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April 16, 2001  6:00 am Eastern Time

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SOURCE: Parish & Company - Preliminary Report to be issued in 3 parts as follows:  general comments, detailed supporting analysis and finally useful links. Please send comments to bill@billparish.com

Is Microsoft's Financial Pyramid Now Collapsing America Online?  Parish & Company issues warning on AOL Time Warner bonds, citing financial engineering and inadequate financial disclosure.

Summary Conclusion

Pyramid schemes, including that erected by Microsoft, are all about generating cash.  Even today, after numerous articles in  leading publications based upon my theory and supporting research, usually without attribution, most analysts and reporters still believe that the core issue at Microsoft is the abuse of non-qualified stock options.  That is astounding and tells me that I have poorly communicated what is occurring.  I'll do my best to provide more details but please also do your part and cite my work to help stimulate a constructive dialogue.  By now it should be abundantly clear that these reports are of the highest quality.

America Online is now discovering that, just as Cisco Systems failed in using a merger strategy to compete with Microsoft's pyramid scheme, America Online will soon also fail in its strategy to compete with the scheme using financial engineering due to a liquidity crisis.  In April America Online issued $4 billion of new bonds.  Imagine that!  AOL already has more than $22 billion in bank debt on which they pay an average rate of 7.5 percent.  In contrast, Microsoft has no bank debt and therefore no cash drain due to  interest charges.

This year alone AOL will pay almost $2 billion in interest on its debt and meanwhile most people are focused on the increased number of new subscriptions to Time Magazine and other media outlets generated by the merger in addition to AOL's ability to slash costs at Time Warner, i.e. layoff opportunities.  The problem is that Microsoft has put AOL in a mathematical vice from which they can no longer escape no matter how rosy their revenue forecasts, how much they cut costs or how much they are able to manipulate their financial results.

Also not disclosed to the general public is that AOL assumed a $16 billion back tax bill when it bought Time Warner.  AOL also assumed $9.7 billion in Time Warner stock option debt upon completing the merger.  Perhaps most remarkable is that Time Warner was so cash strapped prior to the merger that it had a special line of credit of $1.3 billion on which it paid very high fees, the collateral being the future cash to be received from the exercise of employee stock options.  The sum of the bank debt, back taxes and the stock option liability now exceed $45 billion, more than AOL Time Warner's gross annual revenues.

Equally astonishing is that AOL has manufactured more than $120 billion in equity by writing up Time Warner's assets upon completing the merger.  If this all sounds too hard to believe, one need only look at the balance sheet and examine total equity for the companies prior to the merger and after the merger. This is a game played by their accountants.  The cable system alone was written up more than $10 billion.

What could possibly have compelled AOL to dispose of its future by buying Time Warner, a purchase that was clearly made with the expectation of selling privacy and calling it advertising based upon an inability to support the structural costs and report sufficient profit from providing Internet access.  AOL's CEO said it best in an April 15, 2001 Barrons interview by stating  "we're renting out the eyeballs and increasingly the fingers of our subscribers."

I wonder how readers of Fortune, Time and other publications will react when they discover that every article they read, time spent, etc. is being filed into detailed profiles and sold to advertisers.  Of course this is identical to Amazon.com's strategy.  Some of you may recall Jeff Bezos boasting that he could sell the reading habits of IBM employees or any other category for that matter.  This completely backfired and probably explains why Amazon.com's business model has since collapsed.

Sadly, AOL was unable to compete in the Internet access business since it does not enjoy the monopopy tax-free profits from software that Microsoft uses to subsidize its development of MSN, both in terms of delivery and the provision of content. MSN has already overtaken AOL in international markets.

Summary of Significant Financial Facts for AOL Time Warner

Link to  8-KA SEC filing on March 30, 2000: This 18 page SEC report is best reviewed by printing a landscape version and selecting " view - text size - smallest" in your browser. B is in billions

Shares Outstanding (Including Options)                             5 B
Market Value of shares at $40 per share                     $200 B

Total Revenues Fiscal 2000                                        $36.2B
Net Loss for fiscal 2000                                              $(3.9B)
Operating Income                                                          6,760
  (Excludes goodwill and merger costs)                          18.6%
Pre Tax Profit Margin                                                    4,092
  (Operating margin less interest & other expense,           11.3%
  excludes goodwill and merger costs)

Time Warner Bank Debt                                                $20 B
Annual Interest Expense on Time Warner Debt              $1.7 B
Time Warner Back Taxes Assumed by AOL                  $16 B
Time Warner Stock Option Debt Assumed by AOL      $9.6 B

Combined AOL and Time Warner Equity - Pre Merger  $16.7B
Reported Equity per Balance Sheet - Post Merger        $157.6 B
 
History of Microsoft / AOL Battle

What is often forgotten about America Online is that Paul Allen, Microsoft Co-Founder, made an attempt acquire AOL in the early 1990's, at one time owning 20 percent of all shares.  Allen was thwarted in his effort due to conflicts with AOL's board of directors.  This battle did not end here but rather simply changed to the financial venue and a pyramid scheme erected at the Microsoft Corporation, a scheme now poised to collapse AOL due to a staggering miscalculation in AOL's acquisition of Time Warner. Simply put, AOL was deceived by Time Warner and failed to see the merger's impact on cash flow.

All pyramid schemes are about generating cash, as is the pyramid erected by Microsoft.  While many technology companies thought they could participate they have now learned that it is indeed Microsoft's scheme. What AOL did not realize is that no matter how well they played the game, the pyramid was structured to guarantee AOL's collapse due to an inability to generate sufficient cash in order to stay in the game.  The only question remaining was how long AOL could last until they made a serious miscalculation that would impair its cash flow.

This error has been made with the purchase of Time Warner and while top executives are aggressively selling stock, boasting about possible massive cost reductions and layoffs if earnings goals are not met,  the general investing public in unaware of what has happened.

Remarkably, AOL also recently announced a $5B share buyback program and is studying how to come up with the cash to purchase AT&T's 25 percent interest in TimeWarner that will cost between $9 and $15 billion.

What could possibly inspire AOL to make what could be an Amazon.com like mistake in its cash management?  Like Amazon.com,  AOL is focused on more esoteric measures of performance such as EBITDA (earnings before interest, taxes and depreciation).  Could there be anything more deceiving that a company eliminating an expense of almost $2 billion in interest from their primary means of reporting performance, especially since this interest must be paid in cash.

Janus is the largest holder of AOL Time Warner's "Watered Stock" per Yahoo.com

Per Yahoo, the largest AOL shareholders are as follows, $ billions:

Janus                              $10.1 B
AXA                                $4.8 B
Barclays                           $4.7 B
Capital Research              $4.1 B
Fidelity Investments          $3.6B

These market value of these five shareholders alone account for close to AOL's entire annual gross revenues.  In addition, with 5 billion shares outstanding AOL has clearly become a "watered stock" due to its merger with Time Warner in that every $1 change in its price now changes the market value of the company by $5 billion.  The Time Warner merger was clearly an act of desperation by AOL and from Time Warner's perspective an opporrunity to fleece AOl shareholders for reasons explained in this report.

Why Are Analysts Agressively Recommending AOL Stock?

On January 19, 2001 Mary Meeker issued a strong buy recommendation on AOL, citing strong EBITDA (earnings before interest and taxes) growth and predicted a price of $75 by year end. Mary works for a large investment house that would certainly appreciate getting some of AOL's bond underwriting or investment banking business.  It does seem remarkable that the press continues to use analysts such as Meeker after their very poor performance over the last year.  Meanwhile, analysts like myself producing top quality work are unable to bequoted in publications such as the NY Times.

Numerous financial publications have also issued glowing reports citing subscribor growth yet with no mention of the deteriorating cash position and fact that it has become a "watered stock."  In their defense, the first significant post merger SEC filing was not available until late March.

California Energy Crisis, PGE Bankruptcy and America Online Bonds Tied to Microsoft

Another direct impact of Microsoft's pyramid scheme is the manufacture of a false energy crisis in California and across the nation.  What basically happened is that large utilities decided to merge and institute financial engineering legitimized by Microsoft in order to compete in Microsoft's pyramid game.  Unfortunately, utility regulators allowed the utilities to break off their highly profitable power marketing subsidiaries from the cost intensive infrastructure business.

These power marketing subsidiaries with the ability to charge whatever price they want to the utilities while the utilities are strapped by rate caps is not unlike what Microsoft did to destabilize the PC industry.  They effectively made most PC based activities low margin or worse unprofitable in addition to requiring them to institute their own brand of financial engineering in order to survive.  Another good example are E-commerce companies.  This also explains why when you walk into Office Depot you can see a new computer for $500 yet a complete version of Microsoft Office can cost up to $800.

Like AOL, however, these utlities with a cost intensive structure and high debt levels were vulnerable to a liquidity crisis and PG&E has already declared Chapter 11 bankruptcy.  While utlities were unable to aggressively raise prices for regulatory reasons, AOL is similarly confined by market factors, including future competition from wireless satellite internet access as the new high speed band is deployed within 18 months.

Is it not astonishing that no one has determined that the whole energy crisis is manufactured by financial engineering and can be traced directly to financial fraud at the Microsoft Corporation?  At its peak Microsoft was worth $700 billion and even when Pacific Gas and Electric was at its peak valuation of roughly $15 billion, that would have represented pocket change to Microsoft.  Microsoft could have purchased several of the largest utilities and dominated this sector.

As an investment advisor I am continually surprised that many journalists do accept the notion that their is only one capital market.  There is no "tech" market or "telecomm" market.  Capital flows to all markets and therefore Pacific Gas & Electric competes directly with Microsoft and AOL for capital.  The utilities were basically desperate to increase their stock prices in order to compete in a new era of deregulation and therefore had no choice but to enter Microsoft's pyramid game, even though they could not hope to survive.

Most would argue that history will decide the fate of AOL's bonds yet my belief is that Microsoft has already written their epitath.  Even today, after issuing $4 billion in new bonds and all the significant fees being paid to investment firms to issue such bonds, Moody's still maintains an investment grade rating on the AOL bonds. It is for this reason that I have issued my first formal caution with respect to a fixed income product.

Is Accounting Magic Making AOL Look like Pacific Gas and Electric?

You might ask, how does equity on a company's balance sheet magically go from $16.7 billion before the merger to $157.6B after the merger.  What AOL's accountants basically did was write up the value of Time Warner's assets, a form of reappraisal.  This includes recognizing a write-up of more than $20 billion pertaining to the Cable system and also recognizing $126 billion in goodwill.  This is important because it provides the illusion that AOL is well capitalized, that is, with a lot of equity.

What Time Warner management has basically done is fold a debt laden marginally profitable organization with declining cash flow and significant infrastructure upgrade requirements into a company highly sensitive to cash flow.  AOL is now learning, as Amazon.com has already, that Microsoft's pyramid scheme is indeed structured to ensure its demise.
 
Technological and Competitive Landscape

AOL received enormous technology benefits from its acquisition of Netscape Communications yet the rapidly changing technology environment today could soon render many of these advantages obsolete.  AOL is primary a distribution company, not a technologist, and this has helped fuel its success in the past.  Their problem now is how to grow technology internally given their overleveraged financial status.

While AOL is faced with crucial capital budget decisions, for example, how much to spend on upgrading its cable system, and what could be a rapidly deteriorating cash position, Microsoft is awash in cash and able to buy new technologies and invest only marginally in its distribution system, which is primarily supported by outside vendors.

Microsoft's .net initiative will be discussed in an update.
 
Is AOL Paying Microsoft's Corporate Income Tax?

AOL entered the Time Warner merger with more than $13 billion in unused tax deductions, implying a tax lcredit of $4.4 billion assuming a 35 percent rate.  This resulted from the exercise of employee stock options.  Since employees have these option gains included on their W-2 and are taxed at ordinary income rates, the company, AOL in this case, is entitled to take a tax deduction for the same amount.  These stock option wages are never, however, showed as a charge against earnings.  They appear as an expense only on the non-publicly disclosed corporate tax return.  Since AOL hasn't had the profits to fully use these deductions they had been worthless prior to the merger. Now they have been used up and AOL is still stuck with $16 billion in back taxes.

Similar deductions at Microsoft for stock option wages generate cash in the form of lower income tax and indeed Microsoft paid no federal income tax on more than $8 billion in net income during the most recent year.  AOL's surprising mistake was to not understand the significance of Time Warner having back taxes.  What this means is that AOL's $13 billion deduction simply went to offset Time Warner's existing deferred tax liability, back taxes, and even after this effect, AOL is still stuck with a $16 billion back tax bill.

It is important to note that AOL's back taxes are a real debt to the IRS resulting from timing differences in areas such as depreciation.  Time Warner basically took much faster depreciation on its tax books and deferred tax on its financial books we see.  The key point is that the taxes are deferred but still will be paid.  Microsoft, on the other hand, has almost no deferred tax because rather than a timing difference between the tax books and books, they have fully utilized their tax deductions from stock options which are a permanent difference that never reconciles.  In plain English, that means that Microsoft does not have to recognize deferred tax obligations because nothing will ever be owed based upon the nature of its non-qualified stock option deductions they have taken to date.

At the new combined company deferred taxes were reduced and equity increased by the same amount with no related entry to cash and this effectively wiped out AOL's accumulated ununsed stock option deductions.  Inflating equity by $4.4 billion is no insignificant task yet to compete in Microsoft's pyramid game, the focus must remain on cash and this could be AOL's key mistake because again they still have a $16 billion real liability to the IRS that certainly can't be satisfied by printing shares of stock, it will take cash.

If this all seems a little arcane you might simply visit the cash flow statement for each company.  Microsoft's statement will show a line titled "Tax Benefit from exercise of employee stock options."  This is not seen on AOL's cash flow statement because they have been unable to use the deductions due to inadequate profit.

Did Time Warner Stick AOL With $16.2 billion in Back Taxes?

In a strange ironical twist, Time Warner has done to AOL exactly what Microsoft has done to its own employees.  Obviously, this sounds patently ridiculous yet one need only review the SEC filings to see that $16.2 billion of the purchase price AOL paid for Time Warner was allocated to deferred taxes.  In plain English, that means Time Warner stuck AOL with a $16.2 billion back tax bill.  Meanwhile, Wall Street is silent and instead glorifies AOL moving from 27 to 29 million subscribers, many of which are probably not even cash paying subscribers.

It also now appears that many analysts are now trying to issue glowing reports to capture AOL's inevitable significant future debt offerings necessary to not only sustain its operations but also purchase AT&T's 25 percent stake in Time Warner, expected to cost between $8 and $15 billion.

Please note that Parish and Company was the first to clearly explain and document that Time Warner had indeed stuck AOL with $16.2 billion in back taxes.  It is only fair to quote this site, even though this fact can be externally verified.

Are The NY Times and Other Major Business Media Risking a Credibility Disaster?

Many news outlets, most notably the NY Times, now have policies that effectively allow Wall Street analysts to use the work of independent advisors like myself without attribution.  The rationale is that citing big advertisers like Lehman Brothers is ok, even if they are clearly using the work of others. It is really quite astonishing and probably explains why I get so many comments asking "what's going on at the Times?"  Significant media pieces are even starting to appear that substantiate this problem.

One need only review the archive of the NY Times leading reporters and match it to my archive to see a very consistent pattern of using the material without sufficient attribution.  This is not to fault the reporters who have also been pigeon holed into certain "beats" which greatly impairs their ability to cooperate and improve the overall quality of the paper's reporting.  This lack of coordination also makes it easy for the Times managment to justify not doing a particular story.

For example, in early March I negotiated with a reporter from the Times to do a story on several Microsoft employees declaring bankruptcy due to unexpected consequences of their stock option program.  This included introducing the reporter to one such couple and their remarkable story. My stated goal was to help these people and thousands of others in Silicon Valley in a similar situation by introducing a very common sense revenue ruling to address this situation.  I was told the proposed solution was brilliant, practical and that this was a remarkable story.  The attractiveness of this proposal was also confirmed with numerous outside sources including a former Chair of the Senate Finance Committee. In addition, I spent a significant amount of time researching and clearly explaining various aspects of the situation,both regarding incentive and non-qualified stock options.

What I also did two weeks after making the introduction and laying down the foundation was send an email to Steve Ballmer letting him know the story was coming and bcc'd 2000 top journalists, academics, investment analysts and pension managers.  The objective was to let the Times management know that if they killed the story, the world would know.  This was important based upon previous experience with the Times managment, including their allowing former CFO Greg Maffei to do an op-ed piece that grossly misrepresented and refuted a story titled Financial Engineering 1.0 that was largely based upon my work.

In the end, the Times management killed the story since it should have been done by April 15th.  One need only read the story on Sunday April 16th by Gretchen Morgenson titled "Employers Dodge a Bullet their Employees Can't."  This is the link:  http://www.nytimes.com/2001/04/15/business/15WATC.html

If you read between the lines you can see a hodge podge of topics and frustration, most unusual from one who is clearly one of the top 5 business reporters in the country.  We haven't spoken for a month and I hear from other journalists that she was very upset at my sending out an email to Steve Ballmer announcing the story was coming.  Of course I was testing the integrity of the Times managment and they clearly failed.

Is Microsoft's PR Machine Dictating Content to the NY Times?

The most used strategies here to prevent a high profile dialogue on Microsoft's pyramid scheme are advertising muscle, threat of litigation and deflection.  The advertising muscle is obvious and it would be interesting if the Times would disclose the total volume of ad dollars and other financial aspects of their relationship with Microsoft, especially since the President of the Times is from the advertising side of the business rather than the news side.

More sophisticated is the deflection strategy.  This usually involves trying to build an "everyone is doing it case" by trying to for example make the issue executive compensation rather than a pyramid scheme at Microsoft.  In fact, right about when I expected the story on the Microsoft couple declaring bankruptcy the Times did a multi-part spread on executive compensation which only serves to disguise the pyramid.  The key point is that excessive executive compensation is an effect of the pyramid effectively legitimized by financial corruption at Microsoft.

Is AOL Collapsing Journalistic Integrity at Time Warner?

It is my opinion, unsubstantiated, that AOL is consolidating and narrowing key editors and other journalists positions in a classic divide and conquor strategy designed to mute the forces of jounalistic integrity and quality and instead focus on the sale of privacy.  This will be fully addressed in an update with numerous specific examples.  This includes refusing to pay honest cash bonuses but rather paying merit performance in stock options.

Is their anyone out there that really believes that paying a journalist in stock options will not influence the quality of reporting? AOL is clearly saying, look, the only way we can compete with this scheme at Microsoft is to issue stock options, we are cash poor and will otherwise be crushed. Again, this highlights that AOL is not the source of this corruption but rather been compromised due to a need to compete to avoid being crushed by the pyramid's weight.

AOL Announces $5 Billion Share Repurchase Program and Studies European IPO Designed to Raise Cash

On January 19, 2001 AOL Time Warner announced a $5 billion share repurchase program over two years in addition to a $10 billion shelf registration of debt and/or equity securities.  The obvious question becomes, are they planning on issuing new debt to repurchase $5 billion in stock?  If so, could anything be more ridiculous?  And how about a similar announcement made two years ago which was soon after cancelled due to a merger.  Is this a public relations ploy to manipulate the stock price, a key tool used by the Microsoft Corporation yet not of the same utility to AOL since they don't have the cash.

AOL is also quoted in Reuters as saying that it is "considering a European IPO, in addition to other cash raising options."  Strangely, on December 18, 2000 Moody's Upgraded the AOL Time Warner's Corporate Debt to Baa1.

This is surprising given that Microsoft is already overtaking AOL in international markets and AOL's US growth will surely slow due to existing market coverage.

AT&T May Sell Interest in Time Warner in IPO

AT&T clearly wants to sell its 25 percent stake in Time Warner entertainment yet AOL is not willing to pay what AT&T wants.   AT&T, like AOL, really needs to pay down its long term debt to reduce the interest expense drain on its cash flow.  One might ask, how can AOL pay the $9-$15 billion necessary when they are already overextended?

It appears that AOL's only choice will be to issue more bonds and so once again we'll probably see many investment banking firms coming out with strong buy recommendations as they fish for the massive bond underwriting fees that could result.

If Moody's and the other bond rating agencies do their job they will prevent AOL from issuing more bonds by downgrading its existing debt to something below investment grade.  This would imply that AT&T should indeed do an IPO for its interest in Time Warner because it would be grossly irresponsible for AOL to issue such bonds.

Is AOL Manipulating Gross Revenues Through Forced Bartering Agreements In a Futile Effort to Compete with Microsoft?

This is one of the more important and ingenious aspects of Microsoft's scheme, now agressively emulated by AOL in order to compete.  This was best seen, as originally reported by Parish & Company in a previous study, in Microsoft's investment in WebMD in which WebMD received much needed cash and Microsoft took a stake in the company.  WebMD was also required to place a certain amount of advertising on MSN Network while Microsoft agreed to subsidize an equal amount of prescriptions ordered over WebMD.  This helps Microsoft manipulate its gross revenues for MSN and thereby inflate its stock price.

Numerous similar examples exist for AOL, one key difference probably being that AOL is most likely unable to contribute cash and for that reason may focus even more heavily on the forced bartering "cross promotional opportunities," what I would call the sale of privacy.  AOL seems to be adopting a model not unlike that of Double Click.

What investors deserve to know is what percent of AOL's sales are non-cash transactions.  This is impossible to determine given their existing disclosure level and if in excess of 5 percent of total sales would imply gross negligence, in terms of disclosure, on the part of their auditing firm.

AOL Shifts Time Warner Comp from Cash Bonuses To Stock Options

This is a desperate attempt to conserve cash and take the wage expense off the books and thereby inflate earnings. The complex irony is that Microsoft is able to fully utilize its tax deductions generated from stock options due to its monopoly level profits on products yet these deductions are of limited current value to AOL because they took on a $15 billion bill for back taxes when they bought Time Warner.

The key point is that while Microsoft is paying no tax and thereby conserving cash, it is likely that AOL will be forced to make significant cash outlays for taxes given the $15 billion in back taxes they assumed from Time Warner.

Microsoft Pyramid, emulated by AOL, Is Now Igniting False Wage Inflation, Federal Reserve Silent

For almost two years my theory of false product inflation and its impact was discounted yet recently many reporters have used the material to explain the CPI and PPI trends.

On April 16, 2001 Bloomberg reported that wage inflation was up .7 percent even though core CPI increased only .2 percent. It is unfortunate that Alan Greenspan and the Federal Reserve are still tinkering with interest rates and ignoring the fact that the Employment Cost Index does not include stock option wages.  It would be an easy task to update this most important indicator.

False wage inflation is now being triggered and destabilizing the economy due to workers demanding more in cash wages necessary to compete with the paper wages generated by stock options.  This is raising costs and will result in significant layoffs as U.S. based production becomes less desireable on a cost basis.  It will also exacerbate a slowdown in corporate profits and put severe downward pressure on stock prices.

Does AOL's Use of EBITDA Make Microsoft's Income Statement Look Respectable?

You certainly don't see Microsoft using EBITDA the way AOL does.  AOL claims that goodwill is a non-cash charge and therefore should be added back to earnings.  What they do not state is that goodwill is not a valid tax deduction.  What this means is that AOL's taxable income will be much higher than net income and furthur exacerbate their cash flow difficulties as taxes, which must be paid in cash, become due.

It is most unusual that AOL's management so grossly distorts their financial reporting but again they are effectively emulating Microsoft.  One might ask, isn't cash paid to a bank for interest a "cash expense" and one that should therefore be deducted rather than excluded from reported earnings?

AOL Allows the Icon of Predatory Lending, Citigroup, to Fleece Its Customer Base and Extract the Most Profitable Part of Their Customer Relationship

It does appear that Citigroup could indeed be the most significant advertiser on AOL, having recently signed a new exclusive deal.  It is surprising that AOL's management would choose Citigroup given its recent purchase of Associated First Capital, considered the "icon of predatory lending."

AOL does not seem to realize that Citigroup is mining its customer base and will convert these relationships to Citigroup relationships. The real revenue opportunity for AOL is having its own mix of financial services rather than handing this business over to Citigroup based upon a quest for short-term advertising revenues.

AOL has also reported that Salomon Smith Barney brokers, a subsidiary of Citigroup, now receive leads from AOL based upon monitoring AOL user traffic.

AOL's Primary Business is Now The Sale of Privacy, Not Internet Access, Due to Declining Margins on Access Services

Microsoft has effectively destroyed AOL's online business model and pushed the company into focusing on the sale of privacy. Many AOL users have not been concerned about privacy issues yet with the purchase of Time Warner the company will now be able to assemble detailed personal profiles based upon reading habits, i.e. Sports Illustrated, Time, Fortune, etc. and cross reference these databases with web activity.  That is fine and is a valid business yet with AOL selling this information to outside advertisers, could there be a backlash.  Worse for AOL is that these profiles have a diminishing return.

AOL should be able to succeed as an Internet access company yet they face enormous infrastructure upgrade costs and these costs are real and will require cash.  Microsoft, on the other hand, can print up a million copies of its best selling Office Software at minimal marginal cost.

It is my belief that AOL should focus more on software development and provide a broader mix of such products to users.  For example, I might want to use an AOL product that allows me use the web anonymously, especially if I am studying detailed personal and health care related matters.  Sadly, AOL's whole business model is now structured to provide the sale of privacy due to an inability to compete with the financial pyramid at Microsoft.

AOL's Management Repeating Mistakes of Cisco Systems Management

In December of 2000 Cisco Systems managment announced that they would be unaffected by currency instability in Europe, as if they were on an island.  Similarly, Bob Pittman of AOL has announced that the slowdown in advertising won't hurt AOL much.  In fact, he said it would help as advertisers consolidate to their highest quality advertising venues such as AOL.  Pittman also cited that if advertising slowed down they could use that valuable space to advertise their own broad mix of products, for example advertising Sports Illustrated in Fortune magazine.

That may be true yet someone should remind Bob that you can't count such transactions as sales.  This also raises an interesting question, how much of AOL's sales were to Time Warner companies prior to the merger.  These are no longer valid sales but have to be removed as "intercompany or related party transactions."  This is an important rule to keep companies honest.  Can you imagine the Wall Street Journal booking ad revenue for WSJ ads placed in the WSJ?

This complete breakdown in the integrity of financial disclosure can be traced directly to the Microsoft Corporation and is a key element in its financial pyramid scheme. Bob Pittman would never make such statements if it weren't for the influence of Microsoft's pyramid scheme.

Why AOL's Stock Option Program Is Unable to Generate Cash, As Does that at Microsoft

One of the shocks of the failed dot.com's is that tax deductions generated by the companies resulting from the exercise of non-qualified stock options aren't worth much if you have no profit.  These firms permanently extracted equity from their base as employees exercised options and paid ordinary income tax on related gains.

The only real benefit to the company of issuing non-qualified options is the ability to fully utilize the stock option deductions by offsetting them against profits and thereby create cash in the form of non-payment of income tax.  Microsoft can do this yet AOL is limited by its comparatively low profitability.

AOL Becomes A Watered Stock Trying to Play Microsoft's Pyramid Game

With 5 billion shares now outstanding, including options, AOL has become a highly leveraged stock.  A mere change of $2 accounts for the entire gross margin without even considering the increased debt to employees for stock options or the significant annual interest expense on its debt.
 

Concluding Opinion by Parish and Company

Clearly Microsoft's pyramid scheme has left AOL in financial ruins, contrary to what their various other partners contend.   Frankly, I think that Steve Case will try and do what John Malone did with his cable empire and whether Wall Street allows it or not is another issue.

I would expect Case to, as in the case of Pacific Gas and Electric, try and bundle all the low overhead high margin products and services into a separate company and then spin off the debt laden infrastructure to someone who was hopefully as ill informed and naive as he was when Time Warner was purchased.  Perhaps that is why most Wall Street analysts are so bullish on AOL, they smell fees. In the end the public and private pension systems will probably be left holding the bag, as they have with Cisco Systems.

As an advisor, I do truly look forward to publishing more upbeat reports as I did from 1994 through 1998. And by the way, has anyone noticed that the Securities and Exchange Commission still does not have a full time permanent director?  Now there is a major story that even President Bush might appreciate.
 

Three Most Common Questions Regarding Financial Fraud at Microsoft and How It Has Destabilized the Stock Market and Could Indeed Destabilize the Economy

1)  Why don't you focus on the accountants, regulators and politicians?  Aren't they really the ones to blame rather than Microsoft and Bill Gates.

I carefully researched this but was able to conclude that Microsoft was strong arming the accounting standards groups and other regulatory boards in addition to heavily lobbying Congress to overrule the SEC's reform agenda.  They also fired their head of internal audit, a respected former partner of Deloitte and Touche, who told them what they were doing with respect to manipulating earnings was in violation of securities laws and constituted fraud.  Microsoft game him two options, resign or be fired, and he later settled for $4 million under the Federal Whistleblowers Act, as reported by ABC News.

2)  What is this fraud on Microsoft's part.  I don't buy it.

In the financial world fraud is usually based upon a willful intent to deceive investors by inadequately disclosing key items affecting your financial statments.  That may sound somewhat cryptic but that is the way the system works and it's a good thing.  Can you imagine what would happen if investors no longer trusted financial statements, the market would clearly collapse as it did in 1929, and that is why the SEC was created in 1934.

What makes our capital market the envy of the world is its integrity and the key to that is empowering the SEC and not allowing companies like Microsoft to lobby Congress and prevent needed disclosure updates to the system.
 
3) Would you be willing to compromise with Microsoft?

Absolutely.  If they were willing to support a few simple reforms that would probably have minimal impact on their financial condition, for example regarding how 401K plans and related ERISA rules are handled, I would agree to focus elsewhere.  This is what is so astonishing to me, that they have been unwilling to compromise given what most believe is the dramatic impact my reports have had on the company.
 

Limited Copyright April 16, 2001:  You may use this material if the source is clearly cited along with the web site address. Please also note that several thousand leading journalists, academics and investment professionals view these reports and failure to cite them as your source does seriously impair your credibility, especially if you are a journalist.   I now receive numerous comments from journalists surprised that other reporters and analysts use this material without attribution, two notable examples being the SF Chronicle front page story titled Tax Free Routers that was syndicated and repeated in leading publications all over the world, including the Wall Street Journal and Washington Post, and Individual Investors.com's use of material for its analysis of Cisco Systems.

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Bill Parish
Parish & Company
10260 SW Greenburg Rd., Suite 400
Portland, OR  97223
Tel:  503-643-6999  Fax: 503-221-3161
email:  bill@billparish.com
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