Behind AOL's Ad Blitz

by David A. Vise

Aggressive marketing campaign at end of 2003 could make 2004 earnings appear to be greater than they actually are, according to accounting experts and a former AOL employee.

Michael Setliff, who briefly worked as a financial manager at AOL, said he grew suspicious of the company’s decision to boost its marketing budget.

One year ago, America Online warned Wall Street that 2003 would be a sluggish “reset” year, pledging that growth would return to the beleaguered enterprise this year. The Dulles-based firm appears on track to show improved financial results, but not necessarily because its business is taking off again.

The company is likely to benefit from a decision to boost spending in the final three months of the year. As 2003 drew to a close, AOL substantially increased its marketing and told Wall Street analysts of its intent to do so. Ultimately, senior officials added $49 million, or about 10 percent, to the marketing budget in the fourth quarter, opting to ship more than 125 million AOL software disks — about 25 million more than the firm mailed and distributed free through retailers in the same period of the prior year, according to internal documents and company officials.

The advertising blitz ate into 2003 profit but should help improve the bottom line this year when expenses return to normal and the company collects fees from the new customers it wooed with the added advertising — potentially making any gains in the profitability of the core business appear to be greater than they actually are, according to accounting experts and a former AOL employee.

Michael Setliff, who briefly worked as a financial manager at AOL last fall, said he grew suspicious of whether the decision to boost the marketing budget was really intended to attract new subscribers after he was asked to identify more than $100 million in expenses that could be added in late 2003. AOL officials confirmed that Setliff was asked to undertake the task.

Setliff said that when he questioned the moves, his boss told him the various changes were being made to “manage earnings.”

A spokesman for America Online, Jim Whitney, said nobody ever told Setliff anything about managing earnings. Whitney said the company increased its marketing spending to ensure the best possible launch of AOL 9.0, its newest online software.

“AOL 9.0 is the best received upgrade of our service in our history, and it was released at a time when we are having well-publicized subscriber challenges,” Whitney said. “To claim there is something inappropriate about our aggressively marketing 9.0 is simply off the mark.”

What AOL officials don’t dispute is that the end-of-the-year marketing push was needed to hit 2004 financial targets for growth because the firm is bleeding subscribers at an alarmingly high rate. The company has made no secret of the fact that many customers are leaving to take advantage of cheaper service that relies on dial-up phone connections to the Internet, while others are trading up to higher-priced high-speed broadband service offered by cable and telephone companies.

AOL has said it lost 2 million subscribers in the past year, falling to 24.7 million from 26.7 million. But the company hasn’t publicly disclosed the rate at which it is losing and adding subscribers. According to an internal document labeled “Churn Summary,” AOL initially thought it needed to sign up 18.2 million new customers in 2003 just to stay even. Because of the high churn rate of more than 70 percent, AOL internally projected losing 18.2 million customers last year and signing up 16.5 million new users, resulting in a net loss of 1.7 million customers. Those numbers have since grown worse, AOL officials said.

AOL has said it intends to rebuild the business by selling its own low-cost alternative while heavily promoting a broadband offering that subscribers would pay for in addition to the fees they pay their cable or telephone provider for Internet access. Some accounting specialists, however, said it may be difficult for investors to judge whether the new approach is working, given the way the company loaded up the budget with expenses in late 2003. Any profit surge early this year may be the result of mega-marketing hitting the books in late 2003, and fresh cash from new subscribers pouring in early in 2004.

One financial expert, H. David Sherman, author of “Profits You Can Trust,” called AOL’s addition of tens of millions of dollars to the marketing budget in late 2003 a “red flag” and said AOL appears to be “tilting” its earnings in a way that may mislead investors.

“They hope you forget and attribute it to a better business model,” Sherman said.

Edward I. Adler, corporate spokesman for AOL’s parent Time Warner Corp., said the company fully disclosed to Wall Street that it intended to add marketing dollars to fourth-quarter spending.

On July 23, Time Warner Chief Financial Officer Wayne H. Pace told Wall Street analysts that AOL would “meaningfully ramp up marketing spending” in the second half of 2003. On Oct. 22, Pace updated his earlier remarks, adding, “We expect AOL to ramp up marketing associated with the 9.0 release.”

Setliff, an experienced, 40-year-old financial manager, said he was dismissed after he aggressively questioned what appeared to be the company’s effort to massage 2004 earnings.

“It is not right,” Setliff said in an interview. “They are playing some real games. I got fired because I pushed these questions.”

AOL’s Whitney said the company is booking the expenses appropriately. Setliff was fired after a month for reasons “that had nothing to do with the issues raised in this article,” Whitney said. A letter from AOL to Setliff said he was dismissed because of his workplace demeanor.

Setliff, who has moved on to another firm, said he had never encountered a corporate culture like the one at AOL. A former Internal Revenue Service employee, Setliff also had worked for years at Lucent Technologies Inc., where he gained considerable experience in budgeting and financial management, and was encouraged by his boss, John Barry, to ask tough questions.

“Mike was rock solid, very competent, always straight ahead,” said Barry, director of global operations in the professional services division of Lucent. “He is very knowledgeable. He is a straight-up, focused guy.”

Setliff said he was puzzled when some marketing initiatives for late 2003 were approved, even though according to an analysis by McKinsey & Co., an outside consultant to AOL, they seemed unlikely to prove very profitable. America Online officials decided to spend millions of dollars on mass mailings of AOL disks even though, on a scale of one to 100, where one is the highest level of return, mass mailings rated 90 in profitability, internal company documents show.

Setliff said that whenever he raised questions, his boss, AOL marketing executive Kevin Belli, treated him with disdain.

For example, Setliff said Belli directed him to make new expense entries in internal budget documents for the fourth quarter of 2003 without any reference to the related revenue that would hit the books in 2004. When he sought to highlight these changes with a footnote, Setliff said he was rebuked by Belli.

Setliff said he was eventually told by Belli that the changes were needed to “manage earnings.”

America Online spokesman Whitney denied the allegation. “Belli never said that,” Whitney said, adding that the company would not make Belli available for an interview.

The AOL spokesman said America Online, which typically spends about $500 million a quarter on marketing, added $49 million to the marketing budget in the fourth quarter of 2003, shifting only $7 million from 2004 budget plans.

He said the firm was running ahead of projections last year and increased marketing to promote its new software and sign up customers in a tough operating environment. Whitney also said it was natural for the company, in the midst of launching AOL 9.0, to do whatever it could to make the new software offering successful.

While AOL insiders said more than half of the increase in marketing dollars in the fourth quarter was aimed at signing up new dial-up subscribers, Time Warner spokesman Adler noted that the Internet firm also has been engaged in a broad advertising effort.

“We did buy more ads and spend more on marketing,” Adler said. “You can tell that by watching the baseball playoffs, by going into Best Buy or Circuit City, or by looking at buses in New York City.”

AOL is also sponsoring the halftime show at Sunday’s Super Bowl.

The questions about the sustainability of AOL’s earnings come as the company remains the subject of extensive ongoing probes into its bookkeeping practices by the Justice Department and the Securities and Exchange Commission. Those probes are looking at the way America Online reported its financial results before and after its merger with Time Warner in January 2002. The investigations are not examining the 2003 acceleration in marketing expenditures.

In the fall of 2002, Time Warner restated $190 million previously reported by AOL as profit. The corporation, acknowledging that AOL had overstated earnings, also disclosed that it was seeking to cooperate with federal officials and might further reduce previously reported earnings.

Time Warner is slated to release its 2003 earnings tomorrow.

Financial experts said AOL has failed to adequately explain to investors how the year-end marketing drive in 2003 could affect the underlying quality of earnings this year.

Without that, it may appear that America Online is “trying to trick people into thinking the results were better than they really were,” said Howard Schilit, chairman of the Center for Financial Research and Analysis. “It is a way for companies to create an impression that things have improved.”

© 2004 The Washington Post Company