $172 million; 2005: $172 million; 2006: $158 million; and 2007: $158 million. As acquisitions and dispositions occur in the future and as purchase price allocations are finalized, these amounts may vary.
For the year ended December 31, 2002, WCI acquired the following intangible assets (in millions):
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WCI’s and ATC’s 2001 and 2000 results do not reflect the provisions of FAS 142. Had WCI and ATC adopted FAS 142 on January 1, 2000, the net income (loss) would have been changed to the adjusted amounts indicated below:
(a)
Because goodwill is nondeductible for tax purposes, the income tax impact reflects only the ceasing of intangible amortization and equity investee goodwill amortization.
4. MERGER AND RESTRUCTURING COSTS
Merger Costs Capitalized as a Cost of Acquisition
In accordance with generally accepted accounting principles in the United States, WCI generally treats merger costs relating to business combinations accounted for using the purchase method of accounting as additional purchase price paid.
In connection with the Merger, WCI has reviewed its operations and implemented several plans to restructure its operations (“restructuring plans”). As part of the restructuring plans, WCI accrued an initial restructuring liability of approximately $312 million during the first quarter of 2001. WCI adjusted these restructuring liabilities downward by $3 million during 2001 as it refined its restructuring plans. The restructuring accruals relate to costs to exit and consolidate certain activities at WCI, as well as costs to terminate employees of WCI. Such amounts were recognized as liabilities assumed in the purchase business combination and, accordingly, resulted in additional goodwill being recorded in connection with the Merger.
Of the total restructuring accruals, $261 million related to work force reductions and represented employee termination benefits and relocation costs. The total number of employees initially identified to be involuntarily terminated or relocated approximated 2,500. As of December 31, 2002, all terminations and relocations had occurred. Because certain employees can defer receipt of termination benefits, cash payments may continue after the employee has been terminated. Termination payments of approximately $88 million and $52 million were made in 2002 and 2001, respectively. In addition, during 2002, there were non-cash reductions in the restructuring accrual of $40 million, as actual employee termination payments were less than amounts originally estimated. As of December 31, 2002, the remaining liability of approximately $81 million was primarily classified as a current liability in WCI’s accompanying consolidated balance sheet.
The restructuring accrual also includes approximately $48 million associated with exiting certain activities. The restructuring accrual associated with exiting activities specifically includes incremental costs and contractual obligations for items such as leasehold termination payments and other facility exit costs incurred as a direct result of these plans, which will not have future benefits. Payments related to exiting activities were approximately $7 million in both 2002 and 2001, respectively. In addition, during 2002, there were non-cash reductions in the restructuring accrual associated with other exiting activities of approximately $10 million, as actual payments were less than originally estimated. As of December 31, 2002, the remaining
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liability of $24 million was primarily classified as a long-term liability in WCI’s accompanying consolidated balance sheet.
Selected information relating to the restructuring costs included in the allocation of the cost to acquire Time Warner follows (in millions):
(a)
Non-cash reductions represent adjustments to the restructuring accrual, and a corresponding reduction in goodwill as actual costs related to employee terminations and other exit costs were less than originally estimated.
Restructuring Costs
During the year ended December 31, 2002, WCI incurred and accrued other restructuring costs of $8 million that related to various employee and contractual terminations, including certain contractual employee termination benefits. WCI has recorded approximately $20 million of restructuring costs (including $13 million incurred between the music operations’ November 30 year-end and WCI’s December 31, 2002 year-end), which were partially offset by the reversal of a previously recorded accrual of $12 million as a result of it no longer being probable that the related contractual employee termination benefits would be paid by WCI (Note 1).
Included in the restructuring charge was approximately $4 million related to work force reductions and represented employee termination benefits. The number of employees expected to be terminated was approximately 165. As of December 31, 2002, approximately 20 of the terminations had occurred. The remaining 145 terminations are expected to occur by the end of 2003. The severed employees principally related to WCI’s U.S. and Canadian music distribution operations. The remaining $4 million primarily related to incremental costs and contractual termination obligations for items such as lease termination payments and other facility exit costs. As of December 31, 2002, $4 million has been paid against these accruals. The remaining $4 million is primarily classified as a current liability in the accompanying consolidated statement of operations.
During 2001, the restructuring plans included approximately $37 million of merger costs, relating to the renegotiation of various contractual commitments, that were expensed as incurred and included in operating income (loss) in the accompanying consolidated statement of operations. Of the $37 million, $20 million related to employee termination benefits for several senior executives and $17 million related to additional costs related to merger initiatives. As of December 31, 2002, all of the $37 million had been paid. During 2000, WCI expensed approximately $18 million in merger-related costs related to the failed merger of the
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global music operations of Time Warner and EMI Group plc. These costs are included in operating income (loss) on the accompanying consolidated statement of operations.
Selected information relating to the restructuring plans follows (in millions):
(a)
Non-cash reductions represent adjustments to the restructuring accrual as actual costs related to employee terminations were less than originally estimated.
5. INVESTMENT IN TWE
The General Partners’ investment in and amounts due to and from TWE at December 31, 2002 and 2001 consists of the following:
The General Partners’ respective investments in TWE declined significantly during the year, primarily the result of the General Partners’ share of TWE’s $21.763 billion cumulative effect of an accounting change relating to the adoption of FAS 142 and a $2.355 billion impairment. In addition, upon the adoption of FAS 142, $6.857 billion of goodwill at TWE generated in the Merger was reallocated to other segments of AOL Time Warner thereby reducing TWE’s net assets. For a more comprehensive description of the impact of these items on TWE, see the accompanying TWE consolidated financial statements.
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Partnership Structure
TWE is a Delaware limited partnership that was capitalized on June 30, 1992 and currently owns and operates substantially all of the Filmed Entertainment-Warner Bros., Cable Networks-HBO and Cable businesses previously owned by the General Partners. Prior to the change in ownership relating to the exercise of an option by AT&T which is discussed below, the General Partners in the aggregate held 63.27% of the Series A Capital and Residual Capital of TWE and 100% of the Series B Capital of TWE. TW Companies, directly or indirectly, held 11.22% of the Series A Capital and Residual Capital limited partnership interests. The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE were held by MediaOne TWE Holdings, Inc., a subsidiary of AT&T. AT&T’s interest in TWE acquired by Comcast upon consummation of the merger of Comcast and AT&T’s broadband business in November 2002.
During the second quarter of 2002, AT&T exercised a one-time option to increase its ownership in the Series A Capital and Residual Capital of TWE. As a result, on May 31, 2002, AT&T’s interest in the Series A Capital and Residual Capital of TWE increased by approximately 2.13% to approximately 27.64%. This resulted in a decrease in WCI’s and ATC’s corresponding interest in the Series A Capital and Residual Capital of TWE of approximately 1.07% and 0.74%, respectively, to approximately 36.43% and 25.03%, respectively. Similarly, TW Companies’ interest in the Series A Capital and Residual Capital decreased by approximately 0.32% to approximately 10.90%. In accordance with Staff Accounting Bulletin No. 51, “Accounting For Sales of Stock of a Subsidiary,” WCI and ATC have reflected the pretax impact of the dilution of its interest in TWE of approximately $365 million and $240 million, respectively, as an adjustment to paid-in-capital. During the third quarter of 2002, TW Companies’ 10.90% interest in TWE was transferred to WCI and ATC, increasing WCI’s and ATC’s interests in the Series A and Residual Capital of TWE to 41.88% and 30.48%, respectively.
In August 2002, AOL Time Warner and AT&T announced that they had agreed to restructure TWE. The restructuring is expected to be completed on March 31, 2003. The restructuring will result in the following: (i) WCI will acquire complete ownership of TWE’s content assets (including Warner Bros., Warner Bros. Library and Home Box Office, which will become separate, wholly owned subsidiaries of WCI); (ii) all of AOL Time Warner’s directly-owned cable television system interests will be contributed to a separate company which will become a majority-owned subsidiary of AOL Time Warner and will be renamed Time Warner Cable Inc. (“TWC Inc.”); (iii) TWE will become a subsidiary of TWC Inc. and will continue to own the cable television system interests it previously owned; (iv) Comcast will receive $2.1 billion in cash, which the company anticipates will be funded through a new credit facility at TWC Inc. that has not yet been established and AOL Time Warner equity securities valued at $1.5 billion; (v) a Comcast Trust will also retain a 21% economic interest in the Company’s cable business, through a 17.9% direct ownership interest in TWC Inc. (representing a 10.7% voting interest) and a limited partnership interest in TWE representing a 4.7% residual equity interest; and (vi) AOL Time Warner will retain an overall 79% economic interest in the cable business, through an 82.1% ownership interest in TWC Inc. (representing an 89.3% voting interest) and a partnership interest in TWE representing a 1% residual equity interest and a $2.4 billion preferred component. The 1% direct interest and $2.4 billion preferred interest in TWE, as well as part of AOL Time Warner’s ownership interest in WCI, will be held through ATC.
Based upon its 89.3% controlling voting interest in TWC Inc., AOL Time Warner will consolidate the results of TWC Inc. for accounting purposes. WCI will account for its interest in TWC Inc. under the equity method of accounting. ATC will account for its common and preferred interests in TWE at cost. At the closing of the restructuring, it is anticipated that TWC Inc. will have approximately $8.1 billion in consolidated net debt and preferred equity, including the $2.4 billion preferred interest held by AOL Time Warner. Subject to market and other conditions, AOL Time Warner expects to complete an initial public offering of TWC Inc. common stock during 2003. It is anticipated that the first $2.1 billion of net proceeds raised in any such offering would be used to repay TWC Inc.’s debt incurred to fund the $2.1 billion cash
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payment to Comcast. Thereafter, Comcast will have certain priority registration rights with respect to its stake in TWC Inc.
Partnership Capital and Allocation of Income
Each partner’s interest in TWE generally consists of the undistributed priority capital and residual equity amounts that were initially assigned to that partner, or its predecessor, based on the estimated fair value of the net assets each contributed to TWE (“Undistributed Contributed Capital”), plus, with respect to the priority capital interests only, any undistributed priority capital return. The priority capital return consists of net partnership income allocated to date in accordance with the provisions of the TWE partnership agreement and the right to be allocated additional partnership income which, together, provides for the various priority capital rates of return as specified in the following table. The sum of Undistributed Contributed Capital and the undistributed priority capital return is referred to herein as “Cumulative Priority Capital.” Cumulative Priority Capital is not necessarily indicative of the fair value of the underlying priority capital interests, principally due to above-market rates of return on certain priority capital interests as compared to securities of comparable credit risk and maturity, such as the 13.25% rate of return on the Series B Capital interest owned 100% by the General Partners. Furthermore, the ultimate realization of Cumulative Priority Capital could be affected by the fair value of TWE, which is subject to fluctuation.
A summary of the priority of Undistributed Contributed Capital, the General Partner’s ownership of Undistributed Contributed Capital and Cumulative Priority Capital at December 31, 2002 and priority capital rates of return thereon is as set forth below:
(a)
Excludes partnership income or loss allocated thereto.
(b)
To the extent income allocations are concurrently distributed, the priority capital rates of return on the Series A Capital and Series B Capital are 11.00% and 11.25%, respectively. The Undistributed Contributed Capital relating to the Series B Capital has priority over the priority returns on the Series A Capital.
(c)
The Undistributed Contributed Capital relating to the Residual Capital has priority over the priority returns on the Series B Capital and the Series A Capital.
(d)
Residual Capital is not entitled to stated priority rates of return and, as such, its Cumulative Priority Capital is equal to its Undistributed Contributed Capital. However, in the case of certain events such as the liquidation or dissolution of TWE, Residual Capital is entitled to any excess of the then fair value of the net assets of TWE over the aggregate amount of Cumulative Priority Capital and special tax allocations.
The Undistributed Contributed Capital is generally based on the fair value of the net assets that each partner initially contributed to the partnership. For purposes of allocating partnership income or loss to the partners, partnership income or loss is based on the fair value of the net assets contributed to the partnership and results in significantly less partnership income, or results in partnership losses, in contrast to the net income reported by TWE for financial statement purposes, which is also based on the historical cost of contributed net assets.
Under the TWE partnership agreement, partnership income, to the extent earned, is first allocated to the partners’ capital accounts so that the economic burden of the income tax consequences of partnership operations is borne as though the partnership were taxed as a corporation (“special tax allocations”). After any special tax allocations, partnership income is allocated to the Series A Capital and Series B Capital, in order of priority, at rates of 13.00% and 13.25% per annum, respectively, and finally to the Residual Capital. Partnership losses generally are allocated first to eliminate prior allocations of partnership income to, and then
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to reduce the Undistributed Contributed Capital of, the Residual Capital, Series B Capital and Series A Capital, in that order, and then to reduce any special tax allocations. To the extent partnership income is insufficient to satisfy all special allocations in a particular accounting period, the right to receive additional partnership income necessary to provide for the various priority capital rates of return is carried forward until satisfied out of future partnership income, including any partnership income that may result from any liquidation, sale or dissolution of TWE.
TWE reported a net loss of $21.219 billion and $1.032 billion for the years ended December 31, 2002 and 2001, respectively, and net income of $229 million for the year ended December 31, 2000. In 2002, this loss included a $21.763 billion non-cash charge related to the cumulative effect of an accounting change and a $2.355 billion impairment charge for goodwill, each of which was allocated from AOL Time Warner. In addition, in 2002 there was a $1.182 billion gain attributed to the minority partners of TWE in connection with the restructuring of the TWE-Advance/Newhouse Partnership (“TWE-A/N”). In 2000, this income included a $524 million non-cash charge related to the cumulative effect of an accounting charge. Because of the priority rights over allocations of income/loss and distributions of TWE held by the General Partners, $779 million of TWE’s pretax loss for 2002 was allocated to the General Partners ($427 million to WCI and $352 million to ATC). For 2001, $681 million of TWE’s pretax loss was allocated to the General Partners ($404 million to WCI and $277 million to ATC). For 2000, all of TWE’s pretax income before cumulative effect of accounting change was allocated to the General Partners ($539 million to WCI and $371 million to ATC).
Capital Distributions
The assets and cash flows of TWE are restricted by the TWE partnership and credit agreements and are unavailable for use by the partners except through the payment of certain fees, reimbursements, cash distributions and loans, which are subject to limitations. Under AOL Time Warner’s two senior unsecured long-term revolving bank credit agreements, TWE is permitted to incur additional indebtedness to make loans, advances, distributions and other cash payments to AOL Time Warner, subject to its individual compliance with the leverage ratio covenant contained therein.
At December 31, 2002 and 2001, the General Partners had recorded $8 million and $446 million, respectively, of stock option related distributions due from TWE, based on closing prices of AOL Time Warner common stock of $13.10 and $32.10, respectively. The General Partners are paid when the options are exercised. The General Partners also receive tax-related distributions from TWE on a current basis. During 2002, the General Partners received distributions from TWE in the amount of $497 million, consisting of $473 million of tax-related distributions and $24 million of stock option-related distributions. During 2001, the General Partners received distributions from TWE in the amount of $317 million, consisting of $53 million of tax-related distributions and $264 million of stock option-related distributions. During 2000, the General Partners received distributions from TWE in the amount of $1.003 billion, consisting of $765 million of tax-related distributions and $238 million of stock option-related distributions. Of such aggregate distributions, WCI received $294 million in 2002, $188 million in 2001 and $594 million in 2000, and ATC received $203 million in 2002, $129 million in 2001 and $409 million in 2000. In addition to the tax, stock option and General Partners’ senior priority capital distributions, TWE may make other capital distributions to its partners that are also subject to certain limitations contained in the TWE partnership and credit agreements.
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Summarized Financial Information of TWE
Set forth below is summarized financial information of TWE.
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6. TIME WARNER TELECOM PUBLIC OFFERINGS
Time Warner Telecom, a provider of local and regional optical broadband networks and services to business customers, was formed in July 1998 when Time Warner, TWE and TWE-A/N completed a reorganization of their business telephony operations. As part of that reorganization, TWE’s and TWE-A/N’s interests in Time Warner Telecom were distributed to their partners, Time Warner (including the General Partners), AT&T and the Advance/Newhouse Partnership (“Advance/Newhouse”), a partner in TWE-A/N.
In May 1999, Time Warner Telecom completed an initial public offering of 20% of its common stock (the “Time Warner Telecom IPO”). Time Warner Telecom issued approximately 21 million shares of common stock at a price of $14 per share and raised net proceeds of approximately $270 million, of which $180 million was paid to Time Warner and TWE in satisfaction of certain obligations. In turn, Time Warner and TWE used those proceeds principally to reduce bank debt. In connection with the Time Warner Telecom IPO and certain related transactions, WCI’s ownership interest in Time Warner Telecom was diluted from approximately 28% to approximately 22% and ATC’s ownership interest in Time Warner Telecom was diluted from approximately 19% to approximately 15%.
In January 2001, Time Warner Telecom completed a public offering of an additional 7.475 million shares of its common stock at a price of $74.44, raising proceeds of approximately $556 million. As a result, WCI’s ownership in Time Warner Telecom was diluted from approximately 22% to approximately 20% and ATC’s ownership in Time Warner Telecom was diluted from approximately 15% to approximately 14%.
During 2002 and 2001, WCI recorded impairment charges of approximately $356 million and $542 million, respectively, while ATC recorded impairment charges of approximately $244 million and $372 million, respectively.
As of December 31, 2002, Time Warner Telecom is owned 44% by AOL Time Warner, including 20% by WCI and 14% by ATC. The General Partners’ interests in Time Warner Telecom are being accounted for under the equity method of accounting.
7. OTHER INVESTMENTS
WCI’s other investments consist of:
(a)
The fair value of the General Partners’ cost-method and fair-value investments were approximately $154 million at December 31, 2002 and $112 million at December 31, 2001.
Investment Gains
Prior to June 2002, the Columbia House Company Partnerships (“Columbia House”) was a 50-50 joint venture between AOL Time Warner and Sony Corporation of America (“Sony”). In June 2002, AOL Time Warner and Sony each sold 85% of their respective 50% interest in Columbia House to Blackstone Capital Partners III LP (“Blackstone”), an affiliate of The Blackstone Group, a private investment bank. The sale has resulted in WCI recognizing a pretax gain of approximately $97 million, which is included in other income (expense), net, in the accompanying consolidated statement of operations. In addition, the WCI has deferred
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an approximate $5 million gain on the sale. The deferred gain primarily relates to the estimated fair value of the portion of the proceeds received as a note receivable, which will be deferred until such time as the realization of such note becomes more fully assured. As part of the transaction, AOL Time Warner, including, WCI, will continue to license music and video product to Columbia House for a five-year period.
Investment Write-Downs
The United States economy has experienced a broad decline in the public equity markets, particularly in technology stocks, including investments held in WCI’s and ATC’s portfolios. Similarly, the General Partners have experienced significant declines in the value of certain privately held investments and investments accounted for using the equity method of accounting. As a result, the General Partners recorded non-cash pretax charges to reduce the carrying value of certain investments that experienced other-than-temporary declines. These charges were approximately $446 million for WCI and $244 million for ATC in 2002, $676 million for WCI and $372 million for ATC in 2001, and $115 million for WCI and $0 for ATC in 2000, and are included in other income (expense), net in the accompanying consolidated statements of operations. The portion of the above charges relating to publicly traded securities was $433 million in 2002, $599 million in 2001 and $0 in 2000 for WCI and $244 million in 2002, $372 million in 2001 and $0 in 2000 for ATC. The significant components of these charges are discussed in detail below.
Columbia House Investment Write-Down
In March 2000, the proposed merger between CDNOW, Inc. and Columbia House was terminated. In connection with the termination of the merger, the risk associated with the timely execution of certain strategic alternatives for Columbia House’s operations and the transformation of Columbia House’s traditional business model to an online one increased. As a result, AOL Time Warner’s management concluded that the decline in Columbia House’s business was likely to continue through the near term. As such, WCI recorded a $115 million non-cash pretax charge in the first quarter of 2000 to reduce the carrying value of its investment in Columbia House to an estimate of its fair value. Additionally, in the fourth quarter of 2001, AOL Time Warner’s management concluded that a further decline in Columbia House’s business was other-than-temporary and as such, WCI recorded a $65 million non-cash pretax charge.
Time Warner Telecom Write-Down
As discussed in Note 6, WCI has an approximate 20% interest and ATC has an approximate 14% interest in Time Warner Telecom. The value of both WCI’s and ATC’s investment was adjusted upward in the Merger by approximately $992 million and $682 million, respectively, to their estimated fair values. Since that time, Time Warner Telecom’s share price declined significantly and at December 31, 2001, the decline had met the 20% criteria. The General Partners also reviewed qualitative factors in accordance with its investment policy and determined that the decline in value was not temporary; therefore impairment charges of $542 million for WCI and $372 million for ATC were recognized in the fourth quarter of 2001 based upon the closing value of Time Warner Telecom common stock as of December 31, 2001.
During 2002, the fair value of the General Partners’ investment in Time Warner Telecom continued to decline, resulting in additional impairment charges for WCI and ATC of $255 and $175 million in the first quarter, respectively, $90 million and $62 million in the second quarter, respectively, and $11 million and $7 million in the third quarter, respectively, to reduce the carrying value of the investment to fair value, which was determined by the quarter ending values of Time Warner Telecom common stock. As of December 31, 2002, the carrying value of the General Partners’ investment in Time Warner Telecom had been reduced to $0 as a result of the impairment charges and the General Partners’ share of Time Warner Telecom’s losses pursuant to the equity method of accounting. The General Partners do not have any funding commitments related to Time Warner Telecom.
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Equity Method Investments
In addition to TWE and its equity investees, investments accounted for using the equity method and the voting ownership percentage held by WCI at December 31, 2002 include: Time Warner Telecom (approximately 20% and 14% owned by WCI and ATC, respectively; 44% owned by AOL Time Warner), and other music joint ventures (between 30% and 50% owned). A summary of combined financial information as reported by the equity investees of WCI is set forth below:
The above table represents the combined financial information of entities in which WCI has a significant investment accounted for using the equity method of accounting. These amounts are not the amounts reflected on WCI’s accompanying consolidated financial statements. Consistent with the General Partners’ accounting policy for investments accounted for using the equity method of accounting, as described in Note 1, WCI has included $4.199 billion and ATC has included $1.199 billion in “Other investments” on the accompanying consolidated balance sheets, representing the General Partners’ investments in and amounts due to and from the equity investees. Similarly, WCI has recorded $144 million of expense and ATC has recorded $7 million of expense, in other income (expense), net, in the accompanying consolidated statements of operations, representing the General Partners’ share in the pretax income (loss) of these investees.
As discussed in Note 1, under the purchase method of accounting, the cost to acquire Time Warner was allocated to its underlying net assets, including the General Partners’ investments accounted for using the equity method of accounting, based on their estimated fair values. As a result, WCI’s investments accounted for using the equity method of accounting were adjusted upward by approximately $4.9 billion, including $992 million relating to its investment in Time Warner Telecom and ATC’s investments were adjusted upwards by approximately $3.2 billion, including $682 million related to its investment in Time Warner Telecom.
Ownership in Parent Company
WCI and ATC own 28.9 thousand and 14.8 thousand shares, respectively, of TW Companies common stock. Such investments are accounted for at historical cost, less the portion (collectively estimated at 85%) attributable to TW Companies’ ownership of the General Partners, which is deducted from shareholders’ equity under the caption “Reciprocal interest in TW Companies stock.” The TW Companies common stock owned by the General Partners may only be sold pursuant to an effective registration statement or in a transaction exempt from the registration requirements of the Securities Act of 1933. In addition to TW Companies common stock, ATC also owns certain TW Companies debt securities. Such debt securities, which were not significant at either December 31, 2002 or December 31, 2001, are held by ATC for the
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purpose of satisfying its obligations under its stock options and restricted stock awards subsequent to the acquisition of the ATC minority interest.
8. BORROWING ARRANGEMENTS WITH TW COMPANIES
WCI and ATC each has a revolving credit agreement with TW Companies, which provides for borrowings from TW Companies of up to $1 billion. Each credit agreement expires on December 31, 2008. Interest on any borrowings under each credit agreement is payable quarterly at the prime rate. Each of WCI’s and ATC’s obligation to TW Companies under the credit agreement is subordinate to the General Partner Guarantees. At December 31, 2002 and 2001, there were no borrowings outstanding under these credit agreements.
9. GENERAL PARTNER GUARANTEES
Each General Partner has guaranteed a pro rata portion of approximately $3.3 billion of TWE’s debt and accrued interest at December 31, 2002, based on the relative fair value of the net assets each General Partner (or its predecessor) contributed to TWE. Such indebtedness is recourse to each General Partner only to the extent of its guarantee. The indenture pursuant to which TWE’s notes and debentures have been issued (the “Indenture”) requires the consent of a majority of such holders to effect a termination; however, the Indenture permits the General Partners to engage in mergers and consolidations. There are no restrictions on the ability of the General Partner guarantors to transfer assets, other than TWE assets, to parties that are not guarantors.
The portion of TWE debt and accrued interest at December 31, 2002 that was guaranteed by each General Partner, individually and on a consolidated basis for each General Partner and its subsidiaries, is set forth below:
10. INCOME TAXES
Domestic and foreign pretax income (loss) are as follows:
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Income taxes (benefits) are as set forth below:
(a)
Includes foreign withholding taxes set forth below.
Foreign withholding taxes included in the foreign tax provision are as follows:
No U.S. income or foreign withholding taxes have been recorded by WCI on the permanently reinvested earnings of foreign subsidiaries aggregating approximately $822 million at December 31, 2002. If such earnings were to be repatriated, it is expected that any additional U.S. income tax would be offset by the utilization of the accompanying foreign tax credits.
The differences between the income tax (tax benefit) expected for WCI at the U.S. federal statutory income tax rate and the total income taxes provided are as follows:
The relationship between income taxes and income before income taxes for the other General Partner is principally affected by the charge for the impairment of goodwill and certain other financial statement expenses that are not deductible for income tax purposes.
As a result of the application of the purchase method of accounting in 2001, certain intangible assets and investments accounted for under the equity method of accounting were significantly adjusted upward to their fair value. Since the tax basis of these assets remained unchanged as a result of the Merger, the General
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Partners recognized significant amounts of deferred tax liabilities, which relate to recorded music intangibles and equity investments in 2002 and 2001, respectively.
11. STOCK OPTION PLANS
AOL Time Warner has various stock option plans under which AOL Time Warner may grant options to purchase AOL Time Warner common stock to employees of AOL Time Warner and WCI. Such options have been granted to employees of WCI with exercise prices equal to, or in excess of, fair market value at the date of grant. Accordingly, in accordance with APB 25 and related interpretations, compensation cost generally has not been recognized by AOL Time Warner, nor charged to WCI, related to such stock option plans. Generally, the options become exercisable over a three-year vesting period and expire ten years from the date of grant. Had compensation cost for AOL Time Warner’s stock option plans been determined based on the fair value method set forth under FAS 123, WCI’s net income (loss) would have been changed to the pro forma amounts indicated below:
For purposes of applying FAS 123, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions (which, for 2000, reflect the impact of the announced Merger) used for grants to WCI employees in 2002, 2001 and 2000: dividend yields of 0% for all periods; expected volatility of 52.9%, 59.3% and 46.3%, respectively; risk-free interest rates of 4.12%, 4.88% and 6.34%, respectively; and expected term to exercise of .47 years after vesting for 2002 and 1.0 years after vesting for 2001 and 2000.
The weighted average fair value of an option granted to WCI employees was $9.40 ($5.64, net of taxes), $25.89 ($15.53, net of taxes) and $27.50 ($16.50, net of taxes) for the years ended December 31, 2002, 2001 and 2000, respectively.
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A summary of stock option activity with respect to employees of WCI is as follows:
(a)
Includes all options cancelled and forfeited during the year, as well as options related to employees who have been transferred out of and into WCI to and from other AOL Time Warner divisions.
(b)
In 2001, a special Founder’s Grant was issued to most individuals who were employees of AOL Time Warner during the year the Merger was consummated, only a portion of which is expected to be recurring in the future.
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The following table summarizes information about stock options outstanding with respect to employees of WCI at December 31, 2002:
In connection with Time Warner’s agreement to merge with America Online entered into in January 2000, all Time Warner stock options held by WCI employees at that time became fully vested and exercisable, pursuant to the terms of Time Warner’s stock option plans. In addition, on January 11, 2001, the date the Merger was consummated, each outstanding equity security of Time Warner was converted into 1.5 units of an equivalent equity security of AOL Time Warner. See Note 1 for a summary of the terms of the Merger.
12. BENEFIT PLANS
WCI and its subsidiaries participate in defined benefit pension plans covering substantially all domestic employees. Pension benefits under those plans are based on formulas that reflect the employees’ years of service and compensation levels during their employment period. For the years ended December 31, 2002, 2001 and 2000, WCI made no contributions and recognized expense of $16 million, $7 million and $2 million, respectively, related to these plans.
Effective January 1, 2000, substantially all of the WCI-sponsored defined benefit pension plans were merged into the defined benefit pension plan sponsored by Time Warner (currently sponsored by AOL Time Warner). The remaining WCI-sponsored plan relating to its domestic operations is not material to the consolidated financial statements of WCI.
After the Merger, participation in the defined benefit pension plan covering domestic employees was limited to employees who previously participated in these plans. Effective January 1, 2003, however, the defined benefit plan was reopened to all eligible employees. In addition to its domestic employees, employees of WCI’s operations in foreign countries participate to varying degrees in local pension plans, which in the aggregate are not significant.
Certain domestic employees of WCI also participate in certain defined contribution plans of AOL Time Warner, including savings plans and profit sharing plans, as to which the expense amounted to $6 million in 2002, $5 million in 2001 and $16 million in 2000. Contributions to the savings plans are based upon a percentage of the employees’ elected contributions.
13. DERIVATIVE FINANCIAL INSTRUMENTS
WCI uses derivative financial instruments principally to manage the risk that changes in exchange rates will affect the amount of unremitted or future royalties and license fees to be received from the sale of U.S.
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copyrighted products abroad. The following is a summary of WCI’s foreign currency risk management strategy and the effect of this strategy on WCI’s consolidated financial statements.
Foreign Currency Risk Management
Foreign exchange contracts are used primarily by AOL Time Warner to hedge the risk that unremitted or future royalties and license fees owed to WCI domestic companies for the sale or anticipated sale of U.S. copyrighted products abroad may be adversely affected by changes in foreign currency exchange rates. As part of its overall strategy to manage the level of exposure to the risk of foreign currency exchange rate fluctuations, primarily exposure to changes in the value of the British pound, Japanese yen and European currency, AOL Time Warner hedges a portion of its TWE’s and WCI’s combined foreign currency exposures anticipated over the ensuing fifteen-month period (the “hedging period”). The hedging period for royalties and license fees covers revenues expected to be recognized over the ensuing twelve-month period, however, there is often a lag between the time that revenue is recognized and the transfer of foreign-denominated revenues back into U.S. dollars. Therefore, the hedging period covers a fifteen-month period. To hedge this exposure, AOL Time Warner uses foreign exchange contracts that generally have maturities of three months to fifteen months to provide continuing coverage throughout the hedging period. AOL Time Warner reimburses or is reimbursed by WCI for contract gains and losses related to WCI’s foreign currency exposure. At December 31, 2002, AOL Time Warner had effectively hedged approximately 75% of WCI’s estimated net foreign currency exposures that principally relate to anticipated cash flows for royalties and license fees to be remitted to the U.S. over the ensuing hedging period.
WCI records these foreign exchange contracts at fair value in its consolidated balance sheet and the related gains or losses on these contracts are deferred in shareholders’ equity (as a component of comprehensive income). These deferred gains and losses are recognized in income in the period in which the related royalties and license fees being hedged are received and recognized in income. However, to the extent that any of these contracts are not considered to be perfectly effective in offsetting the change in the value of the royalties and license fees being hedged, any changes in fair value relating to the ineffective portion of these contracts are immediately recognized in income. Gains and losses on foreign exchange contracts generally are included as a component of other income (expense), net, in WCI’s consolidated statement of operations.
At December 31, 2002, AOL Time Warner had contracts for the sale of $1.588 billion and the purchase of $1.341 billion of foreign currencies at fixed rates. Of AOL Time Warner’s $247 million net sale contract position, $613 million of foreign exchange sale contracts and $430 million of foreign exchange purchase contracts related to WCI’s foreign currency exposure, including net contracts for the sale of $90 million of Japanese yen and $252 million of European currency, and net contracts for the purchase of $153 million of the British pound. In 2001, WCI had contracts for the sale of $448 million and purchase of $400 million of foreign currencies, including net contracts for the sale of $146 million of Japanese yen, and net contracts for the purchase of $28 million of European currency and $62 million of the British pound. WCI had deferred approximately $2 million of net losses on foreign exchange contracts at December 31, 2002, which is all expected to be recognized in income over the next twelve months. For the years ended December 31, 2002, 2001 and 2000, WCI recognized $5 million in losses, $19 million in losses and $7 million in losses, respectively, on foreign exchange contracts, which were or are expected to be largely offset by corresponding decreases and increases, respectively, in the dollar value of foreign currency royalty payments that have been or are anticipated to be received in cash from the sale of U.S. copyrighted products abroad. During 2002 and 2001, WCI did not recognize any gains or losses as the result of the discontinuance of cash flow hedges because it was probable that the original forecasted transaction would not occur within the specified time period.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
14. GEOGRAPHICAL INFORMATION
Information as to WCI’s operations in different geographical areas is as follows:
(a)
Revenues are attributable to countries based on location of customer.
(b)
Revenues reflect the provisions of EITF 01-09 and EITF 01-14 that were adopted by WCI in 2002, which require retroactive restatement of 2001 and 2000 results to reflect the new accounting provisions. As a result, the net impact of EITF 01-09 and EITF 01-14 was to increase revenues and costs by equal amounts of $107 million for 2001 and (b) reduce revenues and costs by an equal amount of $120 million in 2000.
Because a substantial portion of WCI’s international revenues is derived from the sale of U.S. copyrighted products abroad, assets located outside the United States are not material.
15. COMMITMENTS AND CONTINGENCIES
Commitments
WCI’s total rent expense amounted to $60 million in 2002, $55 million in 2001 and $59 million in 2000. The minimum net rental commitments of WCI under noncancellable long-term operating leases are: 2003 - $55 million; 2004 - $56 million; 2005 - $59 million; 2006 - $60 million; 2007 - $62 million and after 2007 - $58 million.
Each General Partner is jointly and severally liable for all liabilities, commitments and contingencies of TWE and the Time Warner Service Partnerships, except for approximately $3.3 billion of TWE’s indebtedness and accrued interest, which is recourse to each General Partner only to the extent of its guarantee (Note 9).
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
The following table summarizes separately WCI’s material firm commitments at December 31, 2002 and the timing and effect that such obligations are expected to have on WCI’s liquidity and cash flow in future periods. It should be noted that there are a number of firm commitments made by WCI in the normal course of business, the following table represents the more significant of those firm commitments. WCI expects to fund these commitments with operating cash flow generated in the normal course of business.
(a)
Amount consists primarily of artist advances. Due to the unpredictable timing of these payments, estimates were made regarding which period the advances would be made in.
Contingencies
WCI is subject to various class action lawsuits as well as actions that have been brought by various state attorneys general alleging collusive and other illegal pricing practices by the major record companies in their capacity as distributors of compact discs. Although WCI cannot predict the ultimate outcomes, WCI does not expect that the ultimate outcomes of these cases will have a material adverse impact on WCI’s financial statements or results of operations.
In addition, on April 8, 2002, three former employees of certain subsidiaries of the Company filed Henry Spann et al. v. AOL Time Warner Inc. et al., a purported class action, in the U.S. District Court for the Central District of California. Plaintiffs named as defendants AOL Time Warner, TWE, WEA Corp., WEA Manufacturing Inc., Warner Bros. Records, Atlantic Recording Corporation, various pension plans sponsored by the companies and the administrative committees of those plans. Plaintiffs allege that defendants miscalculated the proper amount of pension benefits owed to them and other class members as required under the plans in violation of ERISA. The lawsuit has been transferred to the U.S. District Court for the Southern District of New York. Due to the preliminary status of this matter, the Company is unable to predict the outcome of this suit.
TWE is subject to certain litigation relating to Six Flags. On June 24, 1997, plaintiffs in Six Flags Over Georgia LLC et al. v. Time Warner Entertainment Company, L.P. et al., filed an amended complaint in the Superior Court of Gwinnett County, Georgia, claiming that, inter alia, defendants, which include TWE, violated their fiduciary duties in operating the Six Flags Over Georgia theme park. On December 18, 1998, following a trial, a jury returned a verdict in favor of plaintiffs. The total awarded to plaintiffs was approximately $454 million in compensatory and punitive damages. The case was appealed to the Georgia Court of Appeals, which affirmed the trial court’s judgment, and denied reconsideration. The Supreme Court of Georgia denied certiorari on January 18, 2001. On February 28, 2001, the compensatory damages portion of the award plus accrued interest was paid to plaintiffs. On March 1, 2001, the United States Supreme Court granted a stay as to payment of the punitive damages part of the jury’s original award, pending the resolution of a petition for certiorari to be filed by TWE, which was filed on June 15, 2001. On October 1, 2001, the United States Supreme Court granted certiorari, vacated the opinion of the Georgia Court of Appeals and remanded the case for further consideration as to punitive damages. On March 29, 2002, the Georgia Court of Appeals affirmed and reinstated its earlier decision regarding the punitive damage award. On April 18, 2002, TWE filed a petition for certiorari to the Georgia Supreme Court seeking review of the decision of the Georgia Court of Appeals, which was denied on September 16, 2002. The Georgia Supreme Court subsequently denied TWE’s motion for reconsideration of its September 16th ruling. Plaintiffs have agreed not to pursue
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
payment of the punitive damages award and accrued interest until the resolution of TWE’s petition for writ of certiorari to the United States Supreme Court, which TWE filed on December 23, 2002. The petition is pending.
The costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in those matters (including those matters described above), and developments or assertions by or against WCI relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on WCI’s business, financial condition and operating results.
16. RELATED PARTY TRANSACTIONS
In the normal course of conducting their businesses, the General Partners have had various transactions with AOL Time Warner, TW Companies and TWE units, generally on terms resulting from a negotiation between the affected units that in management’s view results in reasonable allocations. Employees of WCI participate in various AOL Time Warner medical, stock option and other benefit plans for which WCI is charged its allocable share of plan expenses, including administrative costs. ATC does not have a significant number of employees. AOL Time Warner’s corporate group provides various other services to WCI. The consolidated financial statements of the General Partners include transactions with AOL Time Warner relating to domestic income taxes or tax benefits (Note 10). The Music division of WCI provides home videocassette distribution services to certain TWE operations.
TW Companies had a credit agreement with TWE allowing it to borrow up to $400 million from TWE through September 15, 2000.
WCI earned interest income at a rate of 6.7% from TW Companies on a $610 million note receivable, which was received in December 1997 in exchange for WCI’s common stock of Hasbro. During 2000, WCI’s note receivable from TW Companies, including accrued interest, was settled through a WCI non-cash dividend in the amount of $695 million. In addition, WCI has had transactions with the Columbia House Company partnership and other music joint ventures and with equity investees of AOL Time Warner, generally with respect to sales of product in the ordinary course of business.
17. OTHER FINANCING ARRANGEMENTS
From time to time, WCI, through AOL Time Warner, enters into various other financing arrangements with special purpose entities (“SPEs”). These arrangements include facilities which provide for the accelerated receipt of cash on certain accounts receivables. WCI employs these arrangements because they provide a cost-efficient form of financing, including certain tax benefits, as well as an added level of diversification of funding sources. WCI is able to realize cost efficiencies under these arrangements since the assets securing the financing are held by a legally separate, bankruptcy-remote SPE and provide direct security for the funding being provided. The assets and financing associated with these arrangements, which are discussed in more detail in the following paragraphs, generally qualify for off-balance sheet treatment.
Accounts Receivable Securitization Facility
WCI participates in one of AOL Time Warner’s accounts receivable securitization facilities, which provides for the accelerated receipt of approximately $450 million of cash, in the aggregate, on available accounts receivables, all of which was utilized as of December 31, 2002. In connection with this securitization facility, WCI sells, on a revolving and nonrecourse basis, certain of its accounts receivables (“Pooled Receivables”) to a qualifying SPE, which in turn sells a percentage ownership interest in the Pooled Receivables to third-party commercial paper conduits sponsored by financial institutions. These securitization transactions are accounted for as a sale in accordance FAS 140, because WCI relinquished control of the
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
receivables. Accordingly, accounts receivable sold under these facilities are excluded from receivables in the accompanying consolidated balance sheet.
As proceeds for the accounts receivable sold to the qualifying SPE, AOL Time Warner and WCI receive cash, for which there is no obligation to repay, and an interest-bearing note receivable, which is included in receivables on the accompanying consolidated balance sheet. In addition, AOL Time Warner and WCI service the Pooled Receivables on behalf of the qualifying SPE. Income received by AOL Time Warner and WCI in exchange for this service is equal to the prevailing market rate for such services and has not been material in any period. The notes receivable, which have been adjusted to reflect the portion that is not expected to be collectible, bear an interest rate that varies with the prevailing market interest rates. For this reason and because the accounts receivables underlying the retained ownership interest that are sold to the qualifying SPE are generally short term in nature, the fair value of the notes receivable approximated their carrying value at both December 31, 2002 and December 31, 2001. However, notes receivable may become uncollectible to the extent the qualifying SPE has credit losses and operating expenses. The notes receivable related to the sale of Pooled Receivables to a qualifying SPE reflected on WCI’s consolidated balance sheet were $146 million at December 31, 2002 and $296 million at December 31, 2001.
In January 2003, the FASB issued FIN 46, which requires variable interest entities (commonly referred to as SPEs) to be consolidated by the primary beneficiary of the entity if certain criteria are met. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 become effective for the General Partners’ during the third quarter of 2003. Although the General Partners have not completed their review, the General Partners anticipate that the adoption of FIN 46 will not have a significant impact on their consolidated financial statements.
Cash Flows
Additional financial information with respect to cash payments and receipts is as follows:
Non-cash financing activities in 2002 include the settlement of a WCI receivable from TW Companies through a WCI dividend of $360 million. Noncash investing activities in 2002 include the exchange of 20% of WCI’s interest in Word to Curb Records for noncash consideration of equal value.
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - (Continued)
Interest Expense, Net
Interest expense, net, consists of:
Other Income (Expense), Net
Other income (expense), net, consists of:
(a)
Includes a non-cash pretax charge for WCI and ATC to reduce the carrying value of certain investments for other-than-temporary declines in value of approximately $446 million and $244 million, respectively, for the year ended December 31, 2002, approximately $676 million and $372 million, respectively, for the year ended December 31, 2001 and $108 million and $0 for the year ended December 31, 2000 (Note 7).
Other Current Liabilities
Other current liabilities of WCI consist of:
REPORT OF INDEPENDENT AUDITORS
The Board of Directors of
Warner Communications Inc.
American Television and Communications Corporation
We have audited the accompanying consolidated balance sheets of Warner Communications Inc. (“WCI”) and American Television and Communications Corporation (“ATC”), as of December 31, 2002 and 2001, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2002. Our audits also included the accompanying financial statement schedule listed in the index at Item 15