TIME WARNER INC.
 



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549


Form 10-K


ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

Commission file number 001-15062


TIME WARNER INC.

(Exact name of Registrant as specified in its charter)
     
Delaware
  13-4099534
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)
One Time Warner Center
New York, NY 10019
(Address of Principal Executive Offices)

(212) 484-8000

(Registrant’s Telephone Number, Including Area Code)


Securities registered pursuant to Section 12(b) of the Act:

     
Name of each exchange
Title of each class on which registered


Common Stock, $.01 par value
  New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:

None

     Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months, and (2) has been subject to such filing requirements for the past 90 days. Yes x         No o

     Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o

     Indicate by check mark if the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes x

     As of the close of business on February 29, 2004, there were 4,381,685,546 shares of the registrant’s Common Stock and 171,185,826 shares of the registrant’s Series LMCN-V Common Stock outstanding. The aggregate market value of the registrant’s voting and non-voting common equity securities held by non-affiliates of the registrant (based upon the closing price of such shares on the New York Stock Exchange on June 30, 2003) was approximately $72.30 billion.

Documents Incorporated by Reference:

     
Description of document Part of the Form 10-K


Portions of the definitive Proxy Statement to be used in connection with the registrant’s 2004 Annual Meeting of Stockholders   Part III (Item 10 through Item 14)
(Portions of Items 10 and 12 are not incorporated by
reference and are provided herein; portions of Item 11
are not incorporated by reference and are provided in
the registrant’s definitive Proxy Statement)




 

PART I

 
Item 1. Business.

       Time Warner Inc. (the “Company” or “Time Warner”) is a leading media and entertainment company. The Company was formed in connection with the merger of America Online, Inc. (“America Online”) and Time Warner Inc., now known as Historic TW Inc. (“Historic TW”), which was consummated on January 11, 2001 (the “Merger” or the “America Online-Historic TW Merger”). The Company changed its name from AOL Time Warner Inc. to Time Warner Inc. on October 16, 2003.

      The Company classifies its businesses into the following fundamental areas:

  •  America Online, consisting principally of interactive services;
 
  •  Cable, consisting principally of interests in cable systems providing video and high speed data services;
 
  •  Filmed Entertainment, consisting principally of feature film, television and home video production and distribution;
 
  •  Networks, consisting principally of cable television and broadcast networks; and
 
  •  Publishing, consisting principally of magazine and book publishing.

      At March 2, 2004, the Company had a total of approximately 80,000 active employees.

      For convenience, the terms the “Registrant,” “Company” and “Time Warner” are used in this report to refer to both the parent company and collectively to the parent company and the subsidiaries through which its various businesses are conducted, unless the context otherwise requires.

 
Asset Sales

      In conjunction with the Company’s debt reduction program announced in January 2003, during 2003 and the first quarter of 2004, the Company sold certain of its businesses and non-strategic assets, including all of the Warner Music recorded music, music publishing and CD and DVD manufacturing businesses, the Time Life Inc. direct marketing business, the Company’s 50%-interest in Comedy Central and its interest in Hughes Electronics Corporation. The Company also expects to complete the sale of its winter sports teams prior to the end of the first quarter of 2004.

 
TWE Restructuring

      On March 31, 2003, the Company completed the restructuring (the “TWE Restructuring”) of Time Warner Entertainment Company, L.P. (“TWE”), a limited partnership which formerly held a substantial portion of the Company’s filmed entertainment and cable television assets. Prior to the TWE Restructuring, subsidiaries of Comcast Corporation (“Comcast”) held a 27.64% limited partnership interest in TWE.

      As a result of the TWE Restructuring, Time Warner acquired complete ownership of TWE’s content businesses, including Warner Bros., Home Box Office and TWE’s interests in The WB Television Network and Courtroom Television Network (“Court TV”). Additionally, all of Time Warner’s interests in cable, including those that were wholly owned and those that were held through TWE, are now controlled by a new subsidiary of Time Warner called Time Warner Cable Inc. (“TWC Inc.” or “TWC”). As part of the TWE Restructuring, Time Warner received a 79% economic interest in TWC Inc.’s cable systems and TWE, which continues to own the cable system interests previously owned by it, became a subsidiary of TWC Inc. In exchange for its previous stake in TWE, Comcast (i) received Time Warner preferred stock which will be converted into $1.5 billion of Time Warner common stock; (ii) received a 21.0% economic interest in TWC Inc.’s cable systems; and (iii) was relieved of $2.1 billion of pre-existing debt which was incurred by TWC Inc. as part of the TWE Restructuring. Comcast’s 21.0% economic interest in TWC Inc.’s cable business is held through a 17.9% direct common 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. Time Warner’s 79%

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economic interest in TWC Inc.’s cable business is held through an 82.1% common ownership interest in TWC Inc. (representing an 89.3% voting interest) and a partnership interest in TWE representing a 1% residual equity interest. Time Warner also holds a $2.4 billion mandatorily redeemable preferred equity interest in TWE. For additional information with respect to the TWE Restructuring, see “Description of Certain Provisions of the TWE Partnership Agreement” herein.

      On December 29, 2003, TWC Inc. received a notice from Comcast requesting that TWC Inc. start the registration process under the Securities Act of 1933 for the sale in a firm underwritten offering of Comcast’s 17.9% common interest in TWC Inc. The notice was delivered pursuant to a registration rights agreement related to the TWC Inc. securities. The Company cannot predict the timing of an effective registration in response to the notice. For additional information with respect to TWC Inc., see “Description of Certain Provisions of Agreements related to TWC Inc.” herein.

 
Restructuring of TWE-Advance/Newhouse Partnership and Road Runner

      During 2002, TWE and Advance/Newhouse Partnership (“Advance/Newhouse”) completed the restructuring of the general partnership known as the Time Warner Entertainment-Advance/Newhouse Partnership (“TWE-A/N”). As a result of the restructuring (the “TWE-A/ N Restructuring”), cable systems serving 2.1 million basic video subscribers (the “A/N Systems”), 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 A/N Systems. Time Warner has deconsolidated the financial position and operating results of the A/N Systems for all periods.

      Also, in connection with the TWE-A/N Restructuring, Time Warner effectively acquired Advance/Newhouse’s 17% interest in Road Runner, a high speed cable modem Internet service provider, thereby increasing the Company’s ownership to approximately 82% on a fully attributed basis.

 
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 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 in Management’s Discussion and Analysis of Results of Operations and Financial Condition in the financial pages herein. Time Warner 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

      The Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such reports filed with or furnished to the Securities and Exchange Commission (SEC) pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act are available free of charge on the Company’s website at www.timewarner.com as soon as reasonably practicable after such reports are electronically filed with the SEC.

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AMERICA ONLINE

      America Online, Inc., a wholly owned subsidiary of the Company based in Dulles, Virginia, is the world’s leader in interactive services. America Online’s operations include: the AOL service; the CompuServe service; the Netscape Internet Service; the Wal-Mart Connect service; AOL for Broadband; premium services such as MusicNet@AOL and AOL Call Alert; and America Online’s messaging and Web properties, such as AOL Instant Messenger, ICQ, Moviefone and MapQuest.

The AOL Service

      The core AOL service, a subscription-based service with over 24 million members in the U.S. and 30.6 million members in the U.S. and Europe, combined, at December 31, 2003, provides members with a global, interactive community offering a wide variety of content, features and tools. The range of content, features and tools offered on the AOL service includes the following:

  •  Online Community — The AOL service promotes interactive community through email services, instant messaging, public and private chat rooms, interactive polling, AOL Talk Phone (allowing voice conversations) and AOL Journals (AOL’s “blog” feature).
 
  •  Content — Content on the AOL service is both internally generated and provided by diverse external sources, including other Time Warner divisions. As part of its strategy, the AOL service is focusing, in part, on developing exclusive content. During 2003, AOL launched new programming areas or experiences targeting specific demographic groups, including: KOL, designed for kids aged 6 to 12; AOL Black Focus, targeted to the African-American community; and AOL Latino, a Spanish language Internet service for U.S. Hispanics. Red, launched in early 2004, is an online experience targeted toward teens. Content on the AOL service is organized in a variety of ways for easy access by members, including channels, toolbar icons, customization tools and Favorite Places, which allow members to mark particular Web sites or AOL areas.
 
  •  Customization and Control Features — Members can customize their experience on the AOL service through features and tools, such as an interactive calendar; My AOL Quickview, which allows additional customization of the Welcome Screen; an alerts and reminders service; SuperBuddy icons; mail controls, including anti-spam features; and parental controls which permit parents to limit access to particular AOL areas, features or Web sites. AOL 9.0 Optimized, introduced in 2003, offers personalized spam filters and enhanced parental controls, among other things. AOL also launched AOL Communicator in 2003, a sophisticated email offering targeted at tech-savvy members.
 
  •  AOL Music — AOL Music offers a variety of programming, products and services that enable consumers to discover, listen to and buy music online. AOL Music’s properties include the AOL Music Channel; Radio@AOL, a built-in radio service; Web music features, including Netscape Music and AIM Today; the Winamp audio jukebox player and SHOUTcast, a streaming audio service and Internet music directory. As of December 2003, AOL members are able to access Apple’s iTunes Music Store through AOL Music and pay for their downloads through their AOL “wallet” or other payment options.
 
  •  Shopping — The AOL Shopping channel allows members to shop for a wide variety of products from various retailers while remaining in the AOL service. AOL also offers members shopping opportunities throughout other channels on the service. The channel’s shopping tools and resources include a search function, electronic shopping lists, and AOL’s “wallet.” AOL provides a customer satisfaction guarantee for all merchandise purchased through an AOL Certified Merchant on AOL Shopping.

      Subscriber fees are charged to members of the AOL service based on the level of service selected. The primary narrowband price plan for U.S. members is an unlimited usage plan for $23.90 per month that includes dial-up telephone access to both the AOL service and the Internet. Narrowband members may also select from other pricing plans with lower rates, including limited usage plans and an annual payment plan that

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allows members to pay for a year of the AOL service in advance at a reduced rate. America Online continues to test new price plans and payment methods.

      Members of AOL may cancel their membership at any time, for any reason, by telephone, fax or mail. AOL utilizes a number of incentives and retention programs to encourage members to continue as members, as well as to bring back members who have recently canceled. In addition, AOL undertakes a wide range of marketing campaigns and promotions to attract new members.

 
AOL for Broadband

      The AOL for Broadband service is available to members connecting to the AOL service through a high-speed broadband technology such as cable or digital subscriber lines (DSL) and is marketed primarily as a “bring your own access” (BYOA) product. AOL for Broadband provides these members with expanded multimedia content, including streaming music, CD-quality radio and other audio, full-motion video, streaming news clips, movie trailers, games and online catalogue shopping features. As part of its business strategy, AOL has focused on developing a broadband product with differentiated and exclusive content.

      Under the broadband BYOA plan, members pay a monthly base fee of $14.95, which allows unlimited time on the AOL service via a broadband connection not provided by America Online, plus a limited number of hours each month of dial-up access in the U.S. from America Online and the ability to have multiple simultaneous log-ins for one account (MSL). AOL also provides bundled broadband services to existing subscribers through a number of DSL and cable partners.

 
AOL Europe and Other International Operations

      AOL International oversees the America Online services and operations outside the United States. As of December 31, 2003, AOL Europe, a wholly owned division of America Online, had nearly 6.4 million members in France, Germany, the U.K. and other European countries. In each of these countries, local language content, marketing and community are offered. America Online Latin America, Inc. (“AOLA”), a publicly-traded joint venture, operates services in Brazil, Mexico and Argentina, serves members of the AOL-branded service in Puerto Rico, and had over 400,000 members as of December 31, 2003. The America Online services are also offered through joint ventures or distribution arrangements in Canada and Japan. For additional information with respect to AOLA, see Note 7, “Investments, Including Available-for-Sale Securities — AOL Latin America,” to the Company’s consolidated financial statements set forth in the financial pages herein.

 
Premium and Other Services

      America Online offers a variety of premium services to its members, including AOLbyPhone, which allows members to access AOL services over the telephone; AOL Call Alert, an online call waiting service that lets members know, through a real-time alert on their computer screen, who is calling while they are online; MusicNet@AOL, an online music subscription service; and AOL Voicemail, a service that allows members to listen to voicemail messages on their computer and e-mail messages on their phone. In April 2003, together with McAfee Security, AOL launched a new premium service that provides protection from computer viruses. These premium services are an element of AOL’s overall business strategy to offset reduced revenues due to fewer subscribers and lower prices of BYOA price plans.

      AOL Mobile services deliver a variety of the AOL service’s features and content to users of wireless devices, such as mobile phones, PDAs, and other handheld devices. The content and services available include wireless access to email, news, weather, sports and stock quotes, as well as content from America Online’s other properties. AOL Instant Messenger and ICQ, two of America Online’s messaging products, are also available on a variety of wireless devices.

      America Online also provides text entry solutions for wireless devices through its subsidiary, Tegic Communications, Inc. Tegic’s leading product, the T9 Text Input software, enables individuals to send e-mail,

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short messaging services and instant messages, as well as perform other text-based functions and access the Internet, using the standard telephone keypad to enter words or sentences.

Other Internet Service Providers

      The CompuServe service targets value-oriented Internet service consumers in the U.S. and professional business-oriented consumers outside of the U.S. Additionally, CompuServe seeks opportunities to develop and operate co-branded and custom versions of the CompuServe service and offers private label Internet solutions for strategic partners, such as Hewlett-Packard. Subscriber fees are charged to CompuServe members based on the level of service selected, including an unlimited usage plan, a lower monthly rate providing for a set number of hours usage (with additional usage charged at an hourly rate) and a “bring your own access” plan for members with Internet access from another provider.

      In January 2004, America Online launched the Netscape Internet service, a low-cost Internet service provider (ISP). The Netscape service costs $9.95 per month for unlimited use. In addition to unlimited Internet access, the service offers e-mail, a start page and Internet search powered by Google.

      America Online operates the Wal-Mart Connect service for Wal-Mart. The Wal-Mart Connect service is offered to consumers for $9.94 a month and offers email, instant messaging and online content.

Web Properties and Messaging

      America Online’s Web properties serve as an online network of AOL brands on the Internet, offering a variety of content and applications.

      AOL Instant Messenger is an Internet-based communications service that allows Internet users to know when other users of the service are online and to send and receive instant messages in real time. ICQ Ltd. is an Internet-based real-time communications service that utilizes the ICQ (“I seek you”) instant communications and chat technology with a constant desktop presence. Approximately two-thirds of ICQ users reside outside the U.S.

      Moviefone is one of the leading movie guide and ticketing services in the U.S. Through its interactive telephone service (777-FILM), its online service (Moviefone.com), and its wireless services, Moviefone provides moviegoers with a weekly, free directory of movies, show times and theater locations, and also provides the ability to purchase tickets remotely for a per-ticket service charge.

      MapQuest provides customized maps, destination information and driving directions to consumers through its Web site (MapQuest.com) and its wireless partners. Through licensing agreements, MapQuest helps businesses integrate maps and driving directions into their Internet, intranet and call center applications.

      The Netscape portal (Netscape.com) offers a variety of products and services, including search services, Web-based e-mail, instant messaging and message boards, programming channels and opportunities for electronic commerce. Netscape Netbusiness (netbusiness.netscape.com), an Internet site targeted to owners of small businesses, offers customizable information resources, productivity and communications tools. America Online continues to maintain the Netscape browser, but no future development for the browser is currently planned.

      AOL.com offers members AOL content and features, including email, AOL Instant Messenger, and personalized news and calendar services, when members are able to access the Internet, but not their AOL service.

Technologies

      America Online employs a multiple vendor strategy in designing, structuring and operating the network services utilized in its interactive online services. AOLnet, a transfer control protocol/Internet protocol (TCP/IP) network of third-party network service providers, is used for the AOL service and certain versions

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of the CompuServe service in North America. America Online anticipates continuing to review its network services in order to align its network capacity, provide members of its online services with higher speed access and manage data network costs.

      America Online also utilizes the AOL Transit Data Network (ATDN), the domestic and international network that connects AOL, CompuServe 2000 and Time Warner Cable high speed data customers to the Internet. The ATDN functions as the conduit between all of Time Warner’s content and the Internet, linking together facilities on four continents, with its greatest capacity in the U.S. and Europe. The ATDN Internet backbone is built from high-end routers and high-bandwidth circuits purchased under long-term agreements from third party carriers.

      America Online enters into multiple-year data communications agreements to support AOLnet. In connection with those agreements, America Online may commit to purchase certain minimum data communications services or to pay a fixed cost for the network services. Improving and maintaining AOLnet requires a substantial investment in telecommunications equipment. In addition to making cash purchases of telecommunications equipment, America Online also finances purchases of this equipment by entering into capital leases for such equipment.

Advertising and Commerce

      A component of America Online’s business strategy is earning revenues from advertising and commerce, including partnering with companies such as Google, as well as from related sources such as transaction and licensing fees. America Online offers its advertising and commerce partners a variety of customized programs, which may include premier placement, sponsorship of particular content offerings for designated time periods, or the opportunity to target users with specified interests. America Online also sells selected merchants preferred rights to market particular goods or services within one or more of the online services and properties. In those arrangements, America Online provides its advertising and commerce partners certain marketing and promotional opportunities and in return receives cash payments, the opportunity for revenue sharing, cross-promotion, competitive pricing and/or online conveniences for subscribers.

Marketing

      America Online utilizes a common marketing infrastructure for its multiple brands of interactive services and Web properties. To support its goals of attracting and retaining members or users, as applicable, and developing and differentiating the family of brands, America Online markets its products, services and brands through a broad array of programs and strategies, including broadcast television and radio advertising campaigns, direct mail, telemarketing, magazine inserts (including magazines published by the Company’s publishing segment) and print advertisements, retail distribution, bundling agreements, Web advertising and alternate media. Other marketing strategies include extensive online and offline cross-promotion and co-branding with a wide variety of partners. Additionally, through multi-year bundling agreements, the interactive online services and products are installed on a range of computers made by personal computer manufacturers and are available to consumers by clicking on an icon during the computer’s initial setup process or on the desktop. America Online also utilizes targeted or limited online and offline promotions, marketing programs and pricing plans designed to appeal to particular groups of potential users of its interactive online services and to distinguish and develop its different brands, products and services.

Competition

      America Online competes for subscription revenues with multiple companies providing Internet services (ISPs), such as the Microsoft Network, EarthLink and AT&T Worldnet, and discount ISPs such as NetZero. America Online also competes with companies that provide Internet access via narrowband and broadband technologies, such as Internet access providers, cable companies and telephone companies. Like America Online, other companies, such as Microsoft and Yahoo, offer broadband services to consumers, either as a bundled product or a BYOA product. America Online also competes more broadly for subscription revenues

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and members’ time with cable, information, entertainment and media companies. America Online competes for advertising and commerce revenues with a wide range of companies, including those that focus on the Internet, such as online services, Internet access companies, Web-based portals, and individual Web sites providing content, commerce, community and similar features, as well as media companies, such as those with newspaper or magazine publications, radio stations and broadcast stations or networks. Additionally, America Online faces the risk that competition from other ISPs and other Internet companies may result in reduced revenues for America Online from its premium services, should those services be included as part of basic Internet service.

      America Online faces competition in developing technologies, and risks from potential new developments in distribution technologies and equipment in Internet access. In particular, America Online faces competition from developments in the following types of Internet access distribution technologies or equipment: broadband distribution technologies used in cable Internet access services; advanced personal computer-based access services offered through DSL technologies offered by local telecommunications companies; other advanced digital services offered by wireless companies; television-based interactive services; personal digital assistants or handheld computers; enhanced mobile phones; and other equipment offering functional equivalents to the AOL Mobile services. America Online must keep pace with these developments and also ensure that it either has comparable and compatible technology or access to distribution technologies developed or owned by third parties.

CABLE

      The Company’s Cable business consists principally of interests in cable 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 completed on March 31, 2003, Time Warner Cable Inc. (“TWC Inc.”) became an 82.1%-owned subsidiary of the Company. Of the 10.9 million basic video subscribers served by the Company at December 31, 2003, 1.6 million are in systems owned by TWC Inc. directly or through wholly-owned subsidiaries and 9.3 million are in systems that are owned or managed by TWC Inc.’s joint ventures and partnerships, which include TWE and TWE-A/N, among others. As a result of the TWE Restructuring, TWE became a 94.3%-owned subsidiary of TWC Inc. (with the Company holding a partnership interest in TWE representing a 1% residual equity interest and a $2.4 billion preferred component). All of these systems provide services under the Time Warner Cable brand name.

      As a result of the TWE-A/ N Restructuring in 2002, cable systems serving 2.1 million basic video subscribers (the “A/ N Systems”), 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 A/ N Systems. Time Warner has deconsolidated the financial position and operating results of the A/ N Systems for all periods and has presented these as a part of discontinued operations.

      On December 1, 2003, the Company announced that Time Warner Cable would restructure two joint ventures that it manages, Kansas City Cable Partners, a 50-50 joint venture between Comcast and TWE serving approximately 304,000 basic video subscribers as of December 31, 2003, and Texas Cable Partners, a 50-50 joint venture between Comcast and TWE-A/ N serving approximately 1.2 million basic video subscribers as of December 31, 2003. The Company accounts for its investment in these joint ventures using the equity method. Under the restructuring, completion of which is subject to customary conditions (including receipt of applicable regulatory approvals), Kansas City Cable Partners will be merged into Texas Cable Partners and renamed “Texas and Kansas City Cable Partners, L.P.” Following the restructuring, the combined partnership will be owned 50% by Comcast, and 50% by TWE and TWE-A/ N collectively. Beginning any time after the later of June 1, 2006 and the two-year anniversary of the closing of the restructuring, either Time Warner Cable or Comcast can trigger a dissolution of the partnership. If a dissolution is triggered, the non-triggering party has the right to choose and take full ownership of one of two pools of the combined partnership’s systems — one pool consisting of the Houston systems and the other consisting of the Kansas City and south Texas systems — with an arrangement to distribute the partnership’s

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debt between the two pools. The party triggering the restructuring would own the remaining pool of systems and any debt associated with that pool.

Systems Operations

      Time Warner Cable is the second largest operator of cable systems in the U.S. As of December 31, 2003, cable systems owned or managed by Time Warner Cable passed approximately 18.8 million homes, provided basic video service to 10.9 million subscribers, over 4.3 million of whom also subscribe to Time Warner Cable’s digital video service, and provided high speed data services to nearly 3.4 million residential subscribers and commercial accounts. Time Warner Cable plans to introduce its new Internet protocol-based voice service, known as Digital Phone, in most, if not all, of its operating systems in 2004.

      Time Warner Cable operates large clustered and technologically advanced cable systems. As of December 31, 2003, over 75% of its subscribers were in 19 geographic clusters, each serving more than 300,000 subscribers, and over 99% of its cable systems were capable of carrying two-way broadband services, with approximately 99% having been upgraded to 750MHz or higher. Time Warner Cable’s systems are divided among 31 regional operating divisions, all but three of which are focused on discrete geographic areas. Time Warner Cable is an industry leader in developing and rolling-out new products and services, including video on demand, subscription video on demand, high-definition television and set-top boxes with integrated digital video recorders (DVRs). See “Video 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 Services

      Time Warner Cable’s video subscribers are typically charged monthly subscription fees based on the level of service selected and, in some cases, equipment usage fees. Pay-per-view and video on demand movies and special events are charged on a per view basis. During 2003, video service revenues accounted for approximately 75% of Time Warner Cable’s revenues.

      Time Warner Cable’s systems typically offer two levels of analog video service — basic and standard, which together provide, on average, approximately 70 channels, including local broadcast signals. The basic and standard tiers are available for a fixed monthly fee. Subscribers to Time Warner Cable’s analog video service may purchase premium channels for an additional monthly fee, with discounts generally available for the purchase of packages of more than one premium service. Analog video customers who lease a set top box from Time Warner Cable also have access to pay-per-view movies and special events. The rates Time Warner Cable can charge for its “basic” tier, as well as for equipment rentals and installation services, are subject to regulation under federal law. For more information, see “Regulation and Legislation” below.

      In addition to analog video service, all of Time Warner Cable’s divisions also offer digital video services. As of December 31, 2003, nearly 40% of Time Warner Cable’s basic video subscribers also purchased digital services. Subscribers to digital video service receive all the channels included in the basic and standard tiers plus up to 60 additional digital cable networks, up to 45 CD-quality audio music services, more pay-per-view choices and other features such as enhanced parental control options. Subscribers to digital video service may also purchase mini tiers (e.g., sports tiers and Spanish language tiers) and premium channels for an additional monthly fee, with discounts generally available for the purchase of packages of more than one such service. In many cases, subscribers who elect to purchase premium services receive multiplex versions of these services at

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no additional charge. The digital set-top boxes that subscribers receive also offer an interactive program guide and access to video on demand and subscription video on demand.
 
Video on Demand and Subscription Video on Demand

      As of December 31, 2003, Time Warner Cable offered video on demand and subscription video on demand services in all of its 31 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. 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.

 
High Definition Television

      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. To date, Time Warner Cable has agreed to carry the high definition television signals and other digital signals broadcast by numerous local television stations, including all stations owned and operated by the ABC, CBS, NBC and Fox networks and nearly all public television stations in Time Warner Cable’s operating areas. Time Warner Cable is also carrying the HDTV offerings of HBO, Showtime, Discovery, HDNet and iN DEMAND, as well as high-definition sports programming from Fox’s Regional Sports Networks and NBA-TV.

 
Digital Video Recorders

      As of December 31, 2003, Time Warner Cable offered set-top boxes with integrated DVRs in 30 of its 31 divisions. DVR users can record programming on a hard drive built into the set-top box through the interactive program guide and view the recorded programming using VCR-like functions such as pause, rewind and fast-forward. DVR users can also record one show while watching another and have the ability to pause even “live” television.

 
Programming Rights

      Time Warner Cable generally obtains the right to carry video programming services through negotiation of affiliation agreements with programmers. 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 and Financial Condition, “Business Segment Results — Cable” in the financial pages herein). Time Warner Cable obtains the right to carry local broadcast television stations either through the stations’ exercise of their so-called “must carry” rights, or through negotiated retransmission consent agreements. See “Regulation and Legislation — Communications Act and FCC Regulation — Carriage of Broadcast Television Stations and Other Programming Regulation” below. Time Warner Cable’s existing programming and retransmission consent agreements expire at various times. Time Warner Cable cannot ensure that it will be able to renew any or all of its existing agreements upon expiration or obtain the rights to any other programming services or broadcast television stations on reasonable terms or at all. It is not known whether the loss of any one popular programming supplier would have a material adverse effect on Time Warner Cable’s operations.

 
High Speed Data Services

      As of December 31, 2003, Time Warner Cable had nearly 3.4 million high speed data subscribers, consisting of 3.228 million residential subscribers and 128,000 commercial accounts. Subscribers pay a flat

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monthly fee for high speed data service, which typically includes Internet access and email. Due to their nature, commercial and bulk subscribers are charged at different rates than residential subscribers. During 2003, high speed data revenues accounted for approximately 19% of Time Warner Cable’s revenues.

      Time Warner Cable’s residential customers can choose from a variety of ISPs, including the Company’s Road Runner and 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. Time Warner Cable also offers networking options that allow customers to connect multiple PCs to a single cable modem.

      Time Warner Cable offers its Road Runner branded, high speed data service to both residential and commercial customers in all of Time Warner Cable’s 31 divisions. In connection with the TWE-A/ N Restructuring, TWE and an affiliate of the Company effectively acquired Advance/ Newhouse’s 17% interest in Road Runner, thereby increasing the Company’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, the Company consolidated Road Runner with its results retroactive to January 1, 2002.

      Time Warner Cable’s provision of the AOL for Broadband service and its obligation to make multiple ISP services available to its residential 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 America Online-Historic TW Merger. (See “Regulation and Legislation” below, for a description of these terms).

 
Voice Services

      During 2003, Time Warner Cable launched its new Digital Phone service in Portland, ME, and provided the service to selected customers in Rochester, NY, Raleigh, NC and Kansas City, KS. Digital Phone utilizes voice over Internet protocol or “VoIP” technology which enables subscribers to make and receive calls using traditional telephone handsets connected to a cable modem through their existing in-home telephone wiring. Digital Phone provides unlimited local, in-state and domestic long distance calling, as well as call waiting, caller ID and enhanced “911” services, for a fixed monthly fee. Subscribers switching to Digital Phone can keep their existing landline phone numbers and retain their directory listings.

      Time Warner Cable intends to roll out Digital Phone service in most, if not all, of its operating divisions during 2004. In December 2003, Time Warner Cable announced that it had entered into multi-year agreements with each of MCI and Sprint pursuant to which each will assist Time Warner Cable in the provisioning of Digital Phone service to customers, termination of VoIP voice traffic to the public switched network, delivery of enhanced “911” service, local number portability and long distance traffic carriage.

 
Advertising

      Time Warner Cable also generates revenue by selling advertising time to a variety of national, regional and local businesses. During 2003, advertising revenues accounted for approximately 6% of Time Warner Cable’s revenues.

      Cable 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 broadcast stations as much as possible. As of December 31, 2003, 13 of Time Warner Cable’s 31 divisions participated in local cable advertising interconnects.

      A portion of Time Warner Cable’s advertising revenues come from sales to other Time Warner segments and from sales to programming vendors in support of their channel launches. During 2001 and 2002, these sales represented a substantial portion of Time Warner Cable’s total advertising revenues. However, these advertising revenues decreased sharply during 2003 as the number of new programming service launches declined and other Time Warner segments purchased less advertising from Time Warner Cable. See

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Management’s Discussion and Analysis of Results of Operations and Financial Condition, “Business Segment Results — Cable” in the financial pages herein.
 
Local News Channels

      Time Warner Cable operates, alone or in partnerships, 24-hour local news channels in New York City (NY1 News and NY1 Noticias), Albany, NY (Capital News 9), Rochester, NY (R/ News), Syracuse, NY (News 10 Now), Charlotte and Raleigh, NC (Carolina News 14), Austin, TX (News 8 Austin), San Antonio, TX (News 9 San Antonio) 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.

Competition

      Time Warner Cable faces intense competition from a variety of alternative information and entertainment delivery sources, principally from direct-to-home satellite video providers and regional telephone companies offering DSL service. Competition with regional telephone companies is likely to intensify as Time Warner Cable introduces its Digital Phone service. Furthermore, in the future, technological advances will most likely increase the number of alternatives available to Time Warner Cable’s customers. In general, Time Warner Cable also faces 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. Some DBS providers have entered into co-marketing arrangements with regional telephone companies in an effort to provide customers with both video and DSL service from what appears to the customer to be a single source.

      “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 provided by regional telephone companies and dial-up services over ordinary telephone lines. DSL providers have engaged in aggressive price competition in some of Time Warner Cable’s operating areas and some DSL providers have entered into co-marketing arrangements with DBS operators in an effort to provide customers with both DSL and video service from what appears to the customer to be a single source. 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.

      Digital Phone Competition. Time Warner Cable intends to roll out its new Digital Phone service in most, if not all, of its operating areas during 2004. Digital Phone will compete directly with the local and long distance offerings of the regional telephone companies which provide service in these areas, as well as with wireless phone providers and national providers of VoIP products such as Vonage. As a result, Time Warner Cable anticipates that the competitive environment in which it operates will become increasingly intense, especially in light of the fact that the regional telephone companies also offer online services that compete with Time Warner Cable’s high speed data service.

      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 systems. Some SMATV operators now offer voice and high speed data services.

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      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 faces video competition from telephone companies. Under the 1996 Telecommunications Act, telephone companies are 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 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

      The Company’s Filmed Entertainment businesses produce and distribute theatrical motion pictures, television shows, animation and other programming, distribute home video product and license rights to the Company’s feature films, television programming and characters. All of the foregoing businesses are principally conducted by various subsidiaries and affiliates of Warner Bros. Entertainment Inc., known collectively as the Warner Bros. Entertainment Group (“Warner Bros.”), now wholly owned subsidiaries of the Company. The filmed entertainment segment also includes New Line Cinema Corporation (“New Line”), also a wholly owned subsidiary of the Company.

Feature Films

Warner Bros. Pictures

      Warner Bros. 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.’ 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.’ feature films are produced under both the Warner Bros. Pictures and Castle Rock banners and, commencing in 2004, also by Warner Independent Pictures.

      Warner Bros.’ 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. has entered into certain 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 2003, Warner Bros. released a total of 20 original motion pictures for theatrical exhibition, of which 7 were wholly financed by Warner Bros. and 13 were financed with or by others, including Mystic River, The Last Samurai, Matrix Reloaded and Matrix Revolutions. A total of 25 motion pictures are currently slated to be released during 2004, of which 7 are wholly financed by Warner Bros. and 18 are financed with or by others.

      Warner Bros.’ 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 Gaylord and its wholly owned subsidiary, Pandora Investments SARL, for which Warner Bros. acquires domestic distribution rights.

      Warner Bros. has a distribution arrangement with Franchise Pictures LLC under which, for certain motion pictures, it has domestic distribution rights and foreign distribution rights in selected territories.

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Additionally, Warner Bros. Pictures has an exclusive distribution arrangement with Alcon Entertainment (“Alcon”) for distribution of all of Alcon’s motion pictures in domestic and certain international territories, and an exclusive worldwide distribution arrangement with Shangri-La Entertainment, LLC.

      Warner Independent Pictures, established in August 2003 with a Spring 2004 initial release target, will produce or acquire up to ten smaller budget and alternative films a year for domestic and/or worldwide release.

      Warner Bros. distributes feature films to more than 125 markets internationally. In 2003, Warner Bros. distributed internationally 21 original motion pictures produced by U.S. companies plus 14 “local language” productions that it either produced or acquired.

New Line

      Theatrical films are also produced and distributed by New Line, a leading independent producer and distributor of theatrical motion pictures with two film divisions, New Line Cinema and Fine Line Features. Included in its 13 films released during 2003, New Line released the Oscar-award winning The Lord of the Rings: The Return of the King, the third and final installment in The Lord of the Rings trilogy, and Elf. A total of 15 motion pictures are currently slated for theatrical release by New Line during 2004. Like Warner Bros., New Line releases a diversified slate of films with an emphasis on building and leveraging franchises. As part of its strategy for reducing financial risk and dealing with the rising cost of film production, New Line typically pre-sells the international rights to its releases on a territory by territory basis, while still retaining a share of each film’s potential profitability in those foreign territories.

Home Video

      Warner Home Video Inc. (“WHV”) distributes for home video use DVDs and videocassettes containing filmed entertainment product produced or otherwise acquired by the Company’s various content-producing subsidiaries and divisions, including Warner Bros. Pictures, Warner Bros. Television, Castle Rock, New Line, Home Box Office, Turner Broadcasting System and WarnerVision. WHV also distributes other companies’ product, including DVDs and videocassettes for BBC, PBS and National Geographic, national sports leagues, and Leapfrog (a children’s learning toy company) in the U.S., and certain producers in Italy, the U.K., Australia and 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 force, with warehousing and fulfillment handled by third parties. In some countries, WHV’s product is distributed through licensees. DVD product is replicated under long term contracts with third parties. Videocassette product is manufactured under contracts with independent duplicators. Among WHV’s 2003 DVD and videocassette releases, 17 film titles generated U.S. sales of more than one million units each.

      Since inception of the DVD format, WHV has released close to 2,000 DVD titles in the U.S. and international markets, led by worldwide sales of Harry Potter and the Sorcerer’s Stone and Harry Potter and the Chamber of Secrets, which have sold a total of over 40 million DVD units. DVD is the fastest selling consumer electronics product of all time, with an installed base at December 31, 2003 of nearly 57 million households in the U.S. and over 100 million households internationally (including approximately 25 million households in 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

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owned or managed by Warner Bros. currently has more than 6,600 feature films, approximately 39,000 television titles, and 14,000 animated titles (including 1,500 classic animated shorts).

      Warner Bros.’ television programming is primarily produced by Warner Bros. Television Production Inc. (“WBTV”), which produces primetime dramatic and comedy programming for the major networks, and Telepictures Productions Inc. (“Telepictures”), which specializes in reality-based and talk/variety series for the syndication and primetime markets. For the 2003-04 season, WBTV is producing hits such as Smallville and Gilmore Girls for The WB Television Network and ER, Friends, The West Wing, George Lopez, Without a Trace, Cold Case, The O.C., Two and a Half Men and Nip/ Tuck for third party networks. Telepictures has primetime hits The Bachelor and The Bachelorette as well as first-run syndication staples, such as Extra, and the new talk show, The Ellen DeGeneres Show.

      Warner Bros. Animation Inc. 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.’ 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 (excluding certain license fees), basic cable and syndicated television exhibition. Backlog for all of Time Warner’s filmed entertainment companies amounted to $3.9 billion at December 31, 2003, compared to $3.3 billion at December 31, 2002 (including amounts relating to the intercompany licensing of film product to the Company’s cable television networks (including HBO) of approximately $740 million and $850 million as of December 31, 2003 and December 31, 2002, respectively). The backlog excludes advertising barter contracts.

Other Entertainment Assets

      Warner Bros. Consumer Products Inc. 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 Harry Potter.

      Through joint ventures, Warner Bros. International Cinemas Inc. (“WBIC”) owns interests in 77 multi-screen cinema complexes with 682 screens in Japan, China, Italy, Spain and Taiwan. In early 2004, WBIC entered into agreements with local partners in China under which WBIC will acquire a majority interest in multiplexes in Nanjing and will manage certain others. WBIC sold its interest in its cinema circuits in the U.K., Australia and Portugal during 2003.

      DC Comics, wholly owned by the Company, 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. The Company also owns E.C. Publications, Inc., the publisher of MAD magazine.

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

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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 digital content and physical products are increasing challenges due to advances in compression technologies and proliferation of broadband access which make it easier to copy and distribute large files as well as to transfer such files to physical media. Additionally, the increase in usage of DVRs that allow consumers to skip commercials could significantly impact the advertising markets that drive the commercial television business. 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

      The Company’s Networks business consists principally of domestic and international basic cable networks, pay television programming services, a broadcast television network, and a sports franchise. The basic cable networks (collectively, the “Turner Networks”) owned by Turner Broadcasting System, Inc. (“TBS”) constitute the principal component of the Company’s basic cable networks. Pay television programming consists of the multichannel HBO and Cinemax pay television programming services (collectively, the “Home Box Office Services”) operated by Home Box Office Inc., now a wholly owned subsidiary of the Company. The WB Television Network (“The WB”), a broadcast television network, is operated as a limited partnership in which WB Communications, a wholly owned subsidiary of the Company, holds a 77.5% interest and is the network’s managing general partner.

      The Turner Networks and the Home Box Office Services (collectively, the “Cable Networks”) distribute their programming via cable and other distribution technologies, including satellite distribution.

      The Turner Networks generate their revenue principally from the sale of advertising time (other than Turner Classic Movies, which sells advertising only in certain European markets) and from receipt of monthly per subscriber fees paid by cable system operators, DTH distribution companies, hotels and other customers (known as affiliates) that have contracted to receive and distribute such networks. Turner Classic Movies is commercial-free in most of its distribution area and generates most of its revenue from the monthly fees paid by affiliates, which are generally charged on a per subscriber basis. The Home Box Office Services generate revenue principally from fees paid by affiliates for the delivery of the Home Box Office Services to subscribers who are generally free to cancel their subscriptions at any time. Home Box Office’s agreements with its affiliates are typically long-term arrangements that provide for annual service fee increases and retail promotion activities and have fee arrangements that are generally related to the number of subscribers served by the affiliate. The Home Box Office Services and their affiliates engage in ongoing marketing and promotional activities to retain existing subscribers and acquire new subscribers. Home Box Office also derives revenues from its successful original films and series through the sale of DVDs and videocassettes, as well as, in recent years, from the syndication of Everybody Loves Raymond.

      Although the Cable Networks 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. In addition, further consolidation of multiple-system cable operators could adversely impact the Cable Networks’ prospect for securing future carriage agreements on favorable terms.

      Advertising revenue on the basic cable networks and The WB consists of consumer advertising, which is sold primarily on a national basis (The WB sells time 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

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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 CPMs are influenced by the quantitative and qualitative characteristics of the audience of each network as well as overall advertiser demand in the marketplace.

Turner Networks

 
Domestic Networks

      TBS’s entertainment networks include two general entertainment networks, TBS Superstation, with approximately 87.9 million U.S. households as of December 31, 2003, reported by Nielsen Media Research (“households”); and TNT, with approximately 88.2 million households in the U.S. as of December 31, 2003; as well as Cartoon Network, with approximately 85.7 million households in the U.S. as of December 31, 2003; and Turner Classic Movies, a commercial-free network presenting classic films from TBS’s MGM, RKO and pre-1950 Warner Bros. film libraries, among others, which had approximately 66.9 million households in the U.S. as of December 31, 2003. Programming for these entertainment networks is derived, in part, from the Company’s film, made-for-television and animation libraries as to which TBS or other divisions of the Company own the copyrights, plus licensed programming, including sports, and special made-for-cable films and series. Other networks include Turner South, a regional entertainment network featuring movies and sitcoms from the Turner library and regional news and sports events targeted to viewers in the Southeast, and Boomerang, a network featuring classic cartoons.

      TBS has licensed programming rights from the National Basketball Association (the “NBA”) to televise a certain number of regular season and playoff games on TNT through the 2007-08 season. TBS Superstation and Turner South televise Atlanta Braves baseball games, for which rights fee payments are made to Major League Baseball’s central fund for distribution to all Major League Baseball clubs. Through a joint venture with NBC, TBS also has rights to televise certain NASCAR Nextel Cup and Busch Series races through 2006.

      TBS’s CNN network, a 24-hour per day cable television news service, had more than 88.2 million households in the U.S. as of December 31, 2003. Together with CNN International (“CNNI”), CNN reached more than 200 countries and territories as of December 31, 2003. CNN operates 38 news bureaus, of which 11 are located in the U.S. and 27 are located around the world. In addition to Headline News, which provides updated half-hour newscasts throughout each day, CNN has expanded its brand franchise to include CNNfn, featuring business and consumer news. TBS also has a number of special market news networks.

 
International Networks

      CNNI is distributed to multiple distribution platforms for delivery to cable systems, satellite platforms, broadcasters, hotels and other viewers around the world on a network of 11 regional satellites. CNN en Español is a separate Spanish language all-news network in Latin America. TBS also distributes region-specific and languaged feeds or versions of TNT, Cartoon Network, Turner Classic Movies and Boomerang on either a single channel or combined channel basis in over 100 countries around the world. In the U.K., Turner also distributes Toonami, an all-action animation network.

      In a number of regions, TBS has launched international versions of its channels through joint ventures with local partners. These include CNN+, a Spanish language 24-hour news network distributed in Spain and Andorra; CNN Turk, a Turkish language 24-hour news network; and Cartoon Network Japan. TBS also has a 30.6% interest in VIVA Media AG, a public company, which owns a German television production company and television music channels in Germany, The Netherlands, Poland, Hungary, Switzerland and Eastern Europe, and holds a significant interest in n-tv, a German language news network currently reaching over 48 million homes in Germany and contiguous countries in Europe, primarily via cable and satellite.

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Internet Sites

      In addition to its cable networks, TBS manages various Internet sites that generate revenue from commercial advertising and consumer subscription fees. The CNN News Group has multiple sites, such as CNN.com and allpolitics.com, which are operated by CNN Interactive. The CNN News Group also produces CNNMoney.com together with Time Inc.’s Money Magazine. TBS also operates the NASCAR Web site, NASCAR.com, pursuant to an agreement with NASCAR through 2006, and the PGA’s Web site, PGA.com, pursuant to an agreement with PGA through 2011. CartoonNetwork.com is a popular advertiser-supported site for children ages two to eleven.

Home Box Office

      HBO, operated by the wholly owned subsidiary Home Box Office, Inc., is the nation’s most widely distributed pay television service. Together with its sister service, Cinemax, HBO had approximately 38.8 million subscriptions as of December 31, 2003. Both HBO and Cinemax are made available on a number of multiplex channels and in high definition. Home Box Office continues to roll out its subscription video on demand products, which enable digital cable subscribers who subscribe to the Home Box Office Services to view programs at a time of their choice with VCR-like functionality.

      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 with major motion picture studios and independent producers and distributors in order to ensure continued access to such films. 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 box office performances of the film.

      HBO also defines itself by the exhibition of award-winning original dramatic and comedy series, movies and mini-series such as The Sopranos, Six Feet Under, Sex and the City and Angels in America, and boxing matches, sports documentaries and sports news programs, as well as concerts, comedy specials, family programming and documentaries. HBO won 7 Golden Globe Awards in January 2004, more than all other networks combined. In 2003, HBO also won 18 Emmys® — the most of any network.

      Home Box Office produces Everybody Loves Raymond, now in its eighth season on CBS and its first syndication cycle. HBO Sports operates HBO Pay-Per-View, an entity that distributes pay-per-view prizefights. HBO Video markets videocassettes and DVDs of a variety of feature films including My Big Fat Greek Wedding and a number of HBO’s original movies, miniseries and dramatic and comedy series, including Band of Brothers, The Sopranos and Sex and the City. Home Box Office has also begun to syndicate some of its successful original programs. Through various joint ventures, HBO-branded services are also distributed in more than 50 countries in Latin America, Asia and Central Europe.

The WB Television Network

      The WB provides a national group of affiliated television stations with 13 hours of prime time plus two additional hours of Sunday access programming during six days of the week (Sunday through Friday). The WB’s programming is primarily aimed at adults 18-34. The network’s line-up of programs includes series such as 7th Heaven, Everwood, One Tree Hill, Charmed, Reba, Smallville, Gilmore Girls and Steve Harvey’s Big Time. As of December 31, 2003, Kids’ WB!, a programming service for young viewers, presented 14 hours of animated programming per week, including Mucha Lucha, Yu-Gi-Oh!, What’s New Scooby-Doo? and Pokemon.

      As of December 31, 2003, 84 primary and 9 secondary affiliates provide coverage for The WB in the top 100 television markets. Additional coverage reaching approximately 9 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.

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      Tribune Broadcasting owns a 22.25% interest in The WB and the balance is held by WB Communications Inc., a wholly owned subsidiary of the Company. The WB is managed by the Warner Bros. Entertainment Group.

Other Network Interests

      The Company and Liberty Media (“Liberty”) each have a 50% interest in Court TV, which was available in approximately 79 million homes as of December 31, 2003. 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. Under the Court TV Operating Agreement, beginning January 2006, Liberty may give written notice to the Company requiring the Company to purchase all of Liberty’s interest in Court TV (the “Liberty Put”). The agreement further provides that as of the same date, the Company may, by notice to Liberty, require Liberty to sell all of its interest in Court TV to the Company (the “Time Warner Call”). The price to be paid upon exercise of either the Liberty Put or the Time Warner Call will be an amount equal to one half of the fair market value of Court TV, determined by appraisal.

      Through a wholly owned subsidiary, TBS owns the Atlanta Braves of Major League Baseball. The Braves derive revenue from ticket receipts, advertising and related sales, premium seating sales, concessions, local sponsorships and the sale of local broadcasting rights, and share pro rata in proceeds from national media contracts and licensing activities of Major League Baseball. TBS expects to complete the sale of its professional basketball and hockey franchises during the first quarter of 2004.

Competition

      Each of the 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 and video on demand 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 Turner Networks, The WB and TBS’s Internet sites compete for advertising with numerous direct competitors and other media.

      The Cable Networks’ production divisions compete with other producers and distributors of programs for air time on broadcast networks, independent commercial television stations, and pay and basic cable television networks.

PUBLISHING

      The Company’s magazine and book publishing businesses are conducted primarily by Time Inc., a wholly owned subsidiary of the Company, either directly or through its subsidiaries. Time Warner Book Group Inc., a Time Inc. subsidiary, conducts Publishing’s trade book publishing operations.

Magazines

 
General

      As of March 1, 2004, Time Inc. published over 130 magazines worldwide, including Time, People, Sports Illustrated, Entertainment Weekly, Southern Living, In Style, Fortune, Money, Real Simple, Cooking Light and 77 magazines published by IPC Group Limited in the U.K. and Australia. These magazines generally appeal to the broad consumer market.

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      Time Inc. expands its core magazine businesses generally through the development of product extensions and international editions. Product extensions are generally managed by the individual magazines and involve, among other things, new magazines, specialized editions aimed at particular audiences, and publication of editorial content through different media, such as the Internet, books and television.

 
Description of Magazines

      Generally, each magazine published by Time Inc. in the U.S. has an editorial staff under the supervision of a managing editor and a business staff under the management of a president or publisher. Magazine production and distribution activities are generally centralized. Fulfillment activities for Time Inc.’s U.S. magazines are generally administered from a centralized facility in Tampa, Florida.

      Time Inc.’s major magazines and their areas of editorial focus are summarized below:

      Time is a weekly newsmagazine that summarizes the news and interprets the week’s events, both national and international. Time also has four weekly English-language editions that circulate outside the United States. Time for Kids is a current events newsmagazine for children, ages 5 to 13.

      People is a weekly magazine that reports on celebrities and other notable personalities. People has expanded its franchise in recent years to include People en Español, a Spanish-language magazine aimed primarily at Hispanic readers in the U.S., and Teen People, aimed at teenage readers. Who Weekly is an Australian version of People.

      Sports Illustrated is a weekly magazine that covers sports. Sports Illustrated for Kids is a sports magazine intended primarily for pre-teenagers.

      Entertainment Weekly is a weekly magazine that includes reviews and reports on movies, DVDs, video, television, music and books.

      In Style is a monthly magazine that focuses on celebrity, lifestyle, beauty and fashion. In recent years, In Style has expanded internationally by launching in Australia and the U.K.; it is also published in Germany, Brazil, South Korea and Greece under licensing agreements.

      Fortune is a bi-weekly magazine that reports on worldwide economic and business developments and compiles the annual Fortune 500 list of the largest U.S. corporations. Money is a monthly magazine that reports primarily on personal finance. Other business and financial magazines include FSB: Fortune Small Business, which covers small business, and Business 2.0, a magazine that reports on innovation in the worlds of business and technology.

      Real Simple is a monthly magazine that focuses on life, home, body and soul and provides practical solutions for simplifying various aspects of busy lives.

      Through Southern Progress Corporation, Time Inc. publishes several regional magazines including Southern Living and Sunset, and several specialty publishing titles, including Cooking Light and Health.

      IPC Group Limited, the U.K.’s leading consumer magazine publisher, publishes 77 magazines and numerous special issues and guides in the U.K. and Australia. These publications are largely focused in the television, women’s, home and garden, leisure and men’s lifestyle categories. Its titles include What’s on TV, TV Times, Woman, Marie Claire, Homes & Gardens and Horse & Hound.

      Time4 Media publishes 21 popular participatory sport and outdoor publications such as Golf, Ski, Skiing, Field & Stream, Outdoor Life, Transworld Skateboarding, Transworld Snowboarding and Yachting, as well as Popular Science.

      Through various subsidiaries, Time Inc. publishes Parenting magazine and This Old House magazine and also produces several television series, including This Old House and Ask This Old House.

      Time Inc. also has management responsibility under a management contract for the American Express Publishing Corporation’s publishing operations, including its lifestyle magazines Travel & Leisure, Food & Wine and Departures.

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      Time Inc. has a 49% equity stake in Essence Communications Partners, the publisher of Essence, the premier magazine for African-American women.

 
Advertising

      Advertising carried in Time Inc.’s U.S. magazines is predominantly consumer advertising, including domestic and foreign automobile manufacturers, toiletries and cosmetics, media and entertainment, food, computers and technology, pharmaceuticals, retail and department stores and financial services. In 2003, Time Inc. magazines accounted for approximately 24.3% of the total U.S. advertising revenue in consumer magazines, as measured by the Publishers Information Bureau (PIB). People, Sports Illustrated and Time were ranked 1, 3 and 4, respectively, by PIB, and Time Inc. had 7 of the 30 leading magazines in terms of advertising dollars.

 
Circulation

      Circulation drives the advertising rate base, which is the guaranteed minimum average paid circulation level on which advertising rates are determined. Most of Time Inc.’s magazines are primarily sold by subscription and delivered to subscribers through the mail, other than IPC titles which are primarily sold at newsstand. Subscriptions are sold primarily through direct mail and online solicitation, subscription sales agents, marketing agreements with other companies and insert cards in Time Inc. magazines and other publications. Time Inc. owns in excess of 84% of Synapse Group, Inc. (“Synapse”), a leading magazine subscription agent in the U.S. Synapse sells magazine subscriptions principally through marketing relationships with credit card issuers, consumer catalog companies, commercial airlines with frequent flier programs and Internet businesses.

      Single copies of magazines, sales of which are reported as a component of subscription revenues, are sold through retail outlets such as newsstands, supermarkets, and convenience and drug stores, and may or may not result in repeat purchases and revenues. The copies are supplied by wholesalers or directly through a Time Inc. subsidiary. Time Distribution Services Inc. is responsible for the distribution and marketing of single copies of Time Inc. magazines and certain other publications in the U.S. and Canada. Warner Publisher Services Inc. is a major distributor of books and other publishers’ magazines sold through wholesalers in the U.S. and Canada.

 
Paper and Printing

      Paper constitutes a significant component of physical costs in the production of magazines. During 2003, Time Inc. purchased over half a million tons of paper principally from four independent manufacturers.

      Printing and binding for Time Inc. magazines are performed primarily by major domestic and international independent printing concerns in approximately 12 locations in the U.S. and in locations in 7 other countries. Magazine printing contracts are either fixed-term or open-ended at fixed prices with, in some cases, adjustments based on certain criteria.

Books

      Time Inc.’s trade book publishing operations are conducted primarily by the Time Warner Book Group Inc. (formerly Time Warner Trade Publishing Inc.) through its three major publishing houses, Warner Books, Little, Brown and Company, and Time Warner Book Group UK. During 2003, the Time Warner Book Group placed 50 books on The New York Times bestseller lists, including The Lovely Bones by Alice Sebold, Dude, Where’s My Country? by Michael Moore, Flyboys by James Bradley, and new releases from many of its major recurring bestselling authors, such as James Patterson, Nicholas Sparks and David Baldacci.

      The Time Warner Book Group handles book distribution for Little, Brown and Warner Books, as well as Disney, Microsoft and other publishers, through its distribution center in Indiana. The marketing of trade books is primarily to retail stores, online outlets and wholesalers throughout the U.S., Canada and the U.K. Through their combined U.S. and U.K. operations, the Time Warner Book Group companies have the ability

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to acquire English-language publishing rights for the distribution of hard and soft-cover books throughout the world.

      Oxmoor House, Inc., Leisure Arts, Inc. and Sunset Books publish and distribute a variety of how-to books for the cooking, home repair, gardening, craft, needlework, decorating and travel markets.

Direct Marketing

      Through subsidiaries, Time Inc. conducts direct marketing businesses. In addition to selling magazine subscriptions, Synapse is a direct marketer of consumer products, including software, videos and other merchandise.

      Southern Living at Home, the direct selling division of Southern Progress Corporation, specializes in home décor products which are sold through independent consultants at parties hosted in people’s homes in the United States.

      Book-of-the-Month Club, Inc. (“BOMC”) has a 50-50 joint venture with Bertelsmann AG’s Doubleday book clubs business to operate the U.S. book clubs of BOMC and Doubleday jointly. The joint venture, named Bookspan, acquires the rights to manufacture and sell books to consumers through clubs. Bookspan operates its own fulfillment and warehousing operations in Pennsylvania. Under the relevant agreements, beginning in June 2005, either Bertelsmann or the Company may elect to terminate the venture by giving notice during specified termination periods. If such an election is made, a confidential bid process will take place pursuant to which the highest bidder will purchase the other party’s entire venture interest. The Company is unable to predict whether this bid process will occur or the amount that may be paid out or received under it.

      On December 31, 2003, Time Inc. sold its Time Life Inc. business, a direct marketer of entertainment products such as music and videos.

Postal Rates

      Postal costs represent a significant operating expense for the Company’s magazine and direct marketing activities. Time Inc. strives to minimize postal expense through the use of certain cost-saving measures, including measures with respect to address quality, mail preparation and delivery of products to postal facilities. It has been the Company’s practice generally in selling books and other products by mail to include a separate charge for postage and handling, which is adjusted from time to time to partially offset any increased postage or handling costs.

Competition

      Time Inc.’s magazine operations compete for circulation, audience and advertising with numerous other publishers and retailers, as well as other media. These magazine operations compete for advertising directed at the general public and also advertising directed at more focused demographic groups.

      Time Inc.’s direct marketing operations compete with other direct marketers through all media for the consumer’s attention. In addition to the traditional media sources for product sales, the Internet has become a strong vehicle in the direct marketing business and for subscription sales.

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OTHER SIGNIFICANT ASSETS

      The Company also has an aggregate equity interest in Time Warner Telecom Inc. (“Time Warner Telecom”) of approximately 44% and an aggregate voting interest (consisting of high-voting common stock) of approximately 71%. Time Warner Telecom is a fiber facilities-based integrated communications provider that provides data, dedicated Internet access, and local and long distance voice services to medium and large businesses in 44 metropolitan areas across the United States. The Company’s nominees to the Board of Directors of Time Warner Telecom are limited to less than a majority by the terms of a stockholder agreement and Time Warner Telecom is a separately-managed public company whose stock is traded through Nasdaq. Its financial results are not consolidated with those of the Company. The Company has determined that it does not consider its interest in Time Warner Telecom to be strategic and has so advised Time Warner Telecom.

INTELLECTUAL PROPERTY

      Time Warner Inc. is one of the world’s leading creators, owners and distributors of intellectual property. The Company’s vast intellectual property assets include copyrights in motion pictures, books, magazines and software; trademarks in names, logos and characters; patents or patent applications for inventions related to its products and services; and licenses of intellectual property rights of various kinds. These intellectual property assets, both in the U.S. and in other countries around the world, are among the Company’s most valuable assets. The Company derives value from these assets through a range of business models, including the theatrical release of films, the licensing of its films and television programming to multiple domestic and international television and cable networks and pay television services, and the sale of products such as DVDs, videocassettes, books and magazines. It also derives revenues related to its intellectual property through advertising in its magazines, networks, cable systems and online services and from various types of licensing activities, including licensing of its trademarks and characters. To protect these assets, the Company relies upon a combination of copyright, trademark, unfair competition, patent and trade secret laws and contract provisions. The duration of the protection afforded to the Company’s intellectual property depends on the type of property in question and the laws and regulations of the relevant jurisdiction; in the case of licenses, it also depends on contractual and/or statutory provisions.

      The Company vigorously pursues all appropriate avenues of protection for its intellectual property. However, there can be no assurance of the degree to which these measures will be successful in any given case. Policing unauthorized use of the Company’s products and services is often difficult and the steps taken may not in every case prevent the misappropriation of the Company’s intellectual property. Piracy, particularly in the digital environment, continues to present a threat to revenues from products and services based on intellectual property. The Company seeks to limit that threat through a combination of approaches, including offering legitimate market alternatives, applying digital rights management technologies, pursuing legal sanctions for infringement, promoting appropriate legislative initiatives, and enhancing public awareness of the meaning and value of intellectual property. The Company works with various cross-industry groups and trade associations, as well as with strategic partners to develop and implement technological solutions to control digital piracy.

      Third parties may challenge the validity or scope of the Company’s intellectual property from time to time, and such challenges could result in the limitation or loss of intellectual property rights. In addition, domestic and international laws, statutes and regulations are constantly changing, and the Company’s assets may be either adversely or beneficially affected by such changes. Moreover, effective intellectual property protection may be either unavailable or limited in certain foreign territories. The Company therefore engages in efforts to strengthen and update intellectual property protection around the world, including efforts to ensure effective remedies for infringement.

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REGULATION AND LEGISLATION

      The Company’s cable 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 system business is also subject to regulation by some state governments and substantially all local governments where the Company has cable systems. The Company’s magazine, book and other direct marketing activities are also subject to regulation. In addition, in connection with regulatory clearance of the America Online-Historic TW Merger, the Company’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, and the Decision issued by the European Commission and the undertakings thereunder. The Company is also subject to an FTC consent decree (the “Turner Consent Decree”) as a result of the FTC’s approval of the acquisition of Turner Broadcasting System, Inc. in 1996.

      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, the Company.

FTC Consent Decree

      On December 14, 2000, the FTC issued a Consent Decree in connection with the America Online-Historic TW Merger. The consent decree provided that, with the exception of Road Runner, Time Warner Cable was not permitted to launch an affiliated ISP, like the AOL for 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 Time Warner enters into an AOL for Broadband affiliation agreement with any one of six specified cable operators. In that event, the Company 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 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. America Online is also prohibited from entering into agreements with cable MSOs that restrict the ability of that MSO to enter into agreements with other ISPs or interactive television providers. The Company’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 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

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ISP, from requiring ISPs to include particular content, and from discriminating on the basis of affiliation with regard to technical system performance.

      In addition, the FCC’s Order prohibits the Company from entering into any agreement with Comcast that gives any ISP affiliated with the Company 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 the Company.

Turner FTC Consent Decree

      The Company 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 TBS by Historic TW 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 the Company. Various other conditions remain in effect, including certain restrictions which prohibit the Company 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 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 and was subsequently acquired by Comcast in 2002, 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 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 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. The Turner Consent Decree will expire in February 2007.

Cable System Regulation

 
Communications Act and FCC Regulation

      The Communications Act of 1934, as amended (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.

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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 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 negotiate with cable operators for 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.

      In 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. In 2002, the FCC also initiated a rulemaking proceeding to consider whether it may and should do so and whether local franchising authorities should be permitted to do so. This rulemaking proceeding remains pending.

      Several ISPs appealed the FCC’s order in federal court, arguing that cable modem service is a “telecommunications service.” If the ISPs prevail, cable operators may become subject to a requirement that they carry any ISP desiring carriage. In addition, several local franchising authorities also appealed the order in federal court, arguing that the FCC should have held that cable-modem service is a “cable service.” If the local franchising authorities prevail, cable operators may be required to collect and pay franchise fees on cable

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modem service. On October 6, 2003, a three judge panel of the U.S. Court of Appeals for the 9th Circuit vacated in part, and remanded in part for further proceedings, the FCC’s 2002 order. The FCC has requested an en banc rehearing of this appeal, and the request remains pending before the 9th Circuit.

      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. The Company believes that it is unlikely that the FCC will adopt limits more stringent than those struck down.

      Local telephone companies may provide service as traditional cable operators with local franchises or they may opt to provide their programming over unfranchised “open video systems.” Open video systems are subject to specified requirements, including, but not limited to, a requirement that they set aside a portion of their channel capacity for use by unaffiliated program distributors on a non-discriminatory basis. A federal appellate court overturned various parts of the FCC’s open video rules, including the FCC’s preemption of local franchising requirements for open video operators. The FCC has modified its open video rules to comply with the federal court’s decision.

      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 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. 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.

      Certain regulatory requirements are also 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-

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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 currently scheduled to go into effect on July 1, 2006.

      In December, 2002, cable operators and consumer-electronics companies 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 — a CableCARD® — provided by the cable operator. To implement the agreement, the FCC recently promulgated regulations that require cable systems with activated spectrum of 750 MHz or greater to support unidirectional digital devices; establish a voluntary labeling system for unidirectional devices; prohibit so-called “selectable output controls”; and adopt content-encoding rules. The FCC has issued a notice of proposed rulemaking to consider additional changes. Cable operators, consumer-electronics companies and other market participants are holding discussions that are expected to lead to a similar set of interoperability agreements covering digital devices capable of carrying cable operators’ two-way and interactive products and services.

      Separately, the FCC has adopted cable inside wiring rules to provide specific procedures for the disposition of residential home wiring and internal building wiring where a subscriber terminates service or where an incumbent cable operator is forced by a building owner to terminate service in a multiple dwelling unit building. The FCC has also adopted rules providing that, in the event that an incumbent cable operator sells the inside wiring, it must make the wiring available to the multiple dwelling unit owner or the alternative cable service provider during the 24-hour period prior to the actual service termination by the incumbent, in order to avoid service interruption.

      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 negotiated 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, cable regulation is imposed at the state level as well. The Company 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.

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      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, it is possible that some Time Warner Cable franchises may not be renewed, and Time Warner Cable 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 December 31, 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 traditional circuit switch telephone service provided by incumbent telephone companies. In particular, it is unclear whether and to what extent the “access charge” and “universal service” rules that apply to traditional circuit switch 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. In February 2004 the FCC opened a rulemaking proceeding on VoIP.

Network Regulation

      Under the Communications 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”).

Marketing Regulation

      Time Inc.’s magazine and book marketing activities, as well as other marketing and billing activities by America Online and other divisions of the Company, are subject to regulation by the FTC and each of the state Attorneys General under general consumer protection statutes prohibiting unfair or deceptive acts or practices. Certain areas of marketing activity are also subject to specific federal rules and statutes, such as the Telephone Consumer Protection Act, the Children’s Online Privacy Protection Act, the Gramm-Leach-Bliley Act (relating to financial privacy), the FTC Mail or Telephone Order Merchandise Rule and the FTC Telemarketing Sales Rule. The FTC’s Telemarketing Sales Rule has been amended to establish a nationwide telemarketing do-not-call list. In addition, certain of Time Inc.’s specific marketing methods are subject to agreements with state Attorneys General, such as the regulation of Time Inc.’s use of sweepstakes by a 48-state Assurance of Voluntary Compliance agreed to in 2000. America Online is also subject to a 1998 FTC

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Consent Decree and a 43-state Assurance of Voluntary Compliance with state Attorneys General and a separate 2004 FTC Consent Decree which address America Online’s marketing and billing activities. Further, as a result of the settlement of a lawsuit between merchants and credit card companies, credit card companies may be providing information to merchants which would allow merchants to distinguish between charges made on credit cards and debit cards. As a result, Time Inc. may be required to change its payment acceptance procedures, which could result in decreased subscription renewals.

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 Inc. that affect and govern the ongoing operations of TWC Inc. 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 Inc.

      Stockholders of TWC Inc. As a result of the TWE Restructuring, Time Warner and its subsidiaries received shares of TWC Inc. Class A common stock, which generally has one vote per share, and shares of TWC Inc. Class B common stock, which generally has ten votes per share, which together represent 89.3% of the voting power of TWC Inc. and 82.1% of the equity of TWC Inc. A Comcast Trust received shares of Class A common stock of TWC Inc. representing the remaining 10.7% of the voting power and 17.9% of the equity of TWC Inc. The Class B common stock is not convertible into Class A common stock upon transfer or otherwise. The Class A common stock and the Class B common stock 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 Inc. The Class A common stock votes, as a separate class, with respect to the election of the Class A directors of TWC Inc. (the “Class A Directors”), and the Class B common stock votes, as a separate class, with respect to the election of the Class B directors of TWC Inc. (the “Class B Directors”). Pursuant to the restated certificate of incorporation of TWC Inc. (the “Certificate of Incorporation”), the Class A Directors must represent not less than one-sixth and not more than one-fifth of the directors of TWC Inc., and the Class B Directors must represent not less than four-fifths of the directors of TWC Inc. As a result of its shareholdings, Time Warner has the ability 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.

      The TWC Inc. Certificate of Incorporation requires that there be at least two independent directors on the board of directors of TWC Inc.. In addition, a parent agreement (the “Parent Agreement”) among Time Warner, TWC Inc. and Comcast provides that until such time that an initial public offering of TWC Inc. common stock is effected, at least 50% of the independent directors must be reasonably satisfactory to the Comcast Trust. To the extent possible, all such independent directors will be Class A Directors. If an initial public offering of TWC Inc. is effected, the Certificate of Incorporation requires that at least 50% of the board of directors of TWC Inc. consist of independent directors for three years.

      Protections of Minority Class A Common Stockholders. The approval of the holders of a majority of the voting power of the outstanding shares of Class A common stock held by persons other than Time Warner is necessary in connection with:

  •  any merger, consolidation or business combination of TWC Inc. 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;
 
  •  any change to the 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 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;
 
  •  any change to the Certificate of Incorporation that would alter the number of independent directors required on the TWC Inc. board of directors; and
 
  •  through and until the fifth anniversary of the completion of an initial public offering of TWC Inc., any change to provisions of TWC Inc.’s by-laws concerning restrictions on transactions between TWC Inc. and Time Warner and its affiliates.

Matters Affecting the Relationship between Time Warner and TWC Inc.

      Indebtedness Approval Right. For so long as the indebtedness of TWC Inc. is attributable to Time Warner, in Time Warner’s reasonable judgment, TWC Inc., its subsidiaries and entities that it manages will not, without the consent of 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 (as EBITDA is defined in the applicable agreement and which is comparable to operating income (loss) before depreciation and amortization) plus rental expense, or “EBITDAR,” then exceeds or would exceed 3:1.

      Other Time Warner Rights. Under the Parent Agreement, as long as Time Warner has the right to elect more than a majority of the directors of TWC Inc., TWC Inc. must obtain Time Warner’s consent before it enters into any agreement that binds or purports to bind Time Warner or its affiliates or that would subject TWC Inc. to significant penalties or restrictions as a result of any action or omission of 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.

      Time Warner Standstill. Under the Parent Agreement, Time Warner has agreed that for three years following the completion of an initial public offering of TWC Inc., Time Warner will not make or announce a tender offer or exchange offer for the Class A common stock of TWC Inc. without the approval of a majority of the independent directors of TWC Inc.; and for ten years following an initial public offering of TWC Inc., Time Warner will not enter into any business combination with TWC Inc., including a short-form merger, without the approval of a majority of the independent directors of TWC Inc.

      Transactions between Time Warner and TWC Inc. The by-laws of TWC Inc. provide that Time Warner may only enter into transactions with TWC Inc. and its subsidiaries, including TWE, that are on terms that, at the time of entering into such transaction, are substantially as favorable to TWC Inc. 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 also requires the prior approval of a majority of the independent directors of TWC Inc.

TWC Inc. Registration Rights Agreements

      TWC Inc. Registration Rights Agreement with Comcast Trust. At the closing of the TWE Restructuring, a Comcast Trust entered into a registration rights agreement with TWC Inc. relating to its shares of Class A common stock, as well as any common stock of TWC Inc. that it or another Comcast Trust may receive in connection with a sale of a partnership interest in TWE under the Partnership Interest Sale Agreement (see “Description of Certain Provisions of the TWE Partnership Agreement — Exit Rights”).

      Subject to several exceptions, including TWC Inc.’s right to defer a demand registration under some circumstances, the Comcast Trust has the right to require that TWC Inc. take commercially reasonable steps to register for public resale under the Securities Act of 1933 all shares of Class A common stock owned by it that it requests be registered. On December 29, 2003, TWC Inc. received notice from the Comcast Trust requesting that TWC Inc. commence to register for sale in a firm underwritten offering all of Comcast’s 17.9% common interest in TWC Inc. The Company cannot predict the timing of an effective registration in response to the Comcast Trust’s notice. Under the registration rights agreement, TWC Inc. is not obligated to effect more than one demand registration on behalf of the Comcast Trust in any 270-day period. TWC Inc. is not obligated to effect a demand registration on behalf of the Comcast Trust if the Comcast Trust has received

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proceeds in excess of $250 million (or 10% of TWC Inc.’s market capitalization) from private placements of and hedging transactions relating to TWC Inc.’s common stock in the preceding 270-day period. 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 Inc. shall have sold at least $2.1 billion worth of common stock. Any registered hedging transaction or other monetization with respect to TWC Inc. common stock will be deemed to constitute a demand registration.

      In addition, the Comcast Trust has “piggyback” registration rights subject to customary restrictions on any registration for TWC Inc.’s account or the account of another stockholder, and TWC Inc. and Time Warner are permitted to piggyback on the Comcast Trust’s demand registrations.

      If any registration requested by the Comcast Trust or 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 Inc.’s account must be included until TWC Inc. has sold $2.1 billion worth of securities, whether through public offerings, private placements or hedging transactions;
 
  •  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 Inc. and the Comcast Trust have equal priority, and Time Warner has 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 Inc. common stock. After that date, TWC Inc., the Comcast Trust and Time Warner have equal priority.

      Registration Rights Agreement between TWC Inc. and Time Warner. At the closing of the TWE Restructuring, Time Warner and TWC Inc. entered into a registration rights agreement relating to Time Warner’s shares of TWC Inc. common stock. Subject to several exceptions, including TWC Inc.’s right to defer a demand registration under some circumstances, Time Warner may, under that agreement, require that TWC Inc. take commercially reasonable steps to register for public resale under the Securities Act of 1933 all shares of common stock that Time Warner requests be registered. Time Warner may demand an unlimited number of registrations. In addition, Time Warner has been granted “piggyback” registration rights subject to customary restrictions, and TWC Inc. is permitted to piggyback on Time Warner’s registrations. Any registration statement filed under the agreement is subject to the cut-back priority discussed above. Time Warner has agreed that it will not, until the fifth anniversary of the closing of the TWE Restructuring, dispose of its shares of TWC Inc. common stock other than in registered offerings.

      In connection with the registrations described above under both registration rights agreements, TWC Inc. will indemnify the selling stockholders and bear all fees, costs and expenses, except underwriting discounts and selling commissions.

DESCRIPTION OF CERTAIN PROVISIONS OF THE

TWE PARTNERSHIP AGREEMENT

      On March 31, 2003, the TWE Partnership Agreement was amended in connection with the closing of the TWE Restructuring (as amended, the “New TWE Partnership Agreement”). The following description summarizes certain provisions of the New TWE Partnership Agreement relating to the ongoing operations of TWE. 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 New TWE Partnership Agreement.

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Management and Operations of TWE

      Partners. Following the TWE Restructuring, the partnership interests in TWE were recapitalized with one of the Comcast Trusts holding a partnership interest representing a 4.7% residual equity interest in TWE, with a subsidiary of the Company 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. became the general partner of TWE and a subsidiary of Time Warner and one of the Comcast Trusts became the limited partners of TWE.

      Following the completion of the TWE Restructuring, TWC Inc., as the general partner of TWE, assumed 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 March 31, 2006, and the right to approve of certain amendments to the New TWE Partnership Agreement.

Certain Covenants

      Transactions with Affiliates. The New TWE Partnership Agreement requires 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.

Exit Rights

      Sale and Appraisal Rights of Trust. Under a partnership interest sale agreement (the “Partnership Interest Sale Agreement”) entered in connection with the closing of the TWE Restructuring, at any time following March 31, 2005, the Comcast Trust has the right to require TWC Inc. to purchase all or a portion of the Comcast Trust’s 4.7% residual limited partnership interest in TWE at an appraised fair market value, subject to a right of first refusal in favor of 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 March 31, 2005, 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 Time Warner and, second, in favor of TWC Inc. If TWC Inc. and 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 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.

      In all cases, the purchase price payable by TWC Inc. or 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, at the purchaser’s election. Any 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.

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      Redemption of Preferred Component. The preferred component of Time Warner’s partnership interest must be redeemed by TWE on April 1, 2023.

Restrictions on Transfer

      The New TWE Partnership Agreement provides that TWC Inc. and Time Warner may generally transfer their partnership interests in TWE at any time, except that TWC Inc. may not transfer control of TWE prior to March 31, 2006. However, the Comcast Trust may not transfer its partnership interest in TWE prior to March 31, 2005 and, after that, the Comcast Trust may only transfer its partnership interest pursuant to the Partnership Interest Sale Agreement, described above.

      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

      The general partnership interests in TWE-A/N are held by TWE, TWC Inc. (TWE and TWC Inc. are together, the “TW Partners”), and Advance/Newhouse Partnership, a partnership owned by wholly owned subsidiaries of Advance Publications Inc. and Newhouse Broadcasting Corporation (“A/N”). The TW Partners also hold preferred partnership interests.

2002 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 the Company and TWE retain the economic interests and associated liabilities in the remaining TWE-A/N cable systems. Also, in connection with the restructuring, 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 the Company’s.

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 various engineering-related matters. TWE and A/N also agreed to periodically discuss cooperation with respect to new product development.

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      Actions Requiring Unanimous Consent. Some actions cannot be taken by TWE-A/N, TWE or A/N without the unanimous consent of the TW Partners and A/N or the unanimous consent of an executive committee consisting of members designated by the TW 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;
 
  •  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

      TW Partners. Each TW Partner is generally permitted to directly or indirectly dispose of its entire partnership interest at any time to a wholly owned affiliate of TWE (in the case of transfers by TWE) or to TWE, the Company or a wholly owned affiliate of TWE or the Company (in the case of transfers by TWC Inc.). In addition, the TW Partners are also permitted to transfer their partnership interests through a pledge to secure a loan, or a liquidation of TWE in which the Company, or its affiliates, receives a majority of the interests of TWE-A/N held by the TW Partners. TWE is allowed to issue additional partnership interests in TWE so long as the Company continues to own, directly or indirectly, either 35% or 43.75% of the residual equity capital of TWE, depending on when the issuance occurs.

      A/N Partner. A/N is generally permitted to directly or indirectly transfer its entire partnership interest at any time to certain members of the Newhouse family or specified affiliates of A/N. A/N is also permitted to dispose of its partnership interest through a pledge to secure a loan and in connection with specified 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 to A/N and the A/N Subsidiary 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.

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DESCRIPTION OF AGREEMENT WITH LIBERTY MEDIA CORPORATION

      The following description summarizes certain provisions of the Company’s agreement with Liberty Media and certain of its subsidiaries (collectively, “LMC”) that was entered into in connection with the merger of Turner Broadcasting System, Inc. in 1996 (the “TBS Transaction”) and the Turner Consent Decree. 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 Second Amended and Restated LMC Agreement dated as of September 22, 1995 among Historic TW, Time Warner Companies, Inc. and LMC (the “LMC Agreement”).

Ownership of Time Warner Common Stock

      Pursuant to the LMC Agreement, immediately following consummation of the TBS Transaction, LMC exchanged the 50.6 million shares of Historic TW common stock, par value $.01 per share received by LMC in the TBS Transaction on a one-for-one basis for 50.6 million shares of Series LMCN-V Common Stock of Historic TW. In June 1997, LMC and its affiliates received 6.4 million additional shares of Series LMCN-V Common Stock pursuant to the provisions of an option agreement between Time Warner and LMC and its affiliates. In May 1999, the terms of the Series LMCN-V Common Stock were amended which effectively resulted in a two-for-one stock split. At the time of the America Online-Historic TW Merger, each share of Series LMCN-V Common Stock was exchanged for one and one half shares of a substantially identical Series LMCN-V Common Stock of the Company. Each share of Series LMCN-V Common Stock receives the same dividends and otherwise has the same rights as a share of Time Warner Common Stock except that (a) holders of Series LMCN-V Common Stock are entitled to  1/100th of a vote per share on the election of directors and do not have any other voting rights, except as required by law or with respect to limited matters, including amendments to the terms of the Series LMCN-V Common Stock adverse to such holders, and (b) unlike shares of Time Warner Common Stock, shares of Series LMCN-V Common Stock are not subject to redemption by the Company if necessary to prevent the loss by the Company of any governmental license or franchise. The Series LMCN-V Common Stock is not transferable, except in limited circumstances, and is not listed on any securities exchange.

      LMC exchanged its shares of Historic TW common stock for Series LMCN-V Common Stock in order to comply with the Turner Consent Decree, which effectively prohibits LMC and its affiliates (including TCI) from owning voting securities of the Company other than securities that have limited voting rights. In 2002, LMC sought to eliminate these restrictions from the Turner Consent Decree; the petition was denied by the FTC without prejudice. See “Regulation and Legislation — Turner FTC Consent Decree,” above. Each share of Series LMCN-V Common Stock is convertible into one share of Time Warner Common Stock at any time when such conversion would no longer violate the Turner Consent Decree or have a Prohibited Effect (as defined below), including following a transfer to a third party.

Other Agreements

      Under the LMC Agreement, if the Company takes certain actions that have the effect of (a) making the continued ownership by LMC of the Company’s equity securities illegal under any federal or state law, (b) imposing damages or penalties on LMC under any federal or state law as a result of such continued ownership, (c) requiring LMC to divest any such Company equity securities, or (d) requiring LMC to discontinue or divest any business or assets or lose or significantly modify any license under any communications law (each a “Prohibited Effect”), then the Company will be required to compensate LMC for income taxes incurred by it in disposing of all the Company’s equity securities received by LMC in connection with the TBS Transaction and related agreements (whether or not the disposition of all such equity securities is necessary to avoid such Prohibited Effect).

      The agreements described in the preceding paragraph may have the effect of requiring the Company to pay amounts to LMC in order to engage in (or requiring the Company to refrain from engaging in) activities that LMC would be prohibited under the federal communications laws from engaging in. Based on the current businesses of the Company and LMC and based upon the Company’s understanding of applicable law, the Company does not expect these requirements to have a material effect on its business.

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CURRENCY RATES AND REGULATIONS

      Time Warner’s foreign operations are subject to the risk of fluctuation in currency exchange rates and to exchange controls. Time Warner 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 16, “Derivative Instruments — Foreign Currency Risk Management” to the consolidated financial statements set forth in the financial pages herein. For a discussion of revenues of international operations, see Note 17, “Segment Information” to the consolidated financial statements set forth in the financial pages herein.

Item 2.      Properties.

       The following table sets forth certain information as of December 31, 2003 with respect to the Company’s principal properties (over 250,000 square feet in area) that are occupied for corporate offices or used primarily by the Company’s divisions, all of which the Company considers adequate for its present needs, and all of which were substantially used by the Company or were leased to outside tenants:

                         
Approximate
Square Feet Type of Ownership
Location Principal Use Floor Space/Acres Expiration Date of Lease




New York, NY
One Time Warner Center
 
Executive and administrative offices, studio and technical space (Corporate, TBS, CNN)
     905,000     Owned by the Company primarily for occupancy by the Company beginning in 2004.
New York, NY
75 Rockefeller Plaza
Rockefeller Center
 
Former executive and administrative offices (Corporate)
     560,000     Leased by the Company. Lease expires in 2014. To be sublet to third party tenants.
 
Dulles, VA
22000 AOL Way
 
Executive, administrative and business offices (AOL HQ Campus)
    1,573,050     Owned and occupied by the Company.
 
Mt. View, CA
Middlefield Rd.
 
Executive, administrative and business offices (AOL Campus)
     432,950     Leased by the Company. (Leases expire from 2006- 2013). Approximately 8,000 sq. ft is sublet to third party tenants and approximately 201,450 sq. ft. is being marketed for sublease.
Columbus, OH
Arlington Centre
Blvd.
 
Executive, administrative and business offices (CompuServe/ Netscape Campus)
     290,440     Owned and occupied by the Company. Approximately 11,000 sq. ft. is subleased to a third party tenant.
 
Reston, VA
Sunrise Valley
 
Reston Tech Center with executive and administrative offices (AOL)
     278,000     Owned and occupied by the Company.
 
New York, NY
Time & Life Bldg.
Rockefeller Center
 
Business and editorial offices (Time Inc.)
    1,600,000     Leased by the Company. Most leases expire in 2017. Approximately 116,000 sq. ft. is sublet to outside tenants, including approximately 75,000 sq. ft. leased to Bookspan.

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Approximate
Square Feet Type of Ownership
Location Principal Use Floor Space/Acres Expiration Date of Lease




Atlanta, GA
One CNN Center
 
Executive and administrative offices, studios, technical space and retail (TBS)
    1,250,000     Owned by the Company.
Approximately 47,000 sq. ft.
is sublet to outside
tenants.
 
Atlanta, GA
100 CNN Center
 
Hotel
    1,100,000     50% ownership in joint
venture with Omni
International.
 
Atlanta, GA
1050 Techwood Dr.
 
Offices and studios (TBS)
     830,000     Owned and occupied
by the Company.
 
Lebanon, IN
121 N. Enterprise
 
Warehouse space (Time Inc.)
     500,450     Leased by the Company.
Lease expires in 2006.
 
Lebanon, IN
Lebanon Business Park
 
Warehouse space (Time Inc.)
     251,350     Leased by the Company.
Lease expires in 2009.
 
New York, NY
1100 and 1114 Ave. of the Americas
 
Business offices (HBO)
    350,000 and
275,600
    Leased by the Company.
Leases expire in 2018.
 
Burbank, CA
3400 Riverside Drive
 
Executive and administrative offices (Warner Bros.)
    421,000     Leased by the Company.
Lease expires in 2019
with rights to terminate starting
in 2012.
Approximately 17,000 sq. ft.
sublet to outside tenant.
 
London, England
Kings Reach Tower
 
Executive and administrative offices (Time Inc.)
    251,000     Leased by the Company.
Lease expires in 2007.
 
Burbank, CA
The Warner Bros. Studio
 
Sound stages, administrative, technical and dressing room structures, screening theaters, machinery and equipment facilities, back lot and parking lot and other Burbank properties (Warner Bros.)
  3,303,000 sq. ft.
of improved
space on
158 acres(a)
  Owned by the Company.
 
Valencia, CA Undeveloped land  
Location filming (Warner Bros.)
    232 acres     Owned by the Company.


 
(a) Ten acres consist of various parcels adjoining The Warner Bros. Studio, with mixed commercial, office and residential uses.

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Item 3.       Legal Proceedings.

Securities Matters

      As of March 1, 2004, 30 shareholder class action lawsuits have been filed naming as defendants the Company, certain current and former executives of the Company and, in several instances, America Online, Inc. (“America Online”). These lawsuits were filed in U.S. District Courts for the Southern District of New York, the Eastern District of Virginia and the Eastern District of Texas. The complaints purport to be made on behalf of certain shareholders of the Company and allege that the Company made material misrepresentations and/or omissions of material fact in violation of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act. Plaintiffs claim that the Company failed to disclose America Online’s declining advertising revenues and that the Company and America Online inappropriately inflated advertising revenues in a series of transactions. Certain of the lawsuits also allege that certain of the individual defendants and other insiders at the Company improperly sold their personal holdings of Time Warner stock, that the Company failed to disclose that the Merger was not generating the synergies anticipated at the time of the announcement of the Merger and, further, that the Company inappropriately delayed writing down more than $50 billion of goodwill. The lawsuits seek an unspecified amount in compensatory damages. All of these lawsuits have been centralized in the U.S. District Court for the Southern District of New York for coordinated or consolidated pretrial proceedings (along with the federal derivative lawsuits and certain lawsuits brought under the Employee Retirement Income Security Act (“ERISA”) described below) under the caption In re AOL Time Warner Inc. Securities and “ERISA” Litigation. Additional lawsuits filed by individual shareholders have also been consolidated for pretrial proceedings. The Minnesota State Board of Investment has been designated lead plaintiff for the consolidated securities actions and filed a consolidated amended complaint on April 15, 2003, adding additional defendants including additional officers and directors of the Company, Morgan Stanley & Co., Salomon Smith Barney Inc., Citigroup Inc., Banc of America Securities LLC and JP Morgan Chase & Co. Plaintiffs also added additional allegations, including that the Company made material misrepresentations in its Registration Statements and Joint Proxy Statement-Prospectus related to the Merger and in its Registration Statements pursuant to which debt securities were issued in April 2001 and April 2002, allegedly in violation of Section 11 and Section 12 of the Securities Act of 1933. On July 14, 2003, the Company filed a motion to dismiss the consolidated amended complaint and that motion is pending. On July 25, 2003, the court denied plaintiffs’ motion for relief from the automatic stay of discovery that is in effect under the Private Securities Litigation Reform Act of 1995. The Company intends to defend against these lawsuits vigorously. The Company is unable to predict the outcome of these suits or reasonably estimate a range of possible loss.

      As of March 1, 2004, three putative class action lawsuits have been filed alleging violations of ERISA in the U.S. District Court for the Southern District of New York on behalf of current and former participants in the AOL Time Warner Savings Plan, the AOL Time Warner Thrift Plan and/or the TWC Savings Plan (the “Plans”). Collectively, these lawsuits name as defendants the Company, certain current and former directors and officers of the Company and members of the Administrative Committees of the Plans. The lawsuits allege that the Company and other defendants breached certain fiduciary duties to plan participants by, inter alia, continuing to offer Time Warner stock as an investment under the Plans, and by failing to disclose, among other things, that the Company was experiencing declining advertising revenues and that the Company was inappropriately inflating advertising revenues through various transactions. The complaints seek unspecified damages and unspecified equitable relief. The ERISA actions have been consolidated as part of the In re AOL Time Warner Inc. Securities and “ERISA” Litigation described above. On July 3, 2003, plaintiffs filed a consolidated amended complaint naming additional defendants, including America Online, Inc., certain current and former officers, directors and employees of the Company and Fidelity Management Trust Company. On September 12, 2003, the Company filed a motion to dismiss the consolidated ERISA complaint and that motion is pending. On September 26, 2003, the court granted the Company’s motion for a limited stay of discovery in the ERISA actions. The Company intends to defend against these lawsuits vigorously. The Company is unable to predict the outcome of these cases or reasonably estimate a range of possible loss.

      As of March 1, 2004, 11 shareholder derivative lawsuits have been filed naming as defendants certain current and former directors and officers of the Company, as well as the Company as a nominal defendant.

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Three have been filed in New York State Supreme Court for the County of New York, four have been filed in the U.S. District Court for the Southern District of New York and four have been filed in the Court of Chancery of the State of Delaware for New Castle County. The complaints allege that defendants breached their fiduciary duties by causing the Company to issue corporate statements that did not accurately represent that America Online had declining advertising revenues, that the Merger was not generating the synergies anticipated at the time of the announcement of the Merger, and that the Company inappropriately delayed writing down more than $50 billion of goodwill, thereby exposing the Company to potential liability for alleged violations of federal securities laws. The lawsuits further allege that certain of the defendants improperly sold their personal holdings of Time Warner securities. The lawsuits request that (i) all proceeds from defendants’ sales of Time Warner common stock, (ii) all expenses incurred by the Company as a result of the defense of the shareholder class actions discussed above and (iii) any improper salaries or payments, be returned to the Company. The four lawsuits filed in the Court of Chancery for the State of Delaware for New Castle County have been consolidated under the caption, In re AOL Time Warner Inc. Derivative Litigation. A consolidated complaint was filed on March 7, 2003 in that action, and on June 9, 2003, the Company filed a notice of motion to dismiss the consolidated complaint. On December 9, 2002, the Company moved to dismiss the three lawsuits filed in New York State Supreme Court for the County of New York on forum non conveniens grounds. On May 2, 2003, the motion to dismiss was granted. Two of the lawsuits pending in the U.S. District Court for the Southern District of New York have been centralized for coordinated or consolidated pre-trial proceedings with the securities and ERISA lawsuits described above under the caption In re AOL Time Warner Inc. Securities and “ERISA” Litigation. The parties to the first two federal actions have agreed that all proceedings in that matter should be stayed pending resolution of any motion to dismiss in the consolidated securities actions described above. The third was filed on December 11, 2003, as a case related to the consolidated federal action; plaintiffs have agreed to consolidation for most purposes with the consolidated derivative action and have agreed to a stay pending resolution of any motion to dismiss in the consolidated securities action. The fourth was filed on February 20, 2004. The Company intends to defend against these lawsuits vigorously. The Company is unable to predict the outcome of these suits or reasonably estimate a range of possible loss.

      On July 1, 2003, Stichting Pensioenfonds ABP v. AOL Time Warner Inc. et al. was filed in the U.S. District Court for the Southern District of New York against the Company, current and former officers, directors and employees of the Company and Ernst & Young. Plaintiff alleges that the Company made material misrepresentations and/or omissions of material fact in violation of Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder, Section 11, Section 12, Section 14(a) and Rule 14a-9 promulgated thereunder, Section 18 and Section 20(a) of the Exchange Act. The complaint also alleges common law fraud and negligent misrepresentation. The plaintiff seeks an unspecified amount of compensatory and punitive damages. This lawsuit has been consolidated for coordinated pretrial proceedings under the caption In re AOL Time Warner Inc. Securities and “ERISA” Litigation described above. The Company intends to defend against this lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On November 11, 2002, Staro Asset Management, LLC filed a putative class action complaint in the U.S. District Court for the Southern District of New York on behalf of certain purchasers of Reliant 2.0% Zero-Premium Exchangeable Subordinated Notes for alleged violations of the federal securities laws. Plaintiff is a purchaser of subordinated notes, the price of which was purportedly tied to the market value of Time Warner stock. Plaintiff alleges that the Company made misstatements and/or omissions of material fact that artificially inflated the value of Time Warner stock and directly affected the price of the notes. Plaintiff seeks compensatory damages and/or rescission. This lawsuit has been consolidated for coordinated pretrial proceedings under the caption In re AOL Time Warner Inc. Securities and “ERISA” Litigation described above. The Company intends to defend against this lawsuit vigorously. Due to the preliminary status of this matter, the Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On April 14, 2003, Regents of the University of California et al. v. Parsons et al. was filed in California Superior Court, County of Los Angeles, naming as defendants the Company, certain current and former

39


 

officers, directors and employees of the Company, Ernst & Young LLP, Citigroup Inc., Salomon Smith Barney Inc. and Morgan Stanley & Co. Plaintiffs allege that the Company made material misrepresentations in its registration statements related to the Merger and stock option plans in violation of Sections 11 and 12 of the Securities Act of 1933. The complaint also alleges common law fraud and breach of fiduciary duties under California state law. Plaintiffs seek disgorgement of alleged insider trading proceeds and restitution for their stock losses. Three related cases have been filed in California Superior Court and have been coordinated in the County of Los Angeles (the “California Actions”). On January 26, 2004, the Company filed a motion to stay the California Actions on forum non conveniens and comity grounds and certain individuals filed motions to dismiss for lack of personal jurisdiction. The Company intends to defend against these lawsuits vigorously. The Company is unable to predict the outcome of these suits or reasonably estimate a range of possible loss.

      On May 23, 2003, Treasurer of New Jersey v. AOL Time Warner Inc. et al., was filed in the Superior Court of New Jersey, Mercer County, naming as defendants the Company, certain current and former officers, directors and employees of the Company, Ernst & Young, Citigroup, Salomon Smith Barney, Morgan Stanley, JP Morgan Chase and Banc of America Securities. The complaint is brought by the Treasurer of New Jersey and purports to be made on behalf of the State of New Jersey, Department of Treasury, Division of Investments (the “Division”) and certain funds administered by the Division. Plaintiff alleges that the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiff also alleges violations of New Jersey state law for fraud and negligent misrepresentation. Plaintiff seeks an unspecified amount of damages. On October 29, 2003, the Company moved to stay the proceedings or, in the alternative, dismiss the complaint. Also on October 29, 2003, all named individual defendants moved to dismiss the complaint for lack of personal jurisdiction. The parties have agreed to stay this action and to coordinate discovery proceedings with the consolidated securities action. The Company intends to defend against this lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On July 18, 2003, Ohio Public Employees Retirement System et al v. Parsons et al. was filed in Ohio, Court of Common Pleas, Franklin County naming as defendants the Company, certain current and former officers, directors and employees of the Company, Citigroup Inc., Salomon Smith Barney Inc., Morgan Stanley & Co. and Ernst & Young LLP. Plaintiffs allege that the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiffs also allege violations of Ohio law, breach of fiduciary duty and common law fraud. Plaintiffs seek disgorgement of alleged insider trading proceeds, restitution and unspecified compensatory damages. On October 29, 2003, the Company moved to stay the proceedings or, in the alternative, dismiss the complaint. Also on October 29, 2003, all named individual defendants moved to dismiss the complaint for lack of personal jurisdiction. On January 7, 2004, the court denied defendants’ stay motions and denied in part and granted in part defendants’ motion for a protective order. The Company intends to defend against this lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On July 18, 2003, West Virginia Investment Management Board v. Parsons et al. was filed in West Virginia, Circuit Court, Kanawha County, naming as defendants the Company, certain current and former officers, directors and employees of the Company, Citigroup Inc., Salomon Smith Barney Inc., Morgan Stanley & Co., and Ernst & Young LLP. Plaintiff alleges the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiff also alleges violations of West Virginia law, breach of fiduciary duty and common law fraud. Plaintiff seeks disgorgement of alleged insider trading proceeds, restitution and unspecified compensatory damages. The Company intends to defend against this lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On January 28, 2004, McClure et al. v. AOL Time Warner Inc. et al. was filed in the District Court of Cass County, Texas (purportedly on behalf of several purchasers of Company stock) naming as defendants the Company and certain current and former officers, directors and employees of the Company. Plaintiffs allege that the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiffs also allege breach of fiduciary duty and common law fraud. Plaintiffs seek unspecified compensatory damages. The Company intends to defend against this

40


 

lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On February 24, 2004, Commonwealth of Pennsylvania Public School Employees’ Retirement System et al. v. Time Warner Inc. et al. was filed in the Court of Common Pleas of Philadelphia County naming as defendants the Company, certain current and former officers, directors and employees of the Company, America Online, Historic TW Inc., Morgan Stanley & Co., Citigroup Global Markets Inc., Banc of America Securities LLC, J.P. Morgan Chase & Co. and Ernst & Young LLP. Plaintiffs had previously filed a request for a writ of summons notifying defendants of commencement of an action. Plaintiffs allege that the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiffs also allege violations of Pennsylvania Law, breach of fiduciary duty and common law fraud. Plaintiffs seek unspecified compensatory and punitive damages. The Company intends to defend against this lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      On November 15, 2002, the California State Teachers’ Retirement System filed an amended consolidated complaint in the U.S. District Court for the Central District of California on behalf of a putative class of purchasers of stock in Homestore.com, Inc. (“Homestore”). Plaintiff alleges that Homestore engaged in a scheme to defraud its shareholders in violation of Section 10(b) of the Exchange Act. The Company and two former employees of its AOL division were named as defendants in the amended consolidated complaint because of their alleged participation in the scheme through certain advertising transactions entered into with Homestore. Motions to dismiss filed by the Company and the two former employees were granted on March 7, 2003 and the case was dismissed with prejudice. On July 14, 2003, the district court denied plaintiff’s motion for an order certifying the dismissal of the case for interlocutory appeal. The Company intends to defend against this lawsuit vigorously. The Company is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

      As of March 1, 2004, three class action lawsuits have been filed in the U.S. District Court for the Southern District of New York against the Company, America Online and certain former officers and employees. The complaints purport to be brought on behalf of purchasers of stock in PurchasePro Inc. (“PPRO”). Plaintiffs allege that the Company violated Sections 10(b) and 20(a) of the Exchange Act by aiding and abetting PPRO’s alleged inflation of its financial results. The Company intends to defend against these lawsuits vigorously. The Company is unable to predict the outcome of these suits or reasonably estimate a range of possible loss.

SEC and DOJ Investigations

      The SEC and the Department of Justice (“DOJ”) continue to conduct investigations into accounting and disclosure practices of the Company. Those investigations have focused on transactions principally involving the Company’s America Online segment that were entered into after July 1, 1999, including advertising arrangements and the methods used by the America Online segment to report its subscriber numbers.

      The Company itself had commenced an internal review under the direction of the Company’s Chief Financial Officer into advertising transactions at the America Online segment (“CFO review”) during 2002. As a result of the CFO review, the Company announced on October 23, 2002 that it intended to adjust the accounting for certain transactions. The adjustment had an aggregate impact of reducing the advertising and commerce revenues of the Company during the period from the third quarter of 2000 through the second quarter of 2002 by $190 million. On January 28, 2003, the Company filed amendments to its Annual Report on Form 10-K/ A for the year ended December 31, 2001 and its Quarterly Report on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002 that included restated financial statements reflecting the adjustments announced on October 23, 2002. Although the Company has continued its CFO review process, the Company has not, to date, determined that any further restatement is necessary.

      In its Annual Report on Form 10-K for the year ended December 31, 2002, the Company disclosed that the staff of the SEC had recently informed the Company that, based on information provided to the SEC by

41


 

the Company, it was the preliminary view of the SEC staff that the Company’s accounting for two related transactions between America Online and Bertelsmann, A.G. (“Bertelsmann”) should be adjusted. Pursuant to a March 2000 agreement between the parties, Bertelsmann had the right at two separate times to put a portion of its interest in AOL Europe to the Company (80% in January 2002 and the remaining 20% in July 2002) at a price established by the March 2000 agreement. The Company also had the right to exercise a call of Bertelsmann’s interests in AOL Europe at a higher price. Pursuant to the March 2000 agreement, once Bertelsmann exercised its put rights, the Company had the option, at its discretion up to the day before the closing date, to pay the previously-established put price to Bertelsmann either in cash, Company stock or a combination thereof. In the event the Company elected to use stock, the Company was required to deliver stock in a value equal to the amount of the put price determined based on the average of the closing price for the 30 trading days ending 13 trading days before the closing of the put transaction.

      Prior to the end of March 2001, the Company and Bertelsmann began negotiations regarding Bertelsmann’s desire to be paid for some or all of its interests in AOL Europe in cash, rather than in Company stock. During the negotiations throughout 2001, the Company sought to persuade Bertelsmann that a contractual amendment guaranteeing Bertelsmann cash for its interests in AOL Europe had significant value to Bertelsmann (in an estimated range of approximately $400-800 million), and that in exchange for agreeing to such an amendment, the Company wanted Bertelsmann to extend and/or expand its relationship with the Company as a significant purchaser of advertising. Because, for business reasons, the Company intended to settle in cash, the Company viewed it as essentially costless to forego the option to settle with Bertelsmann in stock. By agreeing to settle in cash, the Company also made it more likely that Bertelsmann would exercise its put rights, which were $1.5 billion less expensive than the Company’s call option.

      In separate agreements executed in March and December of 2001, the Company agreed to settle the put transactions under the March 2000 agreement in cash rather than in stock, without any change to the put price previously established in the March 2000 agreement. Contemporaneously with the agreements to pay in cash, Bertelsmann agreed to purchase additional advertising from the Company of $125 million and $275 million, respectively. The amount of advertising purchased by Bertelsmann pursuant to these two transactions was recognized by the Company as the advertisements were run (almost entirely at America Online) during the period from the first quarter of 2001 through the fourth quarter of 2002. Advertising revenues recognized by the Company totaled $16.3 million, $65.5 million, $39.8 million and $0.5 million, respectively, for the four quarters ending December 31, 2001, and $80.3 million, $84.4 million, $51.6 million and $58.0 million, respectively, for the four quarters ending December 31, 2002. For the period ending December 31, 2003, advertising revenues recognized by the Company totaled $2.1 million, with $2.0 million recognized for the quarter ending March 31, 2003. These two Bertelsmann transactions are collectively the largest multi-element advertising transactions entered into by America Online during the period under review.

      Although the advertisements purchased by Bertelsmann in these transactions were in fact run, the SEC staff expressed to the Company its preliminary view that at least some portion of the revenue recognized by the Company for that advertising should have been treated as a reduction in the purchase price paid by the Company to Bertelsmann rather than as advertising revenue. The Company subsequently provided the SEC a written explanation of the basis for the Company’s accounting for the transactions and the reasons why both the Company and its auditors continued to believe that the transactions had been accounted for correctly.

      The SEC staff has continued to review the Company’s accounting for these transactions, including the Company’s written and oral submissions to the SEC. In July 2003, the SEC’s Office of the Chief Accountant informed the Company that it has concluded that the accounting for these transactions is incorrect. Specifically, in the view of the Office of the Chief Accountant, the Company should have allocated some portion of the $400 million paid by Bertelsmann to America Online for advertising, which was run by the Company and recognized as revenue, as consideration for the Company’s decision to relinquish its option to pay Bertelsmann in stock for its interests in AOL Europe, and, therefore, such portion of the payment should have been reflected as a reduction in the purchase price for Bertelsmann’s interest in AOL Europe, rather than as advertising revenue. In addition, the SEC’s Division of Enforcement continues to investigate the facts and circumstances of the negotiation and performance of these agreements with Bertelsmann, including the value of advertising provided thereunder.

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      Based upon its knowledge and understanding of the facts of these transactions, the Company and its auditors continue to believe its accounting for these transactions is appropriate. It is possible, however, that the Company may learn information as a result of its ongoing review, discussions with the SEC, and/or the SEC’s ongoing investigation that would lead the Company to reconsider its views of the accounting for these transactions. It is also possible that restatement of the Company’s financial statements with respect to these transactions may be necessary. In light of the conclusion of the Office of the Chief Accountant that the accounting for the Bertelsmann transactions is incorrect, it is likely that the SEC would not declare effective any registration statement of the Company or its affiliates, such as the potential initial public offering of TWC Inc., until this matter is resolved.

      The SEC staff also continues to investigate a range of other transactions principally involving the Company’s America Online segment, including advertising arrangements and the methods used by the America Online segment to report its subscriber numbers. The DOJ also continues to investigate matters relating to these transactions and transactions involving certain third parties with whom America Online had commercial relationships. The Company intends to continue its efforts to cooperate with both the SEC and the DOJ investigations to resolve these matters. The Company may not currently have access to all relevant information that may come to light in these investigations, including but not limited to information in the possession of third parties who entered into agreements with America Online during the relevant time period. It is not yet possible to predict the outcome of these investigations, but it is possible that further restatement of the Company’s financial statements may be necessary. It is also possible that, so long as there are other unresolved issues associated with the Company’s financial statements, the effectiveness of any registration statement of the Company or its affiliates may be delayed.

Other Matters

      As of March 1, 2004, 13 putative consumer class action suits have been filed in various state and federal courts naming as defendants the Company or America Online and ICT Group, Inc. All of these suits allege that America Online’s “Spin-off a Second Account” (“SOSA”) program violated consumer protection acts by charging members for “spun-off” or secondary e-mail accounts they purportedly did not agree to create. America Online removed several of the actions filed in state court to federal court. On February 27, 2004, the Judicial Panel on Multidistrict Litigation ordered the federal court cases centralized in the Central District of California for consolidated or coordinated pretrial proceedings. On January 5, 2004, the class action pending in the Superior Court of Washington, Spokane County, titled Dix v. ICT Group and America Online, was dismissed without prejudice based on the forum selection clause set forth in SOSA’s terms of service. America Online has filed or will file similar motions to dismiss in the other state actions not removed to federal court. The Company believes the lawsuits have no merit and intends to defend against them vigorously. Due to their preliminary status, the Company is unable to predict the outcome of these suits or reasonably estimate a range of possible loss.

      On May 24, 1999, two former AOL Community Leader volunteers filed Hallissey et al. v. America Online, Inc. in the U.S. District Court for the Southern District of New York. This lawsuit was brought as a collective action under the Fair Labor Standards Act (“FLSA”) and as a class action under New York state law against America Online and AOL Community, Inc. The plaintiffs allege that, in serving as Community Leader volunteers, they were acting as employees rather than volunteers for purposes of the FLSA and New York state law and are entitled to minimum wages. On December 8, 2000, defendants filed a motion to dismiss on the ground that the plaintiffs were volunteers and not employees covered by the FLSA. The motion to dismiss is pending. A related case was filed by several of the Hallissey plaintiffs in the U.S. District Court for the Southern District of New York alleging violations of the retaliation provisions of the FLSA. This case has been stayed pending the outcome of the Hallissey motion to dismiss. Three related class actions have been filed in state courts in New Jersey, California and Ohio, alleging violations of the FLSA and/or the respective state laws. The New Jersey and Ohio cases were removed to federal court and subsequently transferred to the U.S. District Court for the Southern District of New York for consolidated pretrial proceedings with Hallissey. The California action was remanded to California state court and on January 6, 2004, the court

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denied plaintiffs’ motion for class certification. Plaintiffs in that case have filed an appeal of the order denying class certification, and the trial court has stayed proceedings pending that appeal.

      On January 17, 2002, Community Leader volunteers filed a class action lawsuit in the U.S. District Court for the Southern District of New York against the Company, America Online and AOL Community, Inc. under ERISA. Plaintiffs allege that they are entitled to pension and/or welfare benefits and/or other employee benefits subject to ERISA. In March 2003, plaintiffs filed and served a second amended complaint, adding as defendants the Company’s Administrative Committee and the AOL Administrative Committee. On May 19, 2003, the Company, America Online and AOL Community, Inc. filed a motion to dismiss and the Administrative Committees filed a motion for judgment on the pleadings. Both of these motions are now pending. The Company is unable to predict the outcome of these cases or reasonably estimate a range of possible loss, but intends to defend against these lawsuits vigorously.

      On October 7, 2003, Kim Sevier and Eric M. Payne vs. Time Warner Inc. and Time Warner Cable Inc., a putative nationwide consumer class action, was filed in the U.S. District Court for the Southern District of New York, and on October 23, 2003, Heidi D. Knight v. Time Warner Inc. and Time Warner Cable Inc., also a putative nationwide consumer class action, was filed in the same court. In each case, the plaintiffs allege that defendants unlawfully tie the provision of high speed cable Internet service to leases of cable modem equipment, because they do not provide a discount to customers who provide their own cable modems, in violation of Section 1 of the Sherman Act and the New York Donnelly Act, and, further, that defendants’ conduct resulted in unjust enrichment. On November 19, 2003, the court ordered plaintiffs’ complaints to be consolidated. Plaintiffs filed their amended consolidated class action complaint on December 17, 2003, seeking compensatory damages, disgorgement, attorneys’ fees and injunctive and declaratory relief. On February 6, 2004, the Company moved to compel arbitration and to stay the matter pending such arbitration or alternatively to dismiss the case. The Company believes these lawsuits have no merit and intends to defend against them vigorously. However, due to their preliminary status the Company is unable to predict the outcome of these cases or reasonably estimate a range of possible loss.

      On June 16, 1998, plaintiffs in Andrew Parker and Eric DeBrauwere, et al. v. Time Warner Entertainment Company, L.P. and Time Warner Cable filed a purported nationwide class action in U.S. District Court for the Eastern District of New York claiming that TWE sold its subscribers’ personally identifiable information and failed to inform subscribers of their privacy rights in violation of the Cable Communications Policy Act of 1984 and common law. The plaintiffs are seeking damages and declaratory and injunctive relief. On August 6, 1998, TWE filed a motion to dismiss, which was denied on September 7, 1999. On December 8, 1999, TWE filed a motion to deny class certification, which was granted on January 9, 2001 with respect to monetary damages, but denied with respect to injunctive relief. On June 2, 2003, the U.S. Court of Appeals for the Second Circuit vacated the District Court’s decision denying class certification as a matter of law and remanded the case for further proceedings on class certification and other matters. The Company is unable to predict the outcome of this case or reasonably estimate a range of possible loss, but intends to defend against this lawsuit vigorously.

      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 the Company relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on the Company’s business, financial condition and operating results.

 
Item 4.       Submission of Matters to a Vote of Security Holders.

       Not applicable.

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EXECUTIVE OFFICERS OF THE COMPANY

      Pursuant to General Instruction G(3), the information regarding the Company’s executive officers required by Item 401(b) of Regulation S-K is hereby included in Part I of this report.

      The following table sets forth the name of each executive officer of the Company, the office held by such officer and the age of such officer as of March 1, 2004.

             
Name Age Office



Richard D. Parsons
    55     Chairman of the Board & Chief Executive Officer
Jeffrey L. Bewkes
    51     Chairman, Entertainment & Networks Group
Don Logan
    60     Chairman, Media & Communications Group
Edward I. Adler
    50     Executive Vice President, Corporate Communications
Paul T. Cappuccio
    42     Executive Vice President and General Counsel
Patricia Fili-Krushel
    50     Executive Vice President, Administration
Robert M. Kimmitt
    56     Executive Vice President, Global Public Policy
Olaf Olafsson
    41     Executive Vice President
Wayne H. Pace
    57     Executive Vice President and Chief Financial Officer

      Set forth below are the principal positions held by each of the executive officers named above:

 
Mr. Parsons Chairman of the Board and Chief Executive Officer since May 2003, having served as Chief Executive Officer from May 2002. Prior to May 2002, Mr. Parsons served as Co-Chief Operating Officer from the consummation of the Merger and was President of Historic TW pre-Merger from February 1995. He previously served as Chairman and Chief Executive Officer of The Dime Savings Bank of New York, FSB from January 1991.
 
Mr. Bewkes Chairman, Entertainment & Networks Group since July 2002; prior to that, Mr. Bewkes served as Chairman and Chief Executive Officer of the Home Box Office division of the Company from May 1995 and President and Chief Operating Officer for the preceding five years.
 
Mr. Logan Chairman, Media & Communications Group since July 2002; prior to that, Mr. Logan served as Chairman and Chief Executive Officer of Time Inc., the Company’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.
 
Mr. Adler Executive Vice President, Corporate Communications since January 2004; prior to that, Mr. Adler served as Senior Vice President, Corporate Communications from the consummation of the Merger, Senior Vice President, Corporate Communications of Historic TW pre-Merger from January 2000 and Vice President, Corporate Communications of Historic TW prior to that.
 
Mr. Cappuccio Executive Vice President and General Counsel since the consummation of the Merger, and Secretary until January 2004; prior to the Merger, he served as Senior Vice President and General

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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.
 
Ms. Fili-Krushel Executive Vice President, Administration since July 2001; prior to that, she was Chief Executive Officer of WebMD Health division of WebMD Corporation, an Internet portal providing health information and service for the consumer, from April 2000 to July 2001 and President of ABC Television Network from July 1998 to April 2000. Prior to that, she was President, ABC Daytime from 1993 to 1998.
 
Mr. Kimmitt Executive Vice President, Global Public Policy since July 2001; prior to that, he was President and Vice Chairman of Commerce One, Inc., an electronic commerce company, from March 2000 to June 2001, having served as Vice Chairman and Chief Operating Officer from February 2000. Previously, Mr. Kimmitt was a partner in the Washington, D.C.-based law firm of Wilmer, Cutler & Pickering from 1997 to 2000. He had previously been managing director at Lehman Brothers, an international financial services firm, from 1993 to 1997. Mr. Kimmitt also served as the U.S. Ambassador to Germany from 1991 to 1993.
 
Mr. Olafsson Executive Vice President since March 2003. During 2002, Mr. Olafsson pursued personal interests, including working on a novel that was published in the fall of 2003. Prior to that, he was Vice Chairman of Time Warner Digital Media from November 1999 through December 2001 and prior to that, Mr. Olafsson served as President of Advanta Corp., a financial services company, from March of 1998 until November 1999.
 
Mr. Pace Executive Vice President and Chief Financial Officer since November 2001; prior to that, he was Vice Chairman, Chief Financial and Administrative Officer of TBS from March 2001, having held other executive positions, including Chief Financial Officer at TBS since July 1993. Prior to joining TBS, Mr. Pace was an audit partner with Price Waterhouse, now PricewaterhouseCoopers, an international accounting firm.

PART II

 
Item 5.      Market For Registrant’s Common Equity and Related Stockholder Matters.

      The principal market for the Company’s Common Stock is the New York Stock Exchange. For quarterly price information with respect to the Company’s Common Stock for the two years ended December 31, 2003, see “Quarterly Financial Information” at pages 202 through 203 herein, which information is incorporated herein by reference. The number of holders of record of the Company’s Common Stock as of March 1, 2004 was approximately 67,750.

      The Company has not paid any dividends since its formation.

      There is no established public trading market for the Company’s Series LMCN-V Common Stock, which as of March 1, 2004 was held of record by nine holders.

46


 

 
Item 6.      Selected Financial Data.

      The selected financial information of the Company for the five years ended December 31, 2003 is set forth at pages 200 through 201 herein and is incorporated herein by reference.

 
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 55 through 120 herein is incorporated herein by reference.

 
Item 7A.      Quantitative and Qualitative Disclosures About Market Risk.

      The information set forth under the caption “Market Risk Management” at pages 103 through 105 herein is incorporated herein by reference.

 
Item 8.      Financial Statements and Supplementary Data.

      The consolidated financial statements and supplementary data of the Company and the report of independent auditors thereon set forth at pages 121 through 198, 204 through 211 and 199 herein are incorporated herein by reference.

      Quarterly Financial Information set forth at pages 202 through 203 herein is incorporated herein by reference.

 
Item 9.      Changes In and Disagreements with Accountants on Accounting and Financial Disclosure.

      Not applicable.

 
Item 9A. Controls and Procedures.

      The Company, under the supervision and with the participation of its management, including the Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of the Company’s “disclosure controls and procedures” (as defined in Rule 13a-15(e) under the Exchange Act) as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in timely making known to them material information relating to the Company and the Company’s consolidated subsidiaries required to be disclosed in the Company’s reports filed or submitted under the Exchange Act. The Company has investments in certain unconsolidated entities. As the Company does not control or manage these entities, its disclosure controls and procedures with respect to such entities are necessarily substantially more limited than those it maintains with respect to its consolidated subsidiaries.

      There have not been any changes in the Company’s internal control over financial reporting during the quarter ended December 31, 2003 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.

PART III

 
Items 10, 11, 12, 13 and 14. Directors and Executive Officers of the Registrant; Executive Compensation; Security Ownership of Certain Beneficial Owners and Management; Certain Relationships and Related Transactions; Principal Accounting Fees and Services.

      Information called for by Items 10, 11, 12, 13 and 14 of Part III is incorporated by reference from the Company’s definitive Proxy Statement to be filed in connection with its 2004 Annual Meeting of Stockholders pursuant to Regulation 14A, except that (i) the information regarding the Company’s executive officers called for by Item 401(b) of Regulation S-K has been included in Part I of this report; (ii) the information called for by Items 402(k) and 402(l) of Regulation S-K is not incorporated by reference; and (iii) the information

47


 

regarding certain Company equity compensation plans called for by Item 201(d) of Regulation S-K is set forth below.

      The Company has adopted a Code of Ethics for its Senior Executive and Senior Financial Officers. A copy of the Code is publicly available on the Company’s website at www.timewarner.com/corporate  information. Amendments to the Code or any grant of a waiver from a provision of the Code requiring disclosure under applicable SEC rules will also be disclosed on the Company’s website.

Equity Compensation Plan Information

      The following table summarizes information as of December 31, 2003, about the Company’s outstanding stock options and shares of Common Stock reserved for future issuance under the Company’s existing equity compensation plans.

                         
Number of securities
remaining available for
future issuance under
Number of securities to be equity compensation plans
issued upon exercise of Weighted-average exercise (excluding securities
outstanding options, price of outstanding options, reflected in column
Plan Category warrants and rights warrants and rights (a))(4)




(a) (b) (c)
Equity compensation plans approved by security holders(1)
    75,379,214     $ 45.63       231,744,131  
Equity compensation plans not approved by security holders(2)
    381,901,766     $ 30.33       1,051,586  
Total(3)
    457,280,980     $ 32.85       232,795,717  


(1)  Equity compensation plans approved by security holders are the (i) Time Warner Inc. 2003 Stock Incentive Plan, (ii) Time Warner Inc. 1999 Stock Plan, (iii) Time Warner Inc. 1999 Restricted Stock Plan, (iv) Time Warner Inc. 1988 Restricted Stock Plan for Non-Employee Directors, and (v) Time Warner Inc. Employee Stock Purchase Plan (column (c) includes 9,542,412 shares that were available for future issuance under this plan). The Time Warner Inc. 2003 Stock Incentive Plan was approved by the Company’s stockholders in May 2003. The other plans or amendments to such plans were approved by the stockholders of either America Online or Historic TW in either 1998 or 1999. These plans were assumed by the Company in connection with the America Online-Historic TW Merger, which was approved by the stockholders of both America Online and Historic TW on June 23, 2000.
 
(2)  Equity compensation plans not approved by security holders are (i) the AOL Time Warner Inc. 1994 Stock Option Plan and (ii) the Time Warner Inc. 1999 International Employees Restricted Stock Plan.
 
(3)  Does not include options to purchase an aggregate of 193,320,701 shares of Common Stock (171,915,074 of which were awarded under plans that were approved by the stockholders of either America Online or Historic TW prior to the America Online-Historic TW Merger), at a weighted average exercise price of $24.87, granted under plans assumed in connection with transactions and under which no additional options may be granted.
 
(4)  Includes securities available under the Time Warner Inc. 1988 Restricted Stock Plan for Non-Employee Directors, which uses the formula of .003% of the shares of Common Stock outstanding on December 31 of the prior calendar year (136,075 shares in 2004) to determine the maximum amount of securities available for issuance each year under the plan. Also includes securities available under the following plans that previously used a formula for determining the maximum amount of securities available for issuance based on the number of shares outstanding at December 31 of the prior year, but for which the maximum number of shares is not subject to further adjustment: (i) the Time Warner Inc. 1999 Restricted Stock Plan, which provided for a maximum number of shares of Common Stock available for restricted stock awards of .08% of the shares of Common Stock outstanding on December 31 of the prior

48


 

year and (ii) the Time Warner Inc. 1999 International Employees Restricted Stock Plan, which provided for a maximum number of shares of Common Stock available for restricted stock awards of .04% of the shares of Common Stock outstanding on December 31 of the prior year. Of the shares available for future issuance under the Time Warner Inc. 1999 Stock Plan and the Time Warner Inc. 2003 Stock Incentive Plan, a maximum of 990,333 shares and 40 million shares, respectively, may be awarded as restricted stock as of December 31, 2003.

      The Time Warner Inc. 1999 Stock Plan (the “1999 Stock Plan”) was approved by the stockholders of America Online in October 1999 and was assumed by the Company in connection with the America Online-Historic TW Merger in 2001. Under the 1999 Stock Plan, stock options (non-qualified and incentive) and stock purchase rights, i.e., restricted stock, can be granted to employees, directors and consultants of the Company and its consolidated subsidiaries. No incentive stock options have been awarded under the 1999 Stock Plan. The exercise price of a stock option under the 1999 Stock Plan cannot be less than the fair market value of the Common Stock on the date of grant. The stock options generally become exercisable, or vest, in installments of 25% over a four-year period, subject to acceleration upon the occurrence of certain events such as death or disability, and expire ten years from the grant date. No more than 5 million of the total 100 million shares of Common Stock that can be issued pursuant to the 1999 Stock Plan can be issued for awards of restricted stock. Awards of restricted stock vest in amounts and at times designated at the time of award, and generally have vested over a four- or five-year period. Awards of restricted stock are subject to restrictions on transfer and forfeiture prior to vesting. The awards of stock options made to non-employee directors of the Company are made pursuant to the 1999 Stock Plan, which provides for an award of 8,000 stock options when a non-employee director is first elected to the Board of Directors and then annual awards of 8,000 stock options following the annual meeting of stockholders. Stock options awarded to non-employee directors vest in installments of 25% over a four-year period or earlier if the director does not stand for re-election or is not re-elected after being nominated.

      The AOL Time Warner Inc. 1994 Stock Option Plan (the “1994 Plan”) was assumed by the Company in connection with the America Online-Historic TW Merger. The 1994 Plan expired on November 18, 2003 and stock options may no longer be awarded under the 1994 Plan. Under the 1994 Plan, nonqualified stock options and related stock appreciation rights could be granted to employees (other than executive officers) of and consultants and advisors to the Company and certain of its subsidiaries. No stock appreciation rights are currently outstanding under the 1994 Plan. The exercise price of a stock option under the 1994 Plan could not be less than the fair market value of the Common Stock on the date of grant. The outstanding options under the 1994 Plan generally become exercisable in installments of one-third or one-quarter on each of the first three or four anniversaries, respectively, of the date of grant, subject to acceleration upon the occurrence of certain events, and expire ten years from the grant date.

      The Time Warner Inc. 1999 Restricted Stock Plan (the “1999 Restricted Stock Plan”) was approved by the stockholders of Historic TW in May 1999 and was assumed by the Company in connection with the America Online-Historic TW Merger. Under the 1999 Restricted Stock Plan, awards of restricted stock can be made to employees of the Company and its consolidated subsidiaries. Awards of restricted stock vest in amounts and at times designated at the time of award, but at least 95% of the awards must vest at least three years after the date of award. Awards of restricted stock are subject to restrictions on transfer and forfeiture prior to vesting. As of December 31, 2003, 1,454,525 shares were available for issuance under the 1999 Restricted Stock Plan.

      The Time Warner Inc. 1999 International Employees Restricted Stock Plan (the “International Plan”) was assumed by the Company in connection with the America Online-Historic TW Merger. Under the International Plan, shares of restricted stock may be awarded to certain employees of the Company and its subsidiaries whose place of employment at the time of award is, in whole or in significant part, in jurisdictions outside the United States. Awards of restricted stock under the International Plan vest in amounts and at times designated at the time of award. Awards of restricted stock under the International Plan are subject to restrictions on transfer and forfeiture prior to vesting. As of December 31, 2003, 1,051,586 shares were available for issuance under the International Plan.

49


 

      The Time Warner Inc. 1988 Restricted Stock Plan for Non-Employee Directors (the “Directors’ Restricted Stock Plan”) was approved most recently in May 1999 by the stockholders of Historic TW and was assumed by the Company in connection with the America Online-Historic TW Merger. The Directors’ Restricted Stock Plan will terminate on May 19, 2009. The Directors’ Restricted Stock Plan provides for the award each year on the date of the annual stockholders meeting of shares of restricted stock to non-employee directors of the Company with value established by the Board of Directors. The awards of restricted stock vest in equal annual installments on the first four anniversaries of the first day of the month in which the shares were awarded and in full if the director ends his or her service as a director due to (a) mandatory retirement, (b) failure to be re-elected after being nominated, (c) death or disability, (d) the occurrence of certain transactions involving a change in control of the Company and (e) with the approval of the Board of Directors on a case-by-case basis, under certain other designated circumstances. If a non-employee director leaves the Board for any other reason, then his or her unvested restricted stock is forfeited to the Company.

      The Time Warner Inc. Employee Stock Purchase Plan (the “ESPP”) was approved most recently in October 1998 by the stockholders of America Online and was assumed by the Company in connection with the America Online-Historic TW Merger. Under the ESPP, employees of America Online and certain subsidiaries of America Online may purchase shares of the Company’s Common Stock at a 15% discount from the fair market value of the Common Stock at the beginning or end of a six-month participation period, whichever is lower. The purchases are made through payroll deductions during the participation period and are subject to annual limits.

PART IV

Item 15.     Exhibits, Financial Statements Schedules, and Reports On Form 8–K

      (a)(1)-(2) Financial Statements and Schedules:

        (i) The list of consolidated financial statements and schedules set forth in the accompanying Index to Consolidated Financial Statements and Other Financial Information at page F-1 herein is incorporated herein by reference. Such consolidated financial statements and schedules are filed as part of this report.
 
        (ii) All other financial statement schedules are omitted because the required information is not applicable, or because the information required is included in the consolidated financial statements and notes thereto.

      (3) Exhibits:

      The exhibits listed on the accompanying Exhibit Index are filed or incorporated by reference as part of this report and such Exhibit Index is incorporated herein by reference. Exhibits 10.1 through 10.26 listed on the accompanying Exhibit Index identify management contracts or compensatory plans or arrangements required to be filed as exhibits to this report, and such listing is incorporated herein by reference.

      (b) Reports on Form 8-K:

      The Company filed or furnished the following reports on Form 8-K during the quarter ended December 31, 2003 and in 2004 through March 10, 2004:

                 
Item # Description Date



(i)
    5, 7     Reporting the change of the Company’s name from AOL Time Warner Inc. to Time Warner Inc. (Item 5) and filing the Certificate of Ownership and Merger used to effect such change.   October 16, 2003
 
(ii)
    7, 12     Reporting the Company’s financial results for the quarter ended September 30, 2003 (Items 7 and 12). (The information furnished under Items 7 and 12 is not incorporated by reference into existing or future registration statements filed by the Company).   October 22, 2003

50


 

                 
Item # Description Date



(iii)
    5, 7     Reporting that the Company had entered into an agreement with an investor group to sell the Company’s Warner Music Group business (Item 5) and filing the press release announcing such agreement (Item 7).   November 24, 2003
 
(iv)
    5     Reporting that Time Warner Cable Inc. (“TWC Inc.”) received a notice from Comcast requesting that TWC Inc. commence the registration process under the Securities Act of 1933 for the sale of all of Comcast’s common interests in TWC Inc.   December 29, 2003
 
(v)
    7, 9     Reporting financial and statistical information updated to reflect the Company’s Music segment as a discontinued operation (Items 7 and 9). (The information furnished under Items 7 and 9 is not incorporated by reference into existing or future registration statements filed by the Company).   January 26, 2004
 
(vi)
    7, 12     Reporting the Company’s financial results for the full year and fourth quarter ended December 31, 2003 (Items 7 and 12). (The information furnished under Items 7 and 12 is not incorporated by reference into existing or future registration statements filed by the Company).   January 28, 2004

51


 

SIGNATURES

      Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

  TIME WARNER INC.

  BY:  /s/ WAYNE H. PACE
 
  Name: Wayne H. Pace
  Title: Executive Vice President and
        Chief Financial Officer

Date: March 12, 2004

      Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.

         
Signature Title Date



/s/ RICHARD D. PARSONS

(Richard D. Parsons)
  Director, Chairman of the Board and Chief Executive Officer (principal executive officer)   March 12, 2004
 
/s/ WAYNE H. PACE

(Wayne H. Pace)
  Executive Vice President and
Chief Financial Officer
(principal financial officer)
  March 12, 2004
 
/s/ JAMES W. BARGE

(James W. Barge)
  Sr. Vice President and Controller (principal accounting officer)   March 12, 2004
 
/s/ JAMES L. BARKSDALE

(James L. Barksdale)
  Director   March 12, 2004
 
/s/ STEPHEN F. BOLLENBACH

(Stephen F. Bollenbach)
  Director   March 12, 2004
 
/s/ STEPHEN M. CASE

(Stephen M. Case)
  Director   March 12, 2004
 
/s/ FRANK J. CAUFIELD

(Frank J. Caufield)
  Director   March 12, 2004

52


 

         
Signature Title Date



 
/s/ ROBERT C. CLARK

(Robert C. Clark)
  Director   March 12, 2004
 
/s/ MILES R. GILBURNE

(Miles R. Gilburne)
  Director   March 12, 2004
 
/s/ CARLA A. HILLS

(Carla A. Hills)
  Director   March 12, 2004
 
/s/ REUBEN MARK

(Reuben Mark)
  Director   March 12, 2004
 
/s/ MICHAEL A. MILES

(Michael A. Miles)
  Director   March 12, 2004
 
/s/ KENNETH J. NOVACK

(Kenneth J. Novack)
  Director   March 12, 2004
 


(Franklin D. Raines)
  Director   March  , 2004
 
/s/ R.E. TURNER

(R.E. Turner)
  Director   March 12, 2004
 
/s/ FRANCIS T. VINCENT, JR.

(Francis T. Vincent, Jr.)
  Director   March 12, 2004

53


 

TIME WARNER INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
AND OTHER FINANCIAL INFORMATION
           
Page

Management’s Discussion and Analysis of Results of Operations and Financial Condition
    55  
Consolidated Financial Statements:
       
 
Balance Sheet
    121  
 
Statement of Operations
    122  
 
Statement of Cash Flows
    123  
 
Statement of Shareholders’ Equity
    124  
 
Notes to Consolidated Financial Statements
    125  
Report of Independent Auditors
    199  
Selected Financial Information
    200  
Quarterly Financial Information
    202  
Supplementary Information
    204  
Financial Statement Schedule II — Valuation and Qualifying Accounts
    212  

54


 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION

INTRODUCTION

      Management’s discussion and analysis of results of operations and financial condition (“MD&A”) is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of Time Warner Inc.’s (“Time Warner” or the “Company”) financial condition, changes in financial condition and results of operations. MD&A is organized as follows:

  •  Overview. This section provides a general description of Time Warner’s businesses, as well as recent developments that have occurred either during 2003 or early 2004 that the Company believes are important in understanding the results of operations and financial condition or to anticipate future trends.
 
  •  Results of operations. This section provides an analysis of the Company’s results of operations for the three years ended December 31, 2003. This analysis is presented on both a consolidated and a segment basis. In addition, a brief description is provided of significant transactions and events that impact the comparability of the results being analyzed.
 
  •  Financial condition and liquidity. This section provides an analysis of the Company’s cash flows for the three years ended December 31, 2003, as well as a discussion of the Company’s outstanding debt and commitments, both firm and contingent, that existed as of December 31, 2003. Included in the discussion of outstanding debt is a discussion of the amount of financial capacity available to fund the Company’s future commitments, as well as a discussion of other financing arrangements.
 
  •  Market risk management. This section discusses how the Company manages exposure to potential loss arising from adverse changes in interest rates, foreign currency exchange rates and changes in the market value of investments.
 
  •  Critical accounting policies. This section discusses accounting policies considered important to the Company’s financial condition and results of operations, require significant judgment and require estimates on the part of management in application. In addition, the Company’s significant accounting policies, including the critical accounting policies, are summarized in Note 1 to the accompanying consolidated financial statements.
 
  •  Risk factors and caution concerning forward-looking statements. This section provides a description of risk factors that could adversely affect the operations, business or financial results of the Company or its business segments and how certain forward-looking statements made by the Company in this report, including MD&A and the consolidated financial statements, are based on management’s current expectations about future events, which are inherently susceptible to uncertainty and changes in circumstances.

Use of Operating Income (Loss) before Depreciation and Amortization and Free Cash Flow

      The Company utilizes Operating Income (Loss) before Depreciation and Amortization, among other measures, to evaluate the performance of its businesses. Operating Income (Loss) before Depreciation and Amortization is considered an important indicator of the operational strength of the Company’s businesses. Operating Income (Loss) before Depreciation and Amortization eliminates the uneven effect across all business segments of considerable amounts of non-cash depreciation of tangible assets and amortization of certain intangible assets that were recognized in business combinations. A limitation of this measure, however, is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in the Company’s businesses. Management evaluates the costs of such tangible and intangible assets, the impact of related impairments, as well as asset sales through other financial measures, such as capital expenditures, investment spending and return on capital.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The Company also utilizes Free Cash Flow to evaluate the performance of its businesses. Free Cash Flow is cash provided by continuing operations (as defined by accounting principles generally accepted in the United States) less capital expenditures and product development costs, principal payments on capital leases, dividends paid and partnership distributions, if any. Free Cash Flow is considered to be an important indicator of the Company’s ability to reduce debt and make strategic investments.

      Both Operating Income (Loss) before Depreciation and Amortization and Free Cash Flow should be considered in addition to, not as a substitute for, the Company’s Operating Income (Loss), Net Income (Loss) and various cash flow measures (e.g., Cash Provided by Operations), as well as other measures of financial performance reported in accordance with accounting principles generally accepted in the United States.

OVERVIEW

      Time Warner is the world’s largest media and entertainment company (based on revenues), whose major businesses encompass an array of the most respected and successful media brands. The Company was formed in connection with the merger of America Online, Inc. (“America Online”) and Time Warner Inc., now known as Historic TW Inc. (“Historic TW”), which was consummated on January 11, 2001. Among the Company’s brands are HBO, CNN, AOL, Time, People, Sports Illustrated, Friends, ER and Time Warner Cable, and the Company has made such films as The Lord of the Rings trilogy and the Harry Potter series. As of March 2, 2004, the Company had over 80,000 active employees worldwide. During 2003, the Company generated revenues of approximately $39.6 billion, Operating Income before Depreciation and Amortization of approximately $8.5 billion, Operating Income of approximately $5.4 billion, Cash Flow from Operations of approximately $6.6 billion and Free Cash Flow from continuing operations of approximately $3.3 billion. During 2003, the Company also took significant steps to strengthen its balance sheet and position itself for growth in 2004 — including achieving its net debt (total debt less cash and equivalents) reduction target of approximately $20 billion by March 2004, almost a year ahead of schedule through strong Free Cash Flow generation and the sale of assets, such as the Warner Music Group (“WMG”).

Time Warner Businesses

      Time Warner classifies its businesses into five fundamental areas: AOL, Cable, Filmed Entertainment, Networks and Publishing.

      AOL. AOL is the world’s leader in interactive services with 30.6 million subscribers in the U.S. and Europe at the end of 2003, as well as total revenues of $8.600 billion (21% of the overall Company’s revenues), $1.507 billion in Operating Income before Depreciation and Amortization and $663 million in Operating Income in 2003. AOL generates its revenues primarily from subscription fees charged to subscribers and advertising services rendered.

      Over the past year, AOL’s subscription trends have been in transition. The AOL narrowband (or dial-up) service experienced significant declines in U.S. subscribers, which is expected to continue. Driving this decrease was the continued industry-wide maturing of the premium narrowband business, which is expected to continue, as consumers migrate to high-speed broadband or lower-cost dial-up services. In response, AOL put a new strategy in place, aiming to expand its offerings to reduce its reliance on its traditional narrowband service. It introduced a Bring-Your-Own-Access (“BYOA”) broadband service (AOL FOR BROADBAND) in 2003 and a new lower-cost, dial-up ISP (Netscape Internet Service) in early 2004. In addition, AOL has launched a number of specialized premium services, including a McAfee VirusScan Online product.

      AOL’s advertising revenues declined in 2003, reflecting the continued reduction in benefits from prior period contractual commitments. Management has shifted its focus away from longer term agreements and is

56


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

now focused on more traditional and transaction-based forms of advertising, as both of these areas are expected to grow on an industry-wide basis in 2004.

      AOL expects that its strategic initiatives, as well as its continuing focus on cost management (particularly involving network costs) and continued improvement in its AOL Europe S.A. (“AOL Europe”) operations, will position the business for growth in 2004.

      Cable. Time Warner’s cable business (or Time Warner Cable Inc.) (“TWC Inc.”) is the second-largest cable operator in the U.S. (in terms of subscribers served). TWC Inc. managed 10.919 million basic cable subscribers at the end of 2003 in highly clustered and upgraded systems in 27 states, including New York, Texas, North Carolina and Ohio. TWC Inc. delivered $2.992 billion Operating Income before Depreciation and Amortization, more than any of the Company’s other business segments, and also had revenues of $7.699 billion (19% of the overall Company’s revenues) and $1.531 billion in Operating Income in 2003.

      Time Warner Cable offers three product lines — video, high-speed data and its newest service, voice. Video remains its largest business, but high-speed data has been the fastest growing. The growth of its customer base for basic video cable service is low, as the customer base has matured industrywide and also due to the high rate of penetration and competition from satellite services. In addition, video programming costs, especially for sports, continue to rise across the industry. In advanced video services, TWC Inc. is one of the industry leaders, with digital video, High-Definition or HDTV, Video-on-Demand, Subscription-Video-on-Demand and Digital Video Recorders. Significant digital video penetration provides TWC Inc. with a broad universe of customers for these advanced services.

      High-speed data is TWC Inc.’s fastest-growing business, even though its rate of growth began to slow in 2003, reflecting high penetration rates and increased competition from other distribution technologies.

      The new voice business, Digital Phone, is expected to become available across essentially the entire TWC Inc. footprint by the end of 2004. Digital Phone will enable TWC Inc. to offer its customers for the first time a combined, easy-to-use package of video, high-speed data and voice services and to enable TWC Inc. to compete effectively against similarly bundled offerings expected to be made available by its competitors.

      While TWC Inc. generates its revenues primarily from subscription fees, it also generates revenue by selling advertising time to national and local businesses.

      Filmed Entertainment. Time Warner’s Filmed Entertainment businesses, Warner Bros. Entertainment Group (“Warner Bros.”) and New Line Cinema (“New Line”), generated revenues of $10.967 billion (26% of the overall Company’s revenues), $1.465 billion in Operating Income before Depreciation and Amortization and $1.173 billion in Operating Income in 2003.

      One of the world’s leading studios, Warner Bros., represented about 80% of Filmed Entertainment’s Operating Income before Depreciation and Amortization in 2003. With its film, TV production and video businesses combined with an extensive global distribution infrastructure, Warner Bros. has diversified sources of revenues that have delivered consistent growth in Operating Income before Depreciation and Amortization. The vast majority of New Line’s revenues come from theatrical films and related video revenues. In 2003, it achieved record Operating Income before Depreciation and Amortization, benefiting from the notable success of the Lord of the Rings franchise.

      The sale of DVDs has been the largest driver of the segment’s profit growth over the last few years. Warner Bros.’ industry-leading library, consisting of more than 6,600 theatrical titles and 53,000 live-action and animated television titles position it to capitalize on continuing growth in DVD hardware penetration. Specifically, DVDs continue to generate a growing share of home video revenues, with higher unit margins

57


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

than VHS. With DVD hardware penetration levels worldwide relatively low compared to the penetration of VHS hardware, the Company believes that there is significant opportunity for DVD growth ahead.

      Warner Bros.’ industry-leading television business accounts for about a quarter of its revenues. In the fall of 2003, it had more current production shows on the air than any other studio, with prime-time series on all six broadcast networks (including such hits as Friends, ER, Smallville and The West Wing). Even though this record number of shows requires significant investment in production, the Company believes the cost is warranted due to the potential associated revenue from future syndication opportunities.

      During 2003, piracy continued to be a significant issue for the filmed entertainment industry, especially from online file-sharing, which has expanded from music to movies and television programming due to changes in technology. The Company has taken a variety of actions to combat piracy over the last several years and will continue to do so, both individually and together with industry associations.

      Networks. Time Warner’s Networks group is composed of Turner Broadcasting Systems, Inc. (“Turner”), (the “Turner networks”) networks, Home Box Office (“HBO”) and The WB Network. The segment delivered revenues of $8.434 billion (20% of the overall Company’s revenues), $2.027 billion in Operating Income before Depreciation and Amortization, and $1.809 billion in Operating Income in 2003.

      The Turner networks — including TBS, TNT, CNN, Cartoon Network and CNN Headline News — are among the leaders in advertising-supported cable TV networks. In a shift that has been underway for years, prime-time viewing of all advertising-supported cable television networks surpassed, for the first time in 2003, the aggregate share for the major broadcast networks. For 2003, TNT and TBS ranked first and second in ratings in their key demographics, adults 18-49.

      The Turner networks generate revenue principally from the sale of advertising time and monthly subscriber fees paid by cable system operators, satellite companies and other affiliates. Turner has benefited from strong ratings and a growing advertising opportunity in the latter months of 2003. Keys to Turner’s success are its continued investments in high-quality programming, focused on kids, sports, series, movies and news, as well as brand leverage and operating efficiency.

      HBO operates the HBO and Cinemax multichannel pay television programming services, with the HBO service being the nation’s most widely distributed pay television network. HBO generates revenues principally from monthly subscriber fees from cable system operators, satellite companies and other affiliates. An additional source of revenues is from DVD sales of its original programming (including The Sopranos, Sex and the City, Six Feet Under and Band of Brothers).

      The WB Television Network (“The WB Network”) is a broadcast television network whose target audience is adults in the 18-34 age group demographic. The WB Network generates revenues almost exclusively from the sale of advertising time. Like its broadcast network competitors, in the fall of 2003, The WB Network experienced a decline in its audience of young adults. Because this is The WB Network’s target demographic, the loss had a proportionally larger effect on its overall audience delivery. Among other measures, The WB Network now is developing new programming aimed at expanding its appeal to younger viewers.

      Publishing. Time Warner’s Publishing segment (or Time Inc.) consists principally of interests in magazine publishing and book publishing. The segment generated revenues of $5.533 billion (14% of the overall Company’s revenues), $955 million in Operating Income before Depreciation and Amortization and $664 million in Operating Income in 2003.

      Time Inc. publishes more than 130 magazines including Time, People, Sports Illustrated, Entertainment Weekly, Southern Living, In Style, Fortune, Money, Real Simple and Cooking Light. It generates revenues primarily from magazine circulation, newsstand sales and advertising, and drives growth through higher

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

circulation and advertising, acquisitions and the launch of new magazines. In recent years, Time Inc. has acquired IPC Media (the U.K.’s largest magazine company), magazine subscription marketer Synapse Group Inc. and Time4Media (previously Times Mirror Magazines), a leading publisher of leisure-time magazines. In addition, Time Inc. is continuing to invest in new magazine launches, including four launches planned for 2004. Its direct-selling division, Southern Living At Home, sells home decor products through approximately 32,000 independent consultants at parties hosted in people’s homes throughout the United States.

      Time Inc. experienced a decline in Operating Income before Depreciation and Amortization in 2003 due primarily to losses at its former Time Life direct-marketing business, higher pension costs and continued softness in print advertising. Despite the softness in advertising, Time Inc.’s core magazine business has maintained its industry-leading domestic advertising share of almost 25%. With the sale of Time Life on December 31, 2003, and lower expected pension costs, among other factors, the Company expects Time Inc. to grow Operating Income before Depreciation and Amortization in 2004.

      Time Warner Book Group’s Warner Books and Little, Brown and Company offer a full range of titles spanning entertainment, literature and informative non-fiction. In 2003, Time Warner Book Group placed 50 titles on the New York Times bestsellers list, including Michael Moore’s Dude, Where’s My Country?, James Patterson’s The Lake House and Nicholas Sparks’s The Guardian.

Other Key 2003 Developments

 
Discontinued Operations Presentation of Music Segment

      On March 1, 2004, the Company closed on its previously announced agreement to sell the WMG recorded music and music publishing operations to a private investment group (“the investment group”) for approximately $2.6 billion in cash and an option to re-acquire a minority interest in the operations to be sold. In addition, on October 24, 2003, the Company completed the sale of WMG’s CD and DVD manufacturing, printing, packaging and physical distribution operations (together, “Warner Manufacturing”) to Cinram International Inc. (“Cinram”) for approximately $1.05 billion in cash (Note 5).

      With the completion of these transactions, the Company has disposed of its entire Music segment. Accordingly, the Company has presented the financial condition and results of operations of the Music segment as discontinued operations for all periods presented. Additionally, for 2003, the results of the discontinued operations include a pretax gain of approximately $560 million related to the sale of Warner Manufacturing and a pretax non-cash loss of approximately $1.1 billion related to the write-down of the WMG recorded music and music publishing net assets to their estimated fair value less costs to sell.

Debt Reduction Program

      In January 2003, the Company announced its intention to reduce its overall level of indebtedness. Specifically, the Company indicated its intention was to reduce consolidated net debt (defined as total debt less cash and cash equivalents) to within a range of 2.25 to 2.75 times annual Operating Income before Depreciation and Amortization, excluding writedowns for the impairment of intangible assets and gains and losses on asset disposals (its “leverage ratio”) by the end of 2003 and to reduce total consolidated net debt to approximately $20 billion by the end of 2004.

      At the end of 2003, the Company’s net debt totaled $22.7 billion (a leverage ratio of 2.58), down from $25.8 billion at December 31, 2002, as described in more detail under “Financial Condition and Liquidity.” With the receipt of the $2.6 billion in cash upon the closing of the sale of the Company’s recorded music and music publishing businesses, the Company reduced its net debt to approximately $20 billion and achieved its previously announced net debt reduction target almost a full year ahead of schedule.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Microsoft Settlement

      On January 22, 2002, Netscape Communications Corporation (“Netscape”) sued Microsoft Corporation (“Microsoft”) in the U. S. District Court for the District of Columbia for antitrust violations under Sections 1 and 2 of the Sherman Act, as well as for other common law violations.

      On May 29, 2003, Microsoft and Time Warner announced an agreement to settle the pending litigation between Microsoft and Netscape and to collaborate on long-term digital media initiatives that will accelerate the adoption of digital content (the “Microsoft Settlement”). As part of the settlement, Microsoft agreed to pay $750 million to Time Warner and Time Warner agreed to release Microsoft from the Netscape action and related antitrust claims. In addition, Microsoft agreed to a variety of steps designed to ensure that Microsoft and AOL products work better with each other, including giving AOL the same access to early builds of the Microsoft Windows operating system as Microsoft affords to other third parties, as well as providing AOL with seven years of dedicated support by Microsoft engineers who have access to Windows source code, to help AOL with compatibility and other engineering efforts. The digital media initiatives also established a long-term, non-exclusive license agreement allowing Time Warner the right, but not the obligation, to use Microsoft’s entire Windows Media 9 Series digital media platform, as well as successor Microsoft digital rights management software. Microsoft also agreed to provide AOL with a new distribution channel for its software to certain PC users worldwide. Finally, as part of this settlement, Microsoft agreed to release Time Warner from the obligation to reimburse Microsoft’s attorneys fees in connection with an arbitration ruling under a 1996 distribution agreement. The Company estimates that the fair value of the non-cash element received in the Microsoft settlement amounted to $10 million, resulting in a total gain of $760 million.

Sale of Time Life

      In December 2003, the Company sold its Time Life operations, a direct-marketing business, to Direct Holdings Worldwide LLC (“Direct Holdings”), a venture of Ripplewood Holdings LLC and ZelnickMedia Corporation. Under the terms of the transaction, the Company did not receive any cash consideration. Instead the Company received a contingent consideration arrangement under which it will receive payments in the future if the business sold meets certain performance targets. In connection with the transaction, the Company recognized a loss of $29 million, which is included as a component of operating income (loss) in the accompanying consolidated statement of operations. In 2003, Time Life had revenues of $352 million, an Operating Loss before Depreciation and Amortization of $72 million and an Operating Loss of $82 million.

Sale of Winter Sports Teams

      In September 2003, the Company reached a definitive agreement to sell an 85% interest in the Turner winter sports teams (the Atlanta Thrashers, an NHL team, and the Atlanta Hawks, an NBA team) and operating rights to Philips Arena, an Atlanta sports and entertainment venue. This transaction is expected to close in the first quarter of 2004. In 2003, the winter sports teams and Philips Arena had revenues of $169 million, Operating Loss before Depreciation and Amortization of $35 million and Operating Loss of $37 million.

SEC and DOJ Investigations

      The Securities and Exchange Commission (“SEC”) and the Department of Justice (“DOJ”) continue to conduct investigations into accounting and disclosure practices of the Company. Those investigations have focused on transactions principally involving the Company’s America Online segment that were entered into after July 1, 1999, including advertising arrangements and the methods used by the America Online segment to report its subscriber numbers.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The Company itself had commenced an internal review under the direction of the Company’s Chief Financial Officer into advertising transactions at the America Online segment (“CFO review”) during 2002. As a result of the CFO review, the Company announced on October 23, 2002 that it intended to adjust the accounting for certain transactions. The adjustment had an aggregate impact of reducing the advertising and commerce revenues of the Company during the period from the third quarter of 2000 through the second quarter of 2002 by $190 million. On January 28, 2003, the Company filed amendments to its Annual Report on Form 10-K/ A for the year ended December 31, 2001 and its Quarterly Report on Form 10-Q for the quarters ended March 31, 2002 and June 30, 2002 that included restated financial statements reflecting the adjustments announced on October 23, 2002. Although the Company has continued its CFO review process, the Company has not, to date, determined that any further restatement is necessary.

      In its Annual Report on Form 10-K for the year ended December 31, 2002, the Company disclosed that the staff of the SEC had recently informed the Company that, based on information provided to the SEC by the Company, it was the preliminary view of the SEC staff that the Company’s accounting for two related transactions between America Online and Bertelsmann, A.G., (“Bertelsmann”) should be adjusted. For more detail on the transactions, see Note 18, “Commitments and Contingencies — Contingencies — SEC and DOJ Investigations.” At the time, the Company further disclosed that it had provided the SEC a written explanation of the basis for the Company’s accounting for the transactions and the reasons why both the Company and its auditors continued to believe that the transactions had been accounted for correctly.

      The SEC staff has continued to review the Company’s accounting for these transactions, including the Company’s written and oral submissions to the SEC. In July 2003, the SEC’s Office of the Chief Accountant informed the Company that it has concluded that the accounting for these transactions is incorrect. Specifically, in the view of the Office of the Chief Accountant, the Company should have allocated some portion of $400 million paid by Bertelsmann to America Online for advertising, which was run by the Company and recognized as revenue, as consideration for the Company’s decision to relinquish its option to pay Bertelsmann in stock for its interests in AOL Europe, and, therefore, such portion of the payment should have been reflected as a reduction in the purchase price for Bertelsmann’s interest in AOL Europe, rather than as advertising revenue. In addition, the SEC’s Division of Enforcement continues to investigate the facts and circumstances of the negotiation and performance of these agreements with Bertelsmann, including the value of advertising provided thereunder.

      Based upon its knowledge and understanding of the facts of these transactions, the Company and its auditors continue to believe its accounting for these transactions is appropriate. It is possible, however, that the Company may learn information as a result of its ongoing review, discussions with the SEC, and/or the SEC’s ongoing investigation that would lead the Company to reconsider its views of the accounting for these transactions. It is also possible that restatement of the Company’s financial statements with respect to these transactions may be necessary. In light of the conclusion of the Office of the Chief Accountant that the accounting for the Bertelsmann transactions is incorrect, it is likely that the SEC would not declare effective any registration statement of the Company or its affiliates, such as the potential initial public offering of TWC Inc., until this matter is resolved.

      The SEC staff also continues to investigate a range of other transactions principally involving the Company’s America Online segment, including advertising arrangements and the methods used by the America Online segment to report its subscriber numbers. The DOJ also continues to investigate matters relating to these transactions and transactions involving certain third parties with whom America Online had commercial relationships. The Company intends to continue its efforts to cooperate with both the SEC and the DOJ investigations to resolve these matters. The Company may not currently have access to all relevant information that may come to light in these investigations, including but not limited to information in the possession of third parties who entered into agreements with America Online during the relevant time period. It is not yet possible to predict the outcome of these investigations, but it is possible that further restatement of

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

the Company’s financial statements may be necessary. It is also possible that, so long as there are other unresolved issues associated with the Company’s financial statements, the effectiveness of any registration statement of the Company or its affiliates may be delayed.

TWE Restructuring

      Prior to the restructuring discussed below, a majority of Time Warner’s interests in the Filmed Entertainment and Cable segments, and a portion of its interests in the Networks segment, were held through Time Warner Entertainment Company, L.P. (“TWE”). Time Warner owned general and limited partnership interests in TWE consisting of 72.36% of the pro rata priority capital and residual equity capital and 100% of the junior priority capital. The remaining 27.64% limited partnership interests in TWE were held by subsidiaries of Comcast Corporation (“Comcast”).

      On March 31, 2003, Time Warner and Comcast completed the restructuring of TWE (the “TWE Restructuring”). As a result of the TWE Restructuring, Time Warner acquired complete ownership of TWE’s content businesses, including Warner Bros., HBO, and TWE’s interests in The WB Network, Comedy Central and the Courtroom Television Network (“Court TV”). Additionally, all of Time Warner’s interests in the Cable segment, including those that were wholly-owned and those that were held through TWE, are now controlled by a new subsidiary of Time Warner called TWC Inc. As part of the TWE Restructuring, Time Warner received a 79% economic interest in TWC Inc.’s cable systems. TWE is now a subsidiary of TWC Inc.

      In exchange for its previous stake in TWE, Comcast: (i) received Time Warner preferred stock, which will be converted into $1.5 billion of Time Warner common stock; (ii) received a 21.0% economic interest in TWC Inc.’s cable systems; and (iii) was relieved of $2.1 billion of pre-existing debt at one of its subsidiaries, which was assumed by TWC Inc. as part of the TWE Restructuring.

      Comcast’s 21% economic interest in TWC Inc.’s cable business is held through a 17.9% direct common 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. Time Warner’s 79% economic interest in TWC Inc.’s cable business is held through an 82.1% common ownership interest in TWC Inc. (representing an 89.3% voting interest) and a limited partnership interest in TWE representing a 1% residual equity interest. Time Warner also holds a $2.4 billion mandatorily redeemable preferred equity interest in TWE. The additional ownership interests acquired by Time Warner in the TWE Restructuring have been accounted for as a step acquisition and are reflected in the accompanying consolidated balance sheet as of December 31, 2003. The purchase price allocation is preliminary, however, the Company does not expect the final allocation of the purchase price to differ materially from the amounts included in the consolidated financial statements.

      On December 29, 2003, TWC Inc. received a notice from Comcast requesting that TWC Inc. start the registration process under the Securities Act of 1933 for the sale in a firm underwritten offering of Comcast’s 17.9% common interest in TWC Inc. The notice was delivered pursuant to a registration rights agreement related to the TWC Inc. securities. The Company cannot predict the timing of an effective registration in response to the notice. The Company is not required to purchase Comcast’s shares.

RESULTS OF OPERATIONS

Transactions Affecting Comparability of Results of Operations

      The comparability of the Company’s results of operations, financial position and cash flows has been affected by certain new accounting principles adopted by the Company and certain significant transactions occurring during each period as discussed further below.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

New Accounting Principles

      The Company adopted new accounting guidance that impacted comparability in several areas as follows:

Consolidation of Variable Interest Entities

      In January 2003, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 46, “Consolidation of Variable Interest Entities — an Interpretation of ARB No. 51” (“FIN 46”), which requires variable interest entities (“VIEs”), often referred to as special purpose entities or “SPEs,” to be consolidated if certain criteria are met. FIN 46 was effective upon issuance for all VIEs created after January 31, 2003, and effective July 1, 2003, for VIEs that existed prior to February 1, 2003. During 2003, the FASB delayed the required implementation date of FIN 46 for entities that are not SPEs until March 31, 2004.

      The Company has adopted the provisions of FIN 46, effective July 1, 2003, for those VIEs representing lease-financing arrangements with SPEs. Specifically, the Company has utilized SPEs on a limited basis, primarily to finance the cost of certain aircraft and property, including the Company’s new corporate headquarters at Columbus Circle in New York City and a new productions and operations support center for the Turner networks in Atlanta. As a result of initially applying the provisions of FIN 46 to its lease-financing arrangements with SPEs as of July 1, 2003, the Company consolidated net assets and associated debt of approximately $700 million and recorded a $12 million charge, net of tax, as the cumulative effect of adopting this new standard. A majority of the $700 million in debt was subsequently paid off.

      The Company has elected to defer the adoption of FIN 46 until March 31, 2004, for its equity investments and joint venture arrangements that may be considered VIEs and require consolidation pursuant to FIN 46. The Company has finalized its analysis of the application of FIN 46 to all equity investments and joint ventures and has determined that the application of FIN 46 to the Company’s equity investments and joint venture arrangements as of March 31, 2004, will result in the consolidation of the Company’s investment in America Online Latin America, Inc. (“AOLA”). The Company does not believe that such consolidation will have a material impact on its financial position or results of operations. The Company does not have any obligation to provide funding for AOLA’s operations.

Certain Financial Instruments with Characteristics of Both Liabilities and Equity

      In May 2003, the FASB issued Statement of Financial Accounting Standards (“Statement”) No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity” (“FAS 150”) (Note 1). FAS 150 requires that an issuer classify certain financial instruments as a liability because that financial instrument embodies an obligation of the issuer. The remaining provisions of FAS 150 expand the definition of a liability to encompass certain obligations that a reporting entity can or must settle by issuing its own equity, depending on the nature of the relationship between the holder and the issuer. FAS 150 became effective for Time Warner in the third quarter of 2003 except for the provisions related to certain mandatorily redeemable noncontrolling interests which has been deferred indefinitely as a result of Financial Staff Position 150-3. The adoption of the provisions of FAS 150 required the Company to reclassify $1.5 billion of mandatorily convertible preferred stock issued to Comcast in connection with the TWE Restructuring from shareholders’ equity to liabilities in the accompanying consolidated balance sheet.

Goodwill and Other Intangible Assets

      Effective January 2002, the Company adopted FASB Statement No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”) (Note 1). FAS 142 required that 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, effective January 1, 2002.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      FAS 142 also required that goodwill and certain intangible assets be assessed for impairment annually using fair value measurement techniques. Pursuant to the adoption of FAS 142, during the first quarter of 2002, the Company recorded a $54.235 billion non-cash charge for the impairment of goodwill, which is recorded as a cumulative effect of an accounting change in the accompanying consolidated statement of operations. During the fourth quarter of 2002, the Company performed its annual impairment review for goodwill and other intangible assets and recorded an additional non-cash pretax charge of $44.039 billion, which is recorded as a component of operating income (loss) in the accompanying consolidated statement of operations. As more fully discussed below, during 2003, the Company recognized $318 million of impairment changes of goodwill and intangible assets for the winter sports teams and Time Warner Book Group. The 2003 annual impairment review for goodwill and intangible assets did not result in any impairment charges being recorded.

Significant Transactions and Other Items Affecting Comparability

      As more fully described herein and in the related footnotes to the accompanying consolidated financial statements, the comparability of Time Warner’s results from continuing operations has been affected by certain significant transactions and other items in each period as follows:

                         
Year Ended December 31,

2003 2002 2001



(millions)
Merger and restructuring costs
  $ (109 )   $ (327 )   $ (214 )
Impairment of goodwill and intangible assets
    (318 )     (44,039 )      
Net gain on disposal of consolidated businesses
    14       6        
     
     
     
 
Impact on Operating Income
    (413 )     (44,360 )     (214 )
Microsoft Settlement
    760              
Gains on sale of investments
    797       124        
Investment write-downs
    (204 )     (2,199 )     (2,528 )
     
     
     
 
Impact on other income (expense), net
    1,353       (2,075 )     (2,528 )
     
     
     
 
Pretax impact
    940       (46,435 )     (2,742 )
Income tax impact
    (394 )     958       1,096  
     
     
     
 
After-tax impact
  $ 546     $ (45,477 )   $ (1,646 )
     
     
     
 

Merger and Restructuring Costs

      Merger and restructuring costs consist of charges related to mergers, employee terminations and exit activities, which are expensed in accordance with accounting principles generally accepted in the U.S. During the year ended December 31, 2003, the Company incurred restructuring costs related to various employee and contractual lease terminations of $109 million, including $52 million at AOL, $15 million at Cable, $21 million at Networks and $21 million at Publishing. Excluding $9 million of restructuring costs at Publishing related to Time Life, which was sold in December 2003, the 2003 restructurings are anticipated to generate approximately $100 million in annual savings. During the year ended December 31, 2002, the Company incurred restructuring costs of $327 million, including $266 million at AOL, $15 million at Cable and $46 million at Corporate. During the year ended December 31, 2001, the Company incurred restructuring costs of $214 million, including $201 million at AOL and $13 million at Corporate.

      The 2003 costs include $64 million related to workforce reductions and $45 million related to various contractual and lease terminations, primarily at the AOL and Networks segments. The 2002 costs included

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

$92 million related to workforce reductions and $131 million for the termination of the AOL segment’s lease obligations for network modems that are no longer being used because network providers have upgraded their networks to a newer technology. The remaining $104 million primarily related to contractual termination obligations for items such as lease termination payments and other facility exit costs. The merger and restructuring costs of $214 million in 2001 related to $134 million of employee terminations at the AOL segment and $80 million of other exit costs, including contractual terminations for various leases and contractual commitments for terminated products (e.g., the termination of the iPlanet alliance with Sun Microsystems, Inc.). These costs are included in “Merger and Restructuring Costs” in the accompanying consolidated statement of operations and are discussed in more detail in Note 3 to the accompanying consolidated financial statements.

Impairment of Goodwill and Intangible Assets

      During the year ended December 31, 2003, the Company’s results from continuing operations included $318 million of non-cash impairment charges, including $219 million related to intangible assets of the winter sports teams at the Networks segment and $99 million at the Publishing segment related to goodwill and intangible assets of the Time Warner Book Group. These impairment amounts are included in operating income (loss) in the accompanying 2003 consolidated statement of operations (Note 1).

      In the fourth quarter of 2003, the Company performed its annual impairment review for goodwill and intangible assets. The 2003 annual impairment review for goodwill and intangible assets did not result in any impairment charges being recorded. The 2002 annual impairment review resulted in a non-cash charge of $44.039 billion, which was recorded as a component of operating income (loss) in the accompanying consolidated statement of operations. The $44.039 billion included charges to reduce the carrying value of goodwill at the AOL segment ($33.489 billion) and the Cable segment ($10.550 billion) (Note 2).

Net Gain on Disposal of Consolidated Businesses

      During the year ended December 31, 2003, the Company’s results from continuing operations included recognized $14 million of net gains from the sale of certain consolidated businesses, including a $43 million gain on the sale of its interest in a U.K. cinema chain, which previously had been consolidated by the Filmed Entertainment segment, partially offset by a loss of $29 million on the sale of Time Life at the Publishing segment. During the year ended December 31, 2002, the Company recognized a $6 million gain on the sale of certain consolidated cable television systems at TWE. These gains are included in operating income (loss) in the accompanying consolidated statement of operations.

Microsoft Settlement

      As more fully described above, during 2003, Time Warner recognized a gain as a result of the Microsoft Settlement of approximately $760 million, which is included as a component of “Other income (expense), net,” in the consolidated statement of operations (Note 8).

Gains on Sale of Investments

      For the year ended December 31, 2003, the Company recognized $797 million of net gains from the sale of investments, including a $513 million gain from the sale of the Company’s interest in Comedy Central, a $52 million gain from the sale of the Company’s interest in chinadotcom, a $50 million gain from the sale of the Company’s interest in Hughes Electronics Corp. (“Hughes”) and gains of $66 million on the sale of the Company’s equity interests in international cinema chains not previously consolidated (Note 7).

      For the year ended December 31, 2002, the Company recognized investment gains of $124 million, including a $59 million gain from the sale of a portion of the Company’s interest in The Columbia House

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Company Partnerships and a $31 million gain on the redemption of approximately 1.6 million shares of preferred stock of TiVo Inc. (Note 7).

      These gains are included as a component of “Other income (expense), net” in the accompanying consolidated statement of operations.

Investment Write-Downs

      For the year ended December 31, 2003, non-cash pretax charges to reflect other-than-temporary declines in the Company’s investments were $204 million. These amounts consisted of $212 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, offset in part by $8 million of gains to reflect market fluctuations in equity derivative instruments. Included in the 2003 charge were a writedown of $77 million related to the Company’s 40.3% interest in AOL Japan and a $71 million writedown related to the Company’s 49.8% interest in n-tv KG (“NTV-Germany”), a German news broadcaster (Note 7).

      For the year ended December 31, 2002, non-cash pretax charges to reflect other-than-temporary declines in the Company’s investments were $2.199 billion. These amounts consisted of $2.212 billion to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, offset in part by $13 million of gains to reflect market fluctuations in equity derivative instruments. Included in the $2.212 billion charge relating to other-than-temporary declines in value were non-cash pre-tax charges to reduce the carrying value of the Company’s investments in Time Warner Telecom Inc. (“Time Warner Telecom”) by $796 million, Hughes by $505 million, Gateway, Inc. (“Gateway”) by $140 million, AOLA by $131 million and certain unconsolidated cable television system joint ventures by $420 million (Note 7).

      For the year ended December 31, 2001, non-cash pretax charges to reflect other-than-temporary declines in the Company’s investments were $2.528 billion. These amounts consisted of $2.479 billion to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value and $49 million to reflect market fluctuations in equity derivative instruments. Included in the $2.479 billion charge relating to other-than-temporary declines in value were non-cash pre-tax charges to reduce the carrying value of the Company’s investments in Time Warner Telecom by $1.2 billion, Hughes by $270 million and Gateway by $186 million (Note 7).

      These writedowns are included as a component of “Other income (expense), net” in the accompanying consolidated statement of operations.

Significant Transactions in 2002 and Late 2001 Affecting Comparability

      Time Warner’s results for 2002 were impacted by the following significant transactions that cause them not to be comparable to the results reported in 2001.

  •  AOL Europe. On January 31, 2002, Time Warner acquired 80% of Bertelsmann’s 49.5% interest in AOL Europe for $5.3 billion in cash and on July 1, 2002, acquired the remaining 20% of Bertelsmann’s interest for $1.45 billion in cash (Note 5). In connection with amendments to this transaction, the Company entered into an agreement with Bertelsmann to expand its advertising relationship (Note 17). The Company began consolidating the results of AOL Europe retroactive to the beginning of 2002.
 
  •  Road Runner. In August 2002, Time Warner’s Cable segment acquired the Advance/ Newhouse Partnership’s 17% indirect attributable ownership interest in Road Runner, increasing the Company’s fully attributed ownership to approximately 82% (Note 6). As permitted under accounting principles generally accepted in the U.S., the Company consolidated the results of Road Runner retroactive to the beginning of 2002.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

  •  IPC Group Limited (“IPC”). In October 2001, Time Warner’s Publishing segment acquired IPC, the parent company of IPC Media, from Cinven, a European private equity firm, for approximately $1.6 billion (Note 5). The Company began consolidating the results of IPC on October 1, 2001.

2003 vs. 2002

      Revenues. Consolidated revenues increased 6% to $39.565 billion in 2003 from $37.314 billion in 2002. As shown below, these increases were led by growth in Subscription and Content revenues, offset in part by declines in Advertising and Other revenues:

                         
Year Ended December 31,

2003 2002 % Change



(millions)
Subscription
  $ 20,448     $ 18,959       8 %
Advertising
    6,182       6,299       (2 )%
Content
    11,446       10,216       12 %
Other
    1,489       1,840       (19 )%
     
     
         
Total revenues
  $ 39,565     $ 37,314       6 %
     
     
         

      The increase in Subscription revenues was driven principally by increases at the Cable segment due primarily to the continued deployment of new services and higher rates; at the AOL segment primarily related to the favorable changes in foreign currency exchange rates and increases in subscriber rates outside the U.S.; at the Networks segment primarily driven by higher subscription rates at both Turner and HBO and an increase in the number of subscribers at Turner; and at the Publishing segment due to lower subscription agent commissions (which are netted against revenue) and the favorable effects of foreign currency translation.

      Advertising revenues decreased primarily as a result of declines at the AOL segment, due principally to the decline in the current benefit from prior period contract sales, and the Cable segment, due to a decrease in program vendor advertising. These declines were partially offset by growth at the Networks segment resulting from improved CPMs (advertising cost per one thousand viewers) and ratings that benefited Turner’s domestic entertainment networks and The WB Network.

      The increase in Content revenues related primarily to the Filmed Entertainment segment, due to the worldwide box office success of The Matrix and The Lord of the Rings franchises, higher worldwide DVD revenues and higher television network license fees, and at the Networks segment, due to HBO’s first quarter 2003 home video release of My Big Fat Greek Wedding and, to a lesser extent, higher ancillary sales of HBO programming and licensing and syndication revenue associated with Everybody Loves Raymond.

      The decline in Other revenues was due primarily to the AOL segment’s decision to reduce the promotion of its merchandise business (i.e., reducing pop-up advertisements) to improve the member experience. Other revenues were also reduced, due to the sale of the Company’s interest in a consolidated U.K. cinema chain at the Filmed Entertainment segment in the second quarter of 2003.

      Each of the revenue categories is discussed in greater detail by segment under the “Business Segment Results” section below.

      Cost of Revenues. For the years ended December 31, 2003 and 2002, cost of revenues as a percentage of revenues approximated 59% in both years. Increases in the percentage at Cable (higher programming and depreciation costs) were offset by decreases at AOL (lower network costs) and Filmed Entertainment (overall higher margin films in 2003).

67


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Selling, General and Administrative Expenses. Selling, general and administrative costs as a percentage of revenues increased from 24% for the year ended December 31, 2002, to 25% for the year ended December 31, 2003. These increases were driven primarily by AOL and Cable, which had higher personnel and marketing costs associated with the rollout of new products and services.

Reconciliation of Operating Income (Loss) before Depreciation and Amortization to Operating Income and Net Income (Loss).

      The following table reconciles Operating Income (Loss) before Depreciation and Amortization to Operating Income (Loss). In addition, the table provides the components from Operating Income (Loss) to Net Income (Loss) for purposes of the discussions that follow:

                         
Year Ended December 31,

2003 2002 Change



(millions)
Operating Income (Loss) before Depreciation and Amortization
  $ 8,505     $ (35,791 )     NM  
Depreciation
    (2,500 )     (2,206 )     13 %
Amortization
    (640 )     (557 )     15 %
     
     
         
Operating Income (Loss)
    5,365       (38,554 )     NM  
Interest expense, net
    (1,844 )     (1,758 )     5 %
Other expense, net
    1,210       (2,447 )     NM  
Minority interest expense
    (214 )     (278 )     (23 )%
     
     
         
Income (loss) before income taxes, discontinued operations and cumulative effect of accounting change
    4,517       (43,037 )     NM  
Income tax provision
    (1,371 )     (412 )     233 %
     
     
         
Income (loss) before discontinued operations and cumulative effect of accounting change
    3,146       (43,449 )     NM  
Discontinued operations
    (495 )     (1,012 )     (51 )%
Cumulative effect of accounting change
    (12 )     (54,235 )     NM  
     
     
         
Net income (loss)
  $ 2,639     $ (98,696 )     NM  
     
     
         

      Operating Income (Loss) before Depreciation and Amortization. Operating Income (Loss) before Depreciation and Amortization improved to $8.505 billion in 2003 from a loss of $35.791 billion in 2002.

      Included in these results were several items affecting comparability, including impairments of goodwill and intangible assets, net gains on the disposition of consolidated businesses and merger and restructuring costs, as previously discussed under Significant Transactions and Other Items Affecting Comparability noted above. Excluding these items from both periods, Operating Income (Loss) before Depreciation and Amortization in 2003 increased (from $8.569 billion to $8.918 billion) as a result of improvements at the Cable, Filmed Entertainment and Networks segments, offset in part by declines at the AOL and Publishing segments. The segment results are discussed below in detail under “Business Segment Results.” Also impacting Operating Income before Depreciation and Amortization is an increase in the Corporate Operating Loss before Depreciation and Amortization.

      Corporate Operating Loss before Depreciation and Amortization. Time Warner’s Corporate Operating Loss before Depreciation and Amortization increased to $424 million in 2003 from $398 million in 2002. Included in these amounts are legal and other professional fees related to the SEC and DOJ investigations into the Company’s accounting and disclosure practices and the defense of various shareholder lawsuits ($54 mil-

68


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

lion incurred in 2003 compared to $28 million in 2002). It is not yet possible to predict the outcome of these investigations, and costs are expected to continue to be incurred in future periods. 2002 also included $46 million of restructuring charges, which primarily related to severance costs. In addition, 2003 includes higher compensation costs primarily related to incentive compensation plans.

      The Company expects to incur charges of approximately $50 to $60 million, primarily in the first quarter of 2004, associated with the relocation from the current corporate headquarters. Approximately half of the expected charge represents a non-cash write-off of the fair value lease adjustment for the current corporate headquarters, which was established in purchase accounting at the time of the America Online-Historic TW Merger.

      Depreciation Expense. Depreciation expense increased to $2.500 billion in 2003 from $2.206 billion in 2002 principally due to increases at the Cable and AOL segments. For Cable, as a result of an increase in the amount of capital spending on customer premise equipment in recent years, a larger portion of the Cable segment’s property, plant and equipment consisted of assets with shorter useful lives in 2003 than in 2002. Additionally, the Cable division completed the upgrades of its cable systems in mid-2002. Depreciation expense related to these shorter-lived assets, coupled with incremental depreciation expense on the upgraded cable systems, has resulted in the increase in overall depreciation expense.

      For the AOL segment, the higher expense was due to an increase in network assets acquired under capital leases, offset by an approximate $60 million decrease in depreciation in the fourth quarter of 2003, to reduce excess depreciation inadvertently recorded at AOL over several years prior to 2003. This adjustment is reflected as a reduction of depreciation expense recorded in “selling, general and administrative” expenses (approximately $30 million) and “cost of revenues” (approximately $30 million) in the accompanying consolidated statement of operations. Management does not believe that the understatement of prior years results were material to any of the applicable year’s financial statements. Similarly, management does not believe that the adjustment made is material to current period results.

      Amortization Expense. Amortization expense increased to $640 million in 2003 from $557 million in 2002. The increase relates principally to an increase in the carrying values and related amortization of film library assets at Filmed Entertainment and customer related intangible assets at Cable as a result of the TWE Restructuring.

      Operating Income (Loss). Time Warner’s Operating Income (Loss) increased from a loss of $38.554 billion in 2002 to income of $5.365 billion in 2003. This reflects the increase in business segment Operating Income (Loss) before Depreciation and Amortization, partially offset by an increase in depreciation and amortization expense.

      Interest Expense, Net. Interest expense, net, increased to $1.844 billion in 2003 from $1.758 billion in 2002, due primarily to a change in the mix of debt from lower rate short-term floating rate debt to higher rate long-term fixed rate debt, as well as lower interest income resulting from the conversion of Hughes preferred stock to common stock during 2002. This was offset in part by lower average rates in 2003 on floating rate debt.

69


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Other Income (Expense), Net. Other income (expense), net, detail is shown in the table below:

                 
Year Ended
December 31,

2003 2002


(millions)
Investment-related gains
  $ 797     $ 124  
Loss on writedown of investments
    (204 )     (2,199 )
Microsoft Settlement
    760        
Losses from equity investees
    (97 )     (312 )
Other
    (46 )     (60 )
     
     
 
Other income (expense), net
  $ 1,210     $ (2,447 )
     
     
 

      The changes in investment-related gains, loss on writedown of investments and the Microsoft Settlement are discussed above in detail under “Significant Transactions and Other Items Affecting Comparability.” Excluding the impact of the items discussed above, Other income (expense), net, improved in 2003 as compared to the prior year primarily from a reduction of losses from equity method investees.

      Minority Interest Expense. Time Warner had $214 million of minority interest expense in 2003 compared to $278 million in 2002. The decrease in minority interest expense was primarily related to the elimination of minority interest in AOL Europe as a result of the Company’s purchase of the remaining preferred securities and payment of accrued dividends in April 2003.

      Income Tax Provision. The Company had income tax expense of $1.371 billion in 2003, compared to $412 million in 2002. The Company’s pre-tax income (loss) before discontinued operations and cumulative effect of accounting change was $4.517 billion in 2003, compared to a loss of $43.037 billion in 2002. Applying the 35% U.S. Federal statutory rate to pre-tax income would result in income tax expense of $1.581 billion in 2003 and a benefit of $15.063 billion in 2002. The Company’s actual income tax expense (benefit) differs from these amounts as a result of several factors, including non-temporary differences (i.e., certain financial statement expenses that are not deductible for income tax purposes), foreign income taxed at different rates, state and local income taxes and the recognition in the fourth quarter of 2003 of a $450 million tax benefit on capital losses. The most significant non-temporary difference in 2002 relates to approximately $44 billion of non-deductible losses on the writedown of goodwill (Note 11).

      As of December 31, 2003, the Company had net operating loss carryforwards of approximately $9.6 billion, resulting primarily from stock option exercises. These carryforwards are available to offset future U.S. Federal taxable income of the Company and its subsidiaries included in the consolidated Federal income tax return of the Company and are, therefore, expected to reduce Federal income taxes paid by the Company. If the net operating losses are not utilized, they expire in varying amounts, starting in 2018 through 2021 (Note 11).

      Income (Loss) before Discontinued Operations and Cumulative Effect of Accounting Change. Income (Loss) before discontinued operations and cumulative effect of accounting change was $3.146 billion in 2003 compared to a loss of $43.449 billion in 2002. Basic and diluted net income (loss) per share before discontinued operations and cumulative effect of accounting change were income of $0.70 and $0.68, respectively, in 2003 compared to basic and diluted net loss per share of $9.75 in 2002. In addition, excluding the items previously discussed under Significant Transactions Affecting Comparability of $546 million of income in 2003 and $45.477 billion of losses in 2002, Income (Loss) before Discontinued Operations and Cumulative Effect of Accounting Change increased by $572 million. Of the increase, $450 million was from the income tax benefit from capital losses. The remainder reflects a slight increase in Operating Income and a decrease in losses from equity method investees.

70


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Discontinued Operations, Net of Tax. The 2003 and 2002 results include the impact of the treatment of the Music segment as discontinued operations. In addition, 2002 reflects the deconsolidation of a portion of the TWE-Advance/Newhouse Partnership (“TWE-AN”) (Note 6). Included in the 2003 discontinued operations for the Music segment is a pre-tax gain of approximately $560 million for the sale of Warner Manufacturing, a $1.1 billion pre-tax impairment charge taken to reduce the carrying value of the net assets of the recorded music and music publishing businesses, a $27 million pre-tax loss from the operations of the Music business and $72 million of income tax benefits (Note 5). The 2002 amounts include pre-tax income of $101 million from the operations of the Music business, impairments of the Music segment’s goodwill of $646 million and brands and trademarks of $853 million and $273 million of income tax benefit related to Music. Additionally, 2002 amounts include $113 million of net income from the operations of TWE-AN.

      Cumulative Effect of Accounting Change. As previously discussed, the Company recorded an approximate $12 million charge, net of tax, as a cumulative effect of accounting change upon adoption of FIN 46 in 2003. During 2002, the Company recorded a $54.235 billion cumulative effect charge upon adoption of SFAS 142. Included in this charge was $4.796 billion related to the Music segment.

      Net Income (Loss) and Net Income (Loss) Per Common Share. Net income was $2.639 billion in 2003 compared to a net loss of $98.696 billion in 2002. Basic net income per common share was $0.59 and diluted net income per share was $0.57 in 2003 compared to basic and diluted net loss per common share of $22.15 in 2002. Net Income (Loss) includes the items discussed under Significant Transactions Affecting Comparability, discontinued operations, net of tax and the cumulative effect of accounting change discussed above.

Business Segment Results

      AOL. Revenues, Operating Income (Loss) before Depreciation and Amortization and Operating Income (Loss) of the AOL segment for the years ended December 31, 2003, and 2002 are as follows:

                           
Year Ended December 31,

2003 2002 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 7,593     $ 7,216       5 %
 
Advertising
    787       1,316       (40 )%
 
Other
    220       562       (61 )%
     
     
         
Total revenues
  $ 8,600     $ 9,094       (5 )%
     
     
         
Operating Income (Loss) before Depreciation and Amortization
  $ 1,507     $ (31,957 )     NM  
Depreciation
    (669 )     (624 )     7%  
Amortization
    (175 )     (161 )     9%  
     
     
         
Operating Income (Loss)
  $ 663     $ (32,742 )     NM  
     
     
         

      The growth in Subscription revenues at AOL is primarily attributable to an increase in Subscription revenues at AOL Europe (from $1.153 billion to $1.498 billion). The growth in AOL Europe’s Subscription revenues resulted from a $240 million favorable impact of foreign currency exchange rates and higher pricing that more than offset an increase in VAT (which is netted against revenue) due to a change in European law that took effect July 1, 2003. AOL’s domestic Subscription revenues grew $32 million (from $6.063 billion to $6.095 billion) in 2003 compared to 2002. The expansion of domestic broadband subscribers and increased premium service revenue accounted for the increase. These gains were offset in part by year-over-year declines in revenues related to declines in domestic AOL narrowband subscribers.

71


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The number of AOL brand subscribers in the U.S. was approximately 24.3 million at December 31, 2003, compared to approximately 26.5 million at December 31, 2002, and 24.7 million at September 30, 2003 (total AOL brand subscribers include subscribers receiving the service under various unlimited usage price plans, limited usage price plans, bring your own access (“BYOA”) plans, Original Equipment Manufacturers (“OEMs”) bundled plans, and bulk subscriptions sold at a discount rate to AOL’s selected strategic partners, as well as members receiving the AOL service during introductory free trial periods and members who are receiving the AOL service at no or reduced costs through member service and retention programs). The sequential quarterly decline in domestic AOL brand subscribers resulted from a number of factors, including continued subscriber cancellations and terminations, a reduction in direct marketing response rates, the continued maturing of narrowband services, subscribers adopting other narrowband and broadband services, and a reassessment of various marketing programs, partially offset by growth in broadband subscribers. The Company anticipates that this decline in its narrowband subscriber base will likely continue because of these factors. In addition, the movement toward AOL broadband services could negatively impact future results of operations due to lower average pricing on broadband services than for narrowband services.

      The year-over-year decline in subscribers also reflects the continued maturing of narrowband services described above and the Company’s identification of and removal from the subscriber base of members failing to complete appropriately the registration and payment authorization process and members who were prevented from using the service due to online conduct violations (e.g., spamming, inappropriate language) and who did not properly address the violation.

      AOL brand subscribers are classified based on price plans, rather than the speed of a member’s connection. The majority of AOL’s domestic subscribers are on unlimited usage pricing plans. Additionally, AOL has entered into certain bundling programs with OEMs that generally do not result in Subscription revenues during introductory periods, and previously had sold bulk subscriptions at a discounted rate to AOL’s selected strategic partners for distribution to their employees. The following table summarizes the percentage of AOL’s domestic members on each type of price plan:

                                   
Year Ended December 31,

Percentage of
Total Subs ARPU


2003 2002 2003 2002




 
Unlimited(a)
    78 %     81 %   $ 20.38     $ 19.47  
 
Lower priced plans(b)
    18 %     13 %   $ 11.15     $ 11.03  
 
OEM bundled
    4 %     6 %            
     
     
                 
Total
    100 %     100 %   $ 18.98     $ 18.31  
     
     
     
     
 


(a)   Includes 10% in both 2003 and 2002 under various free trial and retention programs.
(b)   Includes 2% in 2003 and 1% in 2002 under various free trial and retention programs. These plans include BYOA plans, limited usage plans and bulk programs with strategic partners.

    The average monthly Subscription revenue per domestic subscriber (“ARPU”), defined as total AOL brand domestic Subscription revenue divided by the average subscribers for the period, for 2003 increased 4% to $18.98 as compared to $18.31 in 2002. The change in domestic subscription ARPU primarily related to the termination of non-paying members. In addition, ARPU was impacted by changes in the mix of narrowband and broadband product, customer pricing plans, the level of service provided (full connectivity versus BYOA) and by changes in the terms of AOL’s relationships with its broadband cable, DSL and satellite partners. The Company does not expect ARPU to continue to increase in the foreseeable future as the Company continues to introduce new products, such as lower-priced narrowband service, and subscribers continue to migrate from unlimited plans to lower-priced plans, such as BYOA plans.

72


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The number of AOL brand subscribers in Europe was 6.4 million at December 31, 2003, and the average monthly Subscription revenue per European subscriber for 2003 was $19.13. This compares to AOL brand subscribers in Europe of 6.4 million and 6.3 million at December 31, 2002, and September 30, 2003, respectively, and an average monthly Subscription revenue per European subscriber for 2002 of $14.88. The average monthly Subscription revenue per European subscriber in 2003 was impacted primarily by the positive effect of changes in foreign currency exchange rates related to the strengthening of the Euro and British Pound relative to the U.S. Dollar and price increases implemented in the second quarter of 2003 and in mid-2002 in various European countries offering the AOL service. The growth in the number of AOL brand subscribers was essentially flat in 2003 as growth in U.K. subscribers was offset by subscriber declines in Germany and France.

      The decline in Advertising revenues is principally due to a $559 million reduction in revenues from domestic contractual commitments received in prior periods (from $876 million to $317 million) and continued softness in AOL online advertising sales. Of the $876 million of Advertising revenue from contractual commitments for 2002, $15 million was recognized as the result of terminations. There were no terminations in 2003 that resulted in additional revenues. The decline in Advertising revenues also reflects a decrease in the intercompany sales of advertising to other business segments of Time Warner in 2003 as compared to 2002 (from $178 million to $40 million). This reduction also reflects a change in the treatment of intercompany advertising barter transactions. During the second quarter of 2003, there was a change in the application of AOL’s policy for intercompany advertising barter transactions, which reduced both the amount of intercompany advertising revenues and advertising expenses by $51 million for the year. This change, however, had no impact on the AOL segment’s Operating Income (Loss) or its Operating Income (Loss) before Depreciation and Amortization. In addition, because intercompany transactions are eliminated on a consolidated basis, this change in policy did not impact the Company’s consolidated results of operations. The decline in Advertising revenue was partially offset by increased revenue from certain transaction-based advertising contracts (from $35 million in 2002 to approximately $200 million in 2003) related to paid-search categories. The Company expects advertising revenue to increase in 2004 as expected growth in transaction-based and traditional advertising more than offsets an expected decline in revenues from domestic contractual commitments received in prior periods and intercompany sales.

      Of the $787 million of Advertising revenue for 2003, $317 million was generated from the five most significant advertisers. Similarly, of the $1.316 billion of Advertising revenue for 2002, $460 million related to the five most significant advertisers, including $284 million related to Bertelsmann (See “Note 18 — Commitments and Contingencies — SEC and DOJ Investigations”).

      Domestic advertising commitments for future periods declined to $204 million as of December 31, 2003, as compared to $514 million as of December 31, 2002. In addition to the prior period commitments recognized in revenue, the remaining commitments were reduced by $196 million and $292 million for 2003 and 2002, respectively, without any revenue being recognized, to reflect a decline in future consideration to be received related to the termination or restructuring of various contracts. Included in the $204 million of advertising commitments for future periods as of December 31, 2003, is $120 million for the five largest advertising commitments. Similarly, the $514 million of advertising commitments for future periods as of December 31, 2002, includes $217 million for the five largest commitments.

      The Company expects to complete performance on approximately half of its remaining domestic advertising commitments by the end of 2004; however, new sales are projected to replace amounts being recognized as revenue so that the level of commitments is not expected to materially change. Additional terminations or restructurings of advertising commitments could cause further declines in future consideration to be received and revenues that would otherwise be recognized.

73


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Other revenues include merchandising revenue and revenue from providing the Cable segment access to the AOL Transit Data Network for high-speed access to the Internet. The decrease in Other revenues for 2003 was due primarily to the Company’s decision to reduce the promotion of its merchandise business (i.e., reducing pop-up advertisements) to improve the member experience.

      Operating Income (Loss) before Depreciation and Amortization in 2002 included a $33.489 billion impairment charge taken to reduce the carrying value of goodwill. Excluding this impairment charge, Operating Income before Depreciation and Amortization decreased by $25 million in 2003. The decline is due primarily to lower Advertising revenues as discussed above and higher selling, general and administrative expenses, offset in part by lower costs of revenue and lower merger and restructuring costs. The 14% increase in selling, general and administrative expenses (from $2.235 billion to $2.542 billion) primarily related to higher marketing costs, consulting costs, commissions, and personnel costs associated with the rollout of new services, as well as higher legal and insurance costs. The 11% decline in cost of revenues (from $5.061 billion to $4.499 billion) primarily related to lower domestic network and merchandise expenses. Network related expenses decreased 14% to $2.446 billion in 2003, principally attributable to improved pricing and decreased levels of service commitments entered into during 2003 as well as the increased utilization of network assets under capital leases. Merger and restructuring costs declined in 2003 to $52 million as compared to $266 million in 2002 (Note 3).

      Excluding the $33.489 billion impairment in 2002, Operating Income (Loss) declined in 2003 due to the decrease in Operating Income before Depreciation and Amortization discussed above and an increase in depreciation and amortization expense. The increase in depreciation expense primarily related to an increase in network assets acquired under capital leases. This was partially offset by an adjustment of approximately $60 million in the fourth quarter of 2003 to reduce excess depreciation inadvertently recorded at AOL over several years prior to 2003. Management does not believe that the understatement of prior years’ results was material to any of the given years’ financial statements. Similarly, management does not believe that the adjustment made is material to current period results. The increase in amortization expense is primarily related to a reduction in useful lives of certain intangible assets that will cease to be used in early 2004.

      Cable. Revenues, Operating Income (Loss) before Depreciation and Amortization and Operating Income (Loss) of the Cable segment for the years ended December 31, 2003, and 2002 are as follows:

                           
Year Ended December 31,

2003 2002 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 7,233     $ 6,374       13 %
 
Advertising
    466       661       (30 )%
     
     
         
Total revenues
  $ 7,699     $ 7,035       9 %
     
     
         
Operating Income (Loss) before Depreciation and Amortization
  $ 2,992     $ (7,799 )     NM  
Depreciation
    (1,403 )     (1,206 )     16 %
Amortization
    (58 )     (7 )     NM  
     
     
         
Operating Income (Loss)
  $ 1,531     $ (9,012 )     NM  
     
     
         

      The increase in Subscription revenues for 2003 was due to the growth in high-speed data subscribers, higher basic cable rates and an increase in digital video subscribers. High-speed data revenues increased from $1.009 billion in 2002 to $1.422 billion in 2003.

74


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      For the period from December 31, 2002 to December 31, 2003, residential high-speed data subscribers increased by 33% to 3.228 million, commercial high-speed data subscribers increased by 54% to 128,000, digital video subscribers increased by 16% to 4.349 million and basic cable subscribers increased 0.1% to 10.919 million (including 1.572 million subscribers of unconsolidated investees which are managed by the Company). High-speed data subscribers as of December 31, 2002, consisted of 2.426 million residential subscribers and 83,000 commercial subscribers.

      Basic cable subscribers include all subscribers receiving basic cable service. Digital video subscribers reflect subscribers on any level of service received via digital technology. Finally, high-speed data subscribers include subscribers to the Road Runner service, as well as other Internet service providers.

      The decrease in Advertising revenues was primarily related to a decrease in advertising purchased by programming vendors to promote their channels, including new channel launches (from $124 million to $12 million) and a decrease in the intercompany sale of advertising to other business segments of Time Warner (from $125 million to $11 million). This was offset in part by an 8%, or $31 million, increase in general third-party advertising sales.

      Operating Income (Loss) before Depreciation and Amortization for 2002 included a $10.550 billion impairment charge to reduce the carrying value of goodwill and a $6 million gain on the sale of certain consolidated cable systems. Excluding the impairment charge and gain, Operating Income before Depreciation and Amortization in 2003 increased by $247 million, principally as a result of the Subscription revenue gains described above, offset in part by higher costs of revenue and selling, general and administrative expenses. The increase in costs of revenue (from $3.046 billion to $3.341 billion) primarily related to increases in video programming costs, offset in part by reduced high-speed data network expenses. Video programming costs increased 15% to $1.661 billion in 2003, principally attributable to contractual rate increases across the Company’s programming line-up (including sports programming). Video programming costs are expected to rise in 2004, at rates similar to those experienced during 2003, primarily due to the expansion of service offerings and industry-wide programming cost increases (including sports programming) reflecting both inflation-indexed and negotiated license fee increases. The increase in selling, general and administrative expenses (from $1.229 billion to $1.351 billion) primarily related to higher employee-related costs, due in part to the rollout of new services and, to a lesser extent, higher pension expenses.

      Excluding the $10.550 billion impairment, Operating Income increased in 2003 due primarily to the increase in Operating Income before Depreciation and Amortization described above, offset in part by an increase in depreciation and amortization expense. As a result of an increase in the amount of capital spending on customer premise equipment in recent years, a larger proportion of the Cable segment’s property, plant and equipment consisted of assets with shorter useful lives in 2003 than in 2002. Additionally, the Cable division completed the upgrades of its cable systems in mid-2002. Depreciation expense related to these shorter-lived assets, coupled with incremental depreciation expense on the upgraded cable systems, has resulted in the increase in overall depreciation expense. Amortization expense increased $51 million primarily as a result of amortization of subscriber lists that were established in connection with the TWE Restructuring.

75


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Filmed Entertainment. Revenues, Operating Income before Depreciation and Amortization and Operating Income of the Filmed Entertainment segment for the years ended December 31, 2003, and 2002 are as follows:

                           
Year Ended December 31,

2003 2002 % Change



(millions)
Revenues:
                       
 
Advertising
  $ 6     $ 10       (40 )%
 
Content
    10,800       9,824       10 %
 
Other
    161       206       (22 )%
     
     
         
Total revenues
  $ 10,967     $ 10,040       9 %
     
     
         
Operating Income before Depreciation and Amortization
  $ 1,465     $ 1,232       19 %
Depreciation
    (86 )     (79 )     9 %
Amortization
    (206 )     (191 )     8 %
     
     
         
Operating Income
  $ 1,173     $ 962       22 %
     
     
         

      For 2003, Content revenues increased as a result of improvements from theatrical and television product. Increases in revenue from theatrical product included higher worldwide theatrical film rentals ($109 million), higher worldwide home video sales ($174 million) and higher television license fees ($118 million). Increases in revenue from television product is attributable to higher worldwide license fees ($288 million) and improved home video sales ($251 million). The increase in worldwide theatrical film rentals was primarily driven by the success of Harry Potter and the Chamber of Secrets, The Matrix Reloaded, The Lord of the Rings: The Fellowship of the Ring and The Lord of the Rings: The Two Towers. The increase in worldwide home video reflects increased DVD unit sales for both feature films and episodic television series, offset in part by lower VHS revenues. The growth in DVD revenues is attributable to a combination of the popularity of the Company’s film and television releases as well as the expanding worldwide DVD player base. The increase in television revenues is primarily attributable to improved network license fees from several returning series, as well as a higher number of new episodes produced and delivered in 2003 versus 2002. In addition, revenues were negatively impacted by a $40 million reserve established during the fourth quarter in connection with an international VAT tax matter (which is netted against revenue).

      Other revenues consist primarily of comic-book publishing sales and revenues from the portion of the Company’s U.K. cinema operations consolidated for financial reporting purposes. Other revenues declined as a result of the sale of the Company’s U.K. cinema interests in the second quarter of 2003. This operation contributed $51 million of Other revenues in 2003 compared to $108 million in 2002.

      Operating Income before Depreciation and Amortization reflects improved contributions from theatrical product which were offset in part by lower gross profits from television product stemming from an increase in the production of new episodic series (new series are generally produced at a cost in excess of their network license fees). Specifically, Operating Income before Depreciation and Amortization includes increased Content revenues, which was partially offset by decreases in Other revenues discussed above, increases in costs of revenue and selling, general and administrative expenses. The increase in costs of revenue (from $7.619 billion to $8.138 billion) is primarily related to increased film and exploitation costs and by increased television production costs as discussed above. The increase in selling, general and administrative expenses (from $1.189 billion to $1.407 billion) is primarily related to third party distribution fees associated with higher revenue, general cost increases (including annual salary increases) additional headcount and approximately $45 million of additional accruals for employee incentive compensation. In addition, Operating Income

76


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

before Depreciation and Amortization includes a $43 million gain related to the sale of the Company’s interest in a consolidated U.K. cinema interests in 2003.

      The increase in Operating Income was due primarily to the aforementioned changes in Operating Income before Depreciation and Amortization, offset in part by higher depreciation expense due to asset additions to property and equipment as well as higher amortization expense relating to a step-up in the valuation of the Warner Bros. film library assets, which were established in connection with the TWE Restructuring.

      The Company anticipates the rate of growth in both Operating Income before Depreciation and Amortization and Operating Income will be slower during 2004 in comparison to that experienced in 2003 due to difficult comparisons in theatrical results and a non-recurring gain on sale of assets in 2003.

      Networks. Revenues, Operating Income before Depreciation and Amortization and Operating Income of the Networks segment for the years ended December 31, 2003, and 2002 are as follows:

                           
Year Ended December 31,

2003 2002 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 4,588     $ 4,310       6 %
 
Advertising
    2,675       2,423       10 %
 
Content
    981       736       33 %
 
Other
    190       186       2 %
     
     
         
Total revenues
  $ 8,434     $ 7,655       10 %
     
     
         
Operating Income before Depreciation and Amortization
  $ 2,027     $ 2,032        
Depreciation
    (192 )     (172 )     12 %
Amortization
    (26 )     (21 )     24 %
     
     
         
Operating Income
  $ 1,809     $ 1,839       (2 )%
     
     
         

      The increase in Subscription revenues was due primarily to higher subscription rates at both the cable networks of Turner and at HBO and an increase in the number of subscribers at Turner. In addition, as a result of the resolution of certain contractual agreements, certain previously deferred revenues were recognized when the fees became fixed and determinable. As a result, approximately $45 million of revenue that had been deferred was recognized in the third quarter of 2003.

      The increase in Advertising revenues was driven by higher CPMs, sellouts and ratings at Turner’s entertainment networks, reflecting improvement in the cable television advertising market, and, at The WB Network, from higher advertising rates and the impact of an expanded Sunday night schedule that began in September 2002. While the Company expects continued growth in its advertising revenues on an overall basis, The WB Network’s 2003/2004 season-to-date ratings have been lower than in the prior year. The ratings decline could negatively impact advertising revenues in 2004 at The WB Network.

      The increase in Content revenues was primarily due to the success of HBO’s first quarter 2003 home video release of My Big Fat Greek Wedding and to a lesser extent, higher ancillary sales of HBO programming and higher licensing and syndication revenue associated with Everybody Loves Raymond. The Company anticipates that the rate of growth in Content revenues will be lower during 2004 in comparison to that experienced in 2003, primarily related to My Big Fat Greek Wedding.

      Operating Income before Depreciation and Amortization for 2003 includes the previously discussed $219 million of impairment charges at Turner related to the writedown of intangible assets of the winter sports

77


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

teams. Excluding this impairment charge, Operating Income before Depreciation and Amortization improved due to the increase in total revenues described above, offset in part by an increase in costs of revenue and selling, general and administrative expenses. The 8% increase in costs of revenue (from $4.173 billion to $4.527 billion) is primarily due to increases in programming costs and higher distribution costs related to the increase in HBO’s Content revenues. Partially offsetting the higher programming costs was a $45 million deferral of programming costs associated with future revenues from syndication and home video distribution of original programming. The 13% increase in selling, general and administrative expenses (from $1.450 billion to $1.640 billion) is primarily related to higher employee costs at Turner and HBO due to business growth, and an increase in marketing costs. 2002 also included a benefit from the finalization of certain licensing agreements at HBO. In addition, 2003 included $13 million of restructuring costs related to a lease termination and a sublease associated with the planned move of Turner’s New York-based advertising sales department to the Time Warner Center and an additional $8 million of restructuring costs related to various employee and contractual terminations. Both years reflect bad debt reserves on receivables from Adelphia Communications (“Adelphia”), a major cable television operator which declared bankruptcy in 2002. Based on information available at this time, the Company believes that such reserves are appropriate and are sufficient to cover bad debt losses associated with these receivables. If any portion of the receivables reserved becomes recoverable in the future, it will be reflected as a reduction of bad debt expense. Conversely, if the reserves established are not sufficient to cover bad debt losses sustained, this will be reflected as additional bad debt expense in future periods.

      Excluding the impairment charge, Operating Income increased primarily due to the changes in Operating Income before Depreciation and Amortization noted above, partially offset by an increase in depreciation expense related to fixed asset additions, primarily at Turner.

      The winter sports teams, which are expected to be sold in the first quarter of 2004, contributed $169 million and $159 million of revenues in 2003 and 2002, respectively; Operating Losses before Depreciation and Amortization were $35 million and $40 million in 2003 and 2002, respectively; and Operating Losses were $37 million and $45 million in 2003 and 2002, respectively.

      Publishing. Revenues, Operating Income before Depreciation and Amortization and Operating Income of the Publishing segment for the years ended December 31, 2003, and 2002 are as follows:

                           
Year Ended December 31,

2003 2002 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 1,533     $ 1,484       3 %
 
Advertising
    2,459       2,422       2 %
 
Content
    522       513       2 %
 
Other
    1,019       1,003       2 %
     
     
         
Total revenues
  $ 5,533     $ 5,422       2 %
     
     
         
Operating Income before Depreciation and Amortization
  $ 955     $ 1,155       (17 )%
Depreciation
    (116 )     (97 )     20 %
Amortization
    (175 )     (177 )     (1 )%
     
     
         
Operating Income
  $ 664     $ 881       (25 )%
     
     
         

      The 3% increase in Subscription revenues was due to $36 million of favorable effects of foreign exchange rates and a $49 million reduction in subscription agents’ commissions, which are netted against revenue, partially offset by lower subscription revenue per subscriber.

78


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The 2% increase in Advertising revenues reflects easier comparisons to 2002 during the early part of the year, resulting from the aftermath of the events of September 11, 2001, offset in part by a soft print advertising market in the latter part of 2003.

      The increase in Other revenues resulted from increases at Southern Living at Home, a division that sells merchandise via in-home parties, and Synapse, a direct subscription marketing company. These gains were partially offset by a $52 million decrease at Time Life. The sale of Time Life will negatively impact Content and Other revenues in 2004, as Time Life contributed Content revenues of $40 million in 2003 and Other revenues of $312 million in 2003.

      The decrease in Operating Income before Depreciation and Amortization includes the previously discussed $99 million impairment charge related to the goodwill and intangible assets of the Time Warner Book Group. It also includes an $84 million decline at Time Life (a $72 million loss in 2003 versus income of $12 million in 2002), and an increase in pension-related expenses of $44 million. These items were partially offset by an overall increase in revenue. Restructuring charges of $21 million were also recorded in 2003, including $9 million for Time Life workforce reductions. As previously discussed, in December 2003, the Company sold Time Life and recorded a loss on disposal of $29 million. Due to the effect of considerable Company contributions to the defined benefit pension plans in 2003 and a strong return on plan assets, the Company expects that pension costs will decrease in 2004 in comparison to 2003. Operating expenses for the magazine publishing business include manufacturing (paper, printing and distribution) and editorial-related costs, which together increased 2% to $1.627 billion due primarily to the effects of foreign exchange rates.

      The decrease in Operating Income was due primarily to lower Operating Income before Depreciation and Amortization, as discussed above, and higher depreciation expense, primarily related to increased capitalized software and building improvements. Time Life contributed $82 million of Operating Losses in 2003 and Operating Income of $6 million in 2002.

2002 vs. 2001

Consolidated Results

      Revenues. Time Warner’s revenues increased to $37.314 billion in 2002, compared to $33.507 billion in 2001. As shown below, the overall increase in revenues was driven by an increase in Subscription and Content revenues, offset in part by a decrease in Advertising and Other revenues.

                         
Year Ended December 31,

2002 2001 % Change



(millions)
Subscription
  $ 18,959     $ 15,657       21 %
Advertising
    6,299       6,869       (8 )%
Content
    10,216       8,654       18 %
Other
    1,840       2,327       (21 )%
     
     
         
Total revenues
  $ 37,314     $ 33,507       11 %
     
     
         

      As discussed more fully below, the increase in Subscription revenues was principally due to increases in the number of subscribers and in subscription rates at the AOL, Cable and Networks segments, as well as the impact of the acquisitions of Bertelsmann’s interest in AOL Europe (and resulting consolidation) and IPC and the consolidation of Road Runner. The increase in Content revenues was principally due to increased revenues at the Filmed Entertainment segment related to improved international theatrical and worldwide home video results.

79


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The decline in Advertising revenues principally related to the AOL segment, due to continued weakness in online advertising sales and the decline in the current period benefit from prior period contract sales. Excluding the AOL segment, Advertising revenues increased 9% primarily related to growth at the Networks and Publishing segments, including the impact of the acquisition of IPC. The decrease in Other revenues reflected declines at the AOL segment, primarily related to the termination of the iPlanet alliance with Sun Microsystems in the third quarter of 2001.

      Each of the revenue categories is discussed in greater detail by segment under the “Business Segment Results” section below.

      Cost of Revenues. For the years ended December 31, 2002, and 2001, cost of revenues as a percentage of revenues increased from 56% in 2001 to 59% in 2002. The increase related primarily to an increase in video programming costs at the Cable segment and higher programming costs at the Networks segment.

      Selling, General and Administrative Expenses. Selling, general and administrative costs as a percentage of revenues increased from 22% for the year ended December 31, 2001, to 24% for the year ended December 31, 2002. The increase in selling, general and administrative expenses primarily related to higher marketing costs at the AOL segment and to higher accounts receivable allowances at the Networks and Publishing segments.

Reconciliation of Operating Income (Loss) before Depreciation and Amortization to Operating Income (Loss) and Net Loss.

      The following table reconciles Operating Income (Loss) before Depreciation and Amortization to Operating Income (Loss). In addition, the table provides the components from Operating Income (Loss) to Net Loss for purposes of the discussions that follow:

                         
Year Ended December 31,

2002 2001 % Change



(millions)
Operating Income (Loss) before Depreciation and Amortization
  $ (35,791 )   $ 8,671       NM  
Depreciation
    (2,206 )     (1,653 )     33 %
Amortization
    (557 )     (6,366 )     (91 )%
     
     
         
Operating Income (Loss)
    (38,554 )     652       NM  
Interest expense, net
    (1,758 )     (1,316 )     34 %
Other expense, net
    (2,447 )     (3,458 )     (29 )%
Minority interest income (expense)
    (278 )     46       NM  
     
     
         
Loss before income taxes, discontinued operations and cumulative effect of accounting change
    (43,037 )     (4,076 )     NM  
Income tax provision
    (412 )     (145 )     184 %
     
     
         
Loss before discontinued operations and cumulative effect of accounting change
    (43,449 )     (4,221 )     NM  
Discontinued operations
    (1,012 )     (713 )     NM  
Cumulative effect of accounting change
    (54,235 )           NM  
     
     
         
Net loss
  $ (98,696 )   $ (4,934 )     NM  
     
     
         

      Operating Income (Loss) before Depreciation and Amortization. Operating Income (Loss) before Depreciation and Amortization decreased from income of $8.671 billion to a loss of $35.791 billion. Included

80


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

in these results were several items affecting comparability, including the writedowns for the impairment of goodwill and intangible assets, gain on disposition of consolidated businesses and merger and restructuring costs noted above. Excluding these items from both periods, Operating Income (Loss) before Depreciation and Amortization decreased to $8.569 billion in 2002 from $8.885 billion in 2001. The decrease was principally due to a decrease in Operating Income (Loss) before Depreciation and Amortization at the AOL segment, an increase in Corporate expenses and an increase in merger and restructuring costs, offset in part by an increase in Operating Income (Loss) before Depreciation and Amortization at the Company’s other business segments, which is discussed in detail under “Business Segment Results.” Also impacting Operating Income (Loss) before Depreciation and Amortization is an increase in Corporate Operating Loss before Depreciation and Amortization.

      Corporate Operating Loss before Depreciation and Amortization. Time Warner’s Corporate Operating Loss before Depreciation and Amortization increased to $398 million in 2002, from $307 million in 2001. The increase in Operating Loss before Depreciation and Amortization was principally due to legal and other professional fees related to the SEC and DOJ investigations into the financial reporting and disclosure practices of the Company, as well as certain project termination and pension-related costs.

      Depreciation Expense. Depreciation expense increased to $2.206 billion in 2002, from $1.653 billion in 2001, due principally to increases at the Cable segment ($1.206 billion in 2002 compared to $893 million in 2001) and the AOL segment ($624 million in 2002 compared to $422 million in 2001). The increase in depreciation expense at the Cable segment reflects higher levels of capital spending related to the rollout of digital services over the past three years, resulting in increased capital spending on customer premises equipment, which is depreciated over a shorter useful life. Depreciation at the AOL segment increased primarily due to an increase in network assets acquired, as well as a decrease in the useful life of certain network assets.

      Amortization Expense. Amortization expense decreased to $557 million in 2002, from $6.366 billion in 2001. The amortization expense in 2001 primarily reflected amortization of goodwill and other intangible assets recorded in the Merger. The decrease in amortization expense in 2002 was due to the adoption of FAS 142, which resulted in goodwill and certain intangible assets ceasing to be amortized, offset in part by the impact of additional amortization expense from the acquisitions of AOL Europe in January 2002 and IPC in October 2001.

      Operating Income (Loss). Time Warner’s Operating Loss was $38.554 billion in 2002, compared to Operating Income of $652 million in 2001. The Operating Loss in 2002 was primarily related to a non-cash charge of $44.039 billion to reduce the carrying value of goodwill. Excluding this charge, the improvement in Operating Income related to a decrease in amortization expense due to the adoption of FAS 142, offset in part by a decrease in business segment Operating Income (Loss) before Depreciation and Amortization, which is discussed in detail under “Business Segment Results,” and an increase in depreciation expense.

      Interest Expense, Net. Interest expense, net, increased to $1.758 billion in 2002, from $1.316 billion in 2001, due principally to additional interest expense related to incremental borrowings to purchase Bertelsmann’s interest in AOL Europe and IPC, offset in part by lower market interest rates in 2002.

      Other Expense, Net. Other expense, net, decreased to $2.447 billion in 2002, from $3.458 billion in 2001, primarily related to the changes in investment-related gains and losses on the writedown of investments, as discussed in detail under “Significant Transactions and Other Items Affecting Comparability.”

      In addition, other expense, net, benefited from a reduction of losses from equity method investees, primarily related to reduced amortization expense associated with the adoption of FAS 142, offset in part by the absence of prior year net pre-tax investment-related gains, including gains related to the exchange of various unconsolidated cable television systems at TWE (attributable to the minority owners of TWE).

81


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Minority Interest Income (Expense). Time Warner had $278 million of minority interest expense in 2002, compared to $46 million of minority interest income in 2001. Minority interest expense in 2002 primarily reflects the adoption of FAS 142, which resulted in a reduction of amortization expense at the Company’s partially owned consolidated investees, thereby resulting in an increase in the minority interest expense, as more income is attributable to minority partners. Minority interest expense also increased in 2002 as a result of accretion on the preferred securities of AOL Europe. These increases in minority interest expense were partially offset by a reduction in 2002 of an allocation of pretax gains related to the exchange of various cable television systems in 2001 at TWE (attributable to the minority owners of TWE).

      Income Tax Provision. Time Warner had income tax expense of $412 million in 2002, compared to $145 million in 2001. The Company’s pre-tax loss was $43.037 billion in 2002, compared to $4.076 billion in 2001. Applying the 35% U.S. Federal statutory rate to pre-tax loss would result in an income tax benefit of $15.063 billion in 2002 and $1.427 billion in 2001. However, the Company’s income tax expense differs from these amounts as a result of several factors, including non-temporary differences (i.e., certain financial statement expenses that are not deductible for income tax purposes), foreign income taxed at different rates and state and local income taxes. The most significant non-temporary difference in 2002 relates to approximately $44 billion of non-deductible losses on the writedown of goodwill and in 2001 relates to approximately $4.7 billion of non-deductible amortization of goodwill (Note 2).

      As of December 31, 2002, the Company had net operating loss carryforwards of approximately $10.0 billion, primarily resulting from stock option exercises. These carryforwards are available to offset future U.S. Federal taxable income and are, therefore, expected to reduce Federal income taxes paid by the Company. If the net operating losses are not utilized, they expire in varying amounts, starting in 2018 through 2021.

      Loss before Discontinued Operations and Cumulative Effect of Accounting Change. Loss before discontinued operations and cumulative effect of accounting change was $43.449 billion in 2002 and $4.221 billion in 2001. Basic and diluted net loss per share before discontinued operations and cumulative effect of accounting change were $9.75 in 2002 and $0.95 in 2001. Excluding significant transactions affecting comparability in 2002 of $45.5 billion and $1.6 billion in 2001, net income before discontinued operations and cumulative effect of accounting change increased by $4.603 billion. The increase related to lower amortization expense due to the adoption of FAS 142, partially offset by an increase in Operating Income before Depreciation and Amortization.

      Discontinued Operations, Net of Tax. The 2002 and 2001 results include the impact of the treatment of the former Music segment and a portion of TWE-AN as discontinued operations. Discontinued operations totaled a $1.012 billion net loss and a $713 million net loss for 2002 and 2001, respectively. The 2002 amounts include $101 million of pre-tax income from the operations of the Music business, pre-tax impairments of the Music segment’s goodwill of $646 million and brands and trademarks of $853 million and $273 million of income tax benefit. The 2001 discontinued operation results include a pre-tax net loss of $680 million from the operations of the Music business and a $6 million income tax benefit. The 2002 and 2001 amounts also include an additional net income of $113 million and a net loss of $39 million, respectively, from the operations of TWE-AN.

      Cumulative Effect of Accounting Change. As previously discussed, the Company recorded a $54.235 billion cumulative effect of accounting change upon adoption of SFAS 142. Included in this charge was $4.796 billion related to the Music segment.

      Net Loss and Net Loss Per Common Share. Time Warner had a net loss of $98.696 billion in 2002, compared to a net loss of $4.934 billion in 2001. Basic and diluted net loss per common share was $22.15 in 2002, compared to basic and diluted net loss per common share of $1.11 in 2001. Net Income (Loss) includes

82


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

the items discussed under Significant Transactions Affecting Comparability, discontinued operations, net of tax, and the cumulative effect of accounting change discussed above.

Business Segment Results

      AOL. Revenues, Operating Income (Loss) before Depreciation and Amortization and Operating Income (Loss) of the AOL segment for the years ended December 31, 2002, and 2001 are as follows:

                           
Year Ended December 31,

2002 2001 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 7,216     $ 5,353       35 %
 
Advertising
    1,316       2,281       (42 )%
 
Other
    562       981       (43 )%
     
     
         
Total revenues
  $ 9,094     $ 8,615       6 %
     
     
         
Operating Income (Loss) before Depreciation and Amortization
  $ (31,957 )   $ 2,713       NM  
Depreciation
    (624 )     (422 )     48 %
Amortization
    (161 )     (141 )     14 %
     
     
         
Operating Income (Loss)
  $ (32,742 )   $ 2,150       NM  
     
     
         

      The growth in Subscription revenues was primarily related to the acquisition of Bertelsmann’s interest in AOL Europe in 2002 and the resulting consolidation, as well as domestic growth. Domestically, Subscription revenues increased 13% and were principally driven by membership growth and price increases. The number of AOL brand subscribers in the U.S. was approximately 26.5 million at December 31, 2002, compared to approximately 25.2 million at December 31, 2001, and 26.7 million at September 30, 2002. The decline in domestic AOL brand subscribers as compared to the quarter ended September 30, 2002, reflects a number of factors, including a maturing narrowband services subscriber universe, subscribers adopting broadband services, a reduction in direct marketing response rates, an increase in subscriber terminations and cancellations, and the Company’s previously stated increased focus on improving the profitability of its narrowband membership base. The average monthly Subscription revenue per domestic subscriber (“ARPU”) for 2002 increased 3% to $18.31, compared to $17.76 in 2001. The increase in domestic subscription ARPU was due primarily to the standard unlimited rate increase of $1.95 per month to $23.90 (effective beginning in July 2001), offset in part by new member acquisition programs and member service and retention programs that offer incentives in the form of discounts and free months to AOL’s members. Domestic subscription ARPU was also impacted by changes in the mix of narrowband and broadband product, the level of service provided (full connectivity versus BYOA) and by changes in the terms of AOL’s relationships with its broadband cable and DSL partners.

      AOL brand subscribers consist of broadband and narrowband members that are classified based on price plans, rather than the speed of a member’s connection. The majority of AOL’s domestic subscribers are on unlimited usage pricing plans. Additionally, AOL has entered into certain bundling programs with OEMs that generally do not result in Subscription revenues during introductory periods, as well as the sale of bulk

83


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

subscriptions at a discounted rate to AOL’s selected strategic partners for distribution to their employees. The following table summarizes the percentage of AOL’s domestic members on each type of price plan:

                 
Year Ended
December 31,

2002 2001


Unlimited(1)
    81 %     79 %
Lower-priced plans(2)
    13 %     15 %
OEM bundled
    6 %     6 %
     
     
 
Total
    100 %     100 %
     
     
 


(1) Includes 10% and 11%, respectively, under various free trial, member service and retention programs.
(2) Includes less than 1% in 2002 and 2001 under various free trial, member service and retention programs. The lower priced plans include BYOA plans, limited usage plans and bulk employee programs with strategic partners. The weighted average monthly Subscription ARPU for lower priced plans was $11.03 and $11.00 for the years ended December 31, 2002, and 2001, respectively.

    AOL’s results reflect the consolidation of AOL Europe retroactive to the beginning of 2002. The number of AOL brand subscribers in Europe was 6.4 million at December 31, 2002, and the average monthly Subscription revenue per European subscriber for 2002 was $14.88. This compares to AOL brand subscribers in Europe of 5.5 million at December 31, 2001, and average monthly Subscription revenue per European subscriber for 2001 of $12.84. The average monthly Subscription revenue per European subscriber in 2002 was impacted by price increases implemented in 2002 in various European countries offering the AOL service and the positive effect of changes in foreign currency exchange rates.

      The 42% decline in Advertising revenues was principally due to a reduction in benefits from prior-period contract sales and continued weakness in online advertising sales. The Advertising revenue decline was slightly offset by contributions from AOL Europe. Domestic contractual commitments received in prior periods contributed Advertising revenue of $876 million in the 2002 period, compared to $1.547 billion in the comparable prior year period. Included in the amount of revenue from domestic contractual commitments received in prior periods was revenue recognized from the termination of contractual commitments, which declined to $15 million in the 2002 period, compared to $129 million in the prior year period. The decline in Advertising revenues also reflects a decrease in the intercompany sales of advertising to other business segments of Time Warner in 2002, compared to 2001 (from $222 million to $178 million). Of the $1.316 billion of advertising revenue in 2002, $460 million related to the five most significant advertisers, including $284 million related to Bertelsmann. Similarly, of the $2.281 billion of advertising revenue in 2001, $492 million related to the five most significant advertisers, including $179 million related to Bertelsmann (See “Note 18 — Commitments and Contingencies — SEC and DOJ Investigations”).

      During 2002, domestic advertising commitments for future periods declined to $514 million as of December 31, 2002 from $1.450 billion as of December 31, 2001. This compares to advertising commitments of $2.598 billion as of December 31, 2000. During 2002, in addition to the $876 million of prior-period commitments recognized in revenue, remaining commitments were reduced by $292 million, without any revenue being recognized, to reflect a decline in future consideration to be received related to the termination or restructuring of various contracts. Similarly, during 2001, in addition to the $1.547 billion of prior-period commitments recognized in revenue, remaining commitments were reduced by $459 million, without any revenue being recognized, to reflect a decline in future consideration to be received related to the termination or restructuring of various contracts. Included in the $514 million of advertising commitments for future periods as of December 31, 2002, was $217 million for the five largest commitments. Similarly, included in the $1.450 billion of advertising commitments for future periods as of December 31, 2001, was $590 million for the five largest commitments.

84


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The decrease in Other revenues was due primarily to the termination of AOL’s iPlanet alliance with Sun Microsystems in the third quarter of 2001, which contributed $410 million of revenue, $328 million of Operating Income before Depreciation and Amortization and $323 million of Operating Income during 2001. In addition, Other revenues also decreased due to the Company’s decision to reduce the promotion of its merchandise business (i.e., reducing pop-up advertisements) to improve the member experience. These decreases were offset in part by $105 million of intercompany network revenues, which are derived primarily from network services provided to Road Runner, beginning in November 2001.

      Excluding the $33.489 billion impairment charge attributable to AOL in 2002, the decline in Operating Income (Loss) before Depreciation and Amortization in 2002 was due primarily to the advertising revenue shortfall, the absence of the iPlanet alliance ($328 million of Operating Income before Depreciation and Amortization in 2001), an increase in broadband network costs and domestic marketing expenses, and increased merger and restructuring costs (from $201 million to $266 million), as well as Operating Income (Loss) before Depreciation and Amortization losses at AOL Europe of $153 million. This was offset in part by declines in narrowband network costs and equipment leasing costs. Included in the increase in 2002 in domestic marketing expense was an increase in intercompany advertising purchased by AOL on properties of other Time Warner business segments (from $225 million to $277 million), including advertising purchased on Time Warner Cable properties in support of the rollout of AOL Broadband services. The decline in Operating Income (Loss) in 2002 was due primarily to the $33.489 billion goodwill impairment charge, an increase in depreciation expense and the aforementioned decline in Operating Income (Loss) before Depreciation and Amortization.

      Cable. Revenues, Operating Income (Loss) before Depreciation and Amortization and Operating Loss of the Cable segment for the years ended December 31, 2002, and 2001 are as follows:

                           
Year Ended December 31,

2002 2001 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 6,374     $ 5,482       16 %
 
Advertising
    661       546       21 %
     
     
         
Total revenues
  $ 7,035     $ 6,028       17 %
     
     
         
Operating Income (Loss) before Depreciation and Amortization
  $ (7,799 )   $ 2,628       NM  
Depreciation
    (1,206 )     (893 )     35 %
Amortization
    (7 )     (2,483 )     NM  
     
     
         
Operating Loss
  $ (9,012 )   $ (748 )     NM  
     
     
         

      The increase in Subscription revenues was due to higher basic cable rates and increases in high-speed data, digital cable and basic cable subscribers, as well as the impact of the consolidation of Road Runner in 2002. During 2002, residential high-speed data subscribers increased by 63% to 2.426 million, commercial high-speed data subscribers increased by 84% to 83,000, digital cable subscribers increased by 36% to 3.747 million and basic cable subscribers increased by 1.3% to 10.914 million (including 1.552 million subscribers of unconsolidated investees, which are managed by the Company).

      The increase in Advertising revenues was primarily related to an increase in the intercompany sale of advertising to other business segments of Time Warner (from $58 million to $125 million), an increase in advertising purchased by programming vendors to promote their channels, including new channel launches (from $106 million to $124 million) and an 8% increase in general third-party Advertising revenues.

85


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Excluding the $10.550 billion charge in 2002 relating to the impairment of goodwill, Operating Income (Loss) before Depreciation and Amortization increased to $2.751 billion, principally as a result of the revenue gains, as well as a $6 million gain on the sale of consolidated cable systems, offset in part by increases in programming and other operating costs, $15 million of restructuring costs in 2002 related to workforce reductions, and the consolidation of Road Runner’s losses in 2002. The increase in video programming costs of 21% relates to general programming rate increases across both basic and digital services, the addition of new programming services and higher basic and digital subscriber levels. Other operating costs increased as a result of the rollout of new services, higher property taxes associated with the upgrade of cable plants and higher development spending by the Interactive Personal Video division (from $3 million in 2001 to $30 million in 2002). The increased Operating Loss was due primarily to the $10.550 billion goodwill impairment charge and an increase in depreciation expense, offset in part by an increase in Operating Income (Loss) before Depreciation and Amortization and a decrease in amortization expense, due to the adoption of FAS 142.

      Filmed Entertainment. Revenues, Operating Income before Depreciation and Amortization and Operating Income of the Filmed Entertainment segment for the years ended December 31, 2002, and 2001 are as follows:

                           
Year Ended December 31,

2002 2001 % Change



(millions)
Revenues:
                       
 
Advertising
  $ 10     $ 12       (17 )%
 
Content
    9,824       8,378       17 %
 
Other
    206       369       (44 )%
     
     
         
Total revenues
  $ 10,040     $ 8,759       15 %
     
     
         
Operating Income before Depreciation and Amortization
  $ 1,232     $ 1,017       21 %
Depreciation
    (79 )     (89 )     (11 )%
Amortization
    (191 )     (478 )     (60 )%
     
     
         
Operating Income
  $ 962     $ 450       114 %
     
     
         

      The increase in revenues was primarily related to improved Content revenues from worldwide DVD performance, and international theatrical results, offset in part by declines in television and reduced Other revenues related to the closure of the Studio Stores division in 2001. The improved results reflect the worldwide theatrical success of Harry Potter and the Chamber of Secrets, as well as the worldwide home video and international theatrical results of Harry Potter and the Sorcerer’s Stone, Ocean’s Eleven and Scooby Doo: The Movie. Revenues also increased due primarily to New Line Cinema’s theatrical and home video success of The Lord of the Rings: The Fellowship of the Ring and Austin Powers in Goldmember.

      Operating Income before Depreciation and Amortization increased due primarily to the revenue increases, offset in part by higher theatrical film costs, including higher advertising and distribution costs. Operating Income increased primarily due to the Operating Income before Depreciation and Amortization increases and a decrease in amortization expense, due to the adoption of FAS 142.

86


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Networks. Revenues, Operating Income before Depreciation and Amortization and Operating Income (Loss) of the Networks segment for the years ended December 31, 2002, and 2001 are as follows:

                           
Year Ended December 31,

2002 2001 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 4,310     $ 3,988       8 %
 
Advertising
    2,423       2,265       7 %
 
Content
    736       589       25 %
 
Other
    186       208       (11 )%
     
     
         
Total revenues
  $ 7,655     $ 7,050       9 %
     
     
         
Operating Income before Depreciation and Amortization
  $ 2,032     $ 1,797       13 %
Depreciation
    (172 )     (159 )     8 %
Amortization
    (21 )     (1,966 )     (99 )%
     
     
         
Operating Income (Loss)
  $ 1,839     $ (328 )     NM  
     
     
         

      Revenues grew primarily due to an 8% increase in Subscription revenues with growth at both the cable networks of Turner and HBO, a 7% increase in Advertising revenues with growth at both the Turner cable networks and The WB Network and a 25% increase in Content revenues with growth at HBO, offset in part by a slight decrease at the Turner cable networks. Operating Income before Depreciation and Amortization and Operating Income (Loss) increased due to improved results at the Turner cable networks, HBO and The WB Network.

      For the Turner cable networks, Subscription revenues benefited from higher domestic rates and an increase in the number of domestic subscribers. Advertising revenues increased 4%, reflecting a slight recovery in the cable television advertising market during 2002, which was offset in part by a decline in intercompany sales of advertising to other business segments of Time Warner (from $120 million to $107 million). For HBO, Subscription revenues benefited from an increase in the number of subscribers and higher rates. Content and Other revenues benefited from higher home video sales of HBO’s original programming and higher licensing and syndication revenue from the broadcast comedy series Everybody Loves Raymond. For The WB Network, the increase in Advertising revenues was driven by higher advertising rates.

      For the Turner cable networks, the increase in Operating Income before Depreciation and Amortization was due principally to the increased Subscription revenues and lower marketing expenses, offset in part by higher programming costs and professional sports-related salaries. In addition, Operating Income before Depreciation and Amortization was affected negatively by an increase in the allowance for doubtful accounts on receivables from Adelphia Communications (“Adelphia”), a major cable television operator operating in bankruptcy. For HBO, the increase in Operating Income before Depreciation and Amortization was principally due to the increase in revenues and reduced costs relating to the finalization of certain licensing agreements, offset in part by an allowance for doubtful accounts established on receivables from Adelphia, higher write-offs of development costs and increased programming costs. For The WB Network, the Operating Income (Loss) before Depreciation and Amortization increase was principally due to higher Advertising revenues, offset in part by higher program license fees.

      For the Turner cable networks, HBO and The WB Network, the increase in Operating Income (Loss) was due primarily to an increase in Operating Income before Depreciation and Amortization and a decrease in amortization expense, due to the adoption of FAS 142.

87


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      Publishing. Revenues, Operating Income before Depreciation and Amortization and Operating Income (Loss) of the Publishing segment for the years ended December 31, 2002, and 2001 are as follows:

                           
Year Ended December 31,

2002 2001 % Change



(millions)
Revenues:
                       
 
Subscription
  $ 1,484     $ 1,207       23 %
 
Advertising
    2,422       2,239       8 %
 
Content
    513       465       10 %
 
Other
    1,003       778       29 %
     
     
         
Total revenues
  $ 5,422     $ 4,689       16 %
     
     
         
Operating Income before Depreciation and Amortization
  $ 1,155     $ 909       27 %
Depreciation
    (97 )     (70 )     39 %
Amortization
    (177 )     (935 )     (81 )%
     
     
         
Operating Income (Loss)
  $ 881     $ (96 )     NM  
     
     
         

      The increases in Subscription, Advertising and Other revenues were due primarily to the acquisitions of IPC in October 2001 and Synapse Group Inc. in December 2001. Advertising revenues increased 8% due to the acquisition of IPC, as well as the impact of a slight recovery in the general magazine advertising market during 2002. Advertising increases at the non-business oriented publications were partially offset by continued softness in the advertising market for business-oriented publications. The increase in Content revenues was due primarily to increased sales at the Time Warner Book Group due to the carryover successes of 2001 bestsellers and the success of several 2002 releases, including One Nation and The Lovely Bones, as well as the impact of the acquisition of IPC. Growth in Other revenues was partially offset by lower revenues from Time Life’s direct-marketing business.

      The growth in Operating Income before Depreciation and Amortization is due predominantly to the acquisitions of IPC and Synapse and, to a lesser extent, the increase in Advertising revenues due to the previously mentioned slight increase in the advertising market, overall cost savings and reduced costs relating to the final settlement of certain liabilities associated with the closure of American Family Enterprises during 2001, offset in part by additional reserves established on receivables from newsstand distributors. The increase in Operating Income (Loss) was primarily due to the increase in Operating Income before Depreciation and Amortization and a decrease in amortization expense, due to the adoption of FAS 142.

FINANCIAL CONDITION AND LIQUIDITY

December 31, 2003

Current Financial Condition

      At December 31, 2003, Time Warner had $25.7 billion of debt, $3.0 billion of cash and equivalents (net debt of $22.7 billion, defined as total debt less cash and cash equivalents) and $56.0 billion of shareholders’ equity, compared to $27.5 billion of debt, $1.7 billion of cash and equivalents (net debt of $25.8 billion) and $52.8 billion of shareholders’ equity at December 31, 2002. Pursuant to the adoption of FAS 150, effective in the third quarter of 2003, the Company reclassified $1.5 billion of mandatorily convertible preferred stock from shareholders’ equity to liabilities (Note 1). Also, in July 2003, as discussed above, upon the adoption of FIN 46, the Company recorded approximately $700 million of additional long-term debt related to the Company’s new headquarters and other real estate and equipment (Note 1).

88


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      As discussed in more detail below, management believes that Time Warner’s cash flow from operations, cash and equivalents, borrowing capacity under its committed credit facilities and availability under its commercial paper programs are sufficient to fund its capital and liquidity needs for the foreseeable future.

Debt Reduction

      As previously discussed, in January 2003 the Company announced that by the end of 2003 it intended to reduce its total net debt to within a range of 2.25 to 2.75 times the annual Operating Income before Depreciation and Amortization, excluding any writedowns for the impairment of intangible assets and goodwill and gains/losses on asset disposals (its “leverage ratio”). In addition, the Company announced that it intended to reduce total net debt to approximately $20 billion by the end of 2004. The 2003 reduction in net debt (from $25.8 billion to $22.7 billion) results in a leverage ratio of 2.58 at December 31, 2003, and was achieved through the use of Free Cash Flow and other de-leveraging initiatives, including the sale of non-strategic assets. The following table shows the change in net debt from December 31, 2002, to December 31, 2003 (in millions):

           
Net debt at December 31, 2002
  $ 25,779  
 
Debt assumed in the TWE Restructuring
    2,100  
 
Debt incurred to repurchase preferred securities of AOL Europe
    813  
 
Debt assumed upon adoption of FIN 46
    712  
 
Free Cash Flow
    (3,536 )
 
Proceeds from sale of investment in Comedy Central
    (1,225 )
 
Proceeds from sale of investment in Hughes
    (783 )
 
Proceeds from sale of Music Manufacturing
    (1,050 )
 
All other, net
    (105 )
     
 
Net debt at December 31, 2003(a)
  $ 22,705  
     
 


(a) Included in the net debt balance is approximately $355 million representing the unamortized portion of the fair value adjustment recognized as a result of the America Online — Historic TW Merger.

    In addition, the debt reduction program was positively impacted in the first quarter of 2004 as a result of the sale of the Company’s recorded music and music publishing operations for approximately $2.6 billion in cash, which closed on March 1, 2004. With the sale, the Company has reduced its net debt to approximately $20 billion and achieved its previously announced net debt reduction target almost a full year ahead of schedule. Also, in the first quarter of 2004, the Company purchased and retired $94 million of AOL Zero-Coupon Convertible Subordinated Notes, repaid $250 million of 7.4% senior notes that were due in 2004 and exercised the call option on $200 million of 8.4% senior debentures due in 2024.

Cash Flows

      Cash and equivalents increased to $3.040 billion as of December 31, 2003, from $1.730 billion as of December 31, 2002. Components of this change are discussed in more detail in the pages that follow.

89


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Operating Activities

      Sources of cash provided by operations are as follows:

                           
Year Ended December 31,

2003 2002 2001



(millions)
Operating Income (Loss) before Depreciation and Amortization
  $ 8,505     $ (35,791 )   $ 8,671  
Add back: Non-cash impairment charges on intangible assets
    318       44,039        
     
     
     
 
      8,823       8,248       8,671  
Net interest payments(a)
    (1,633 )     (1,548 )     (1,189 )
Net income taxes paid(b)
    (489 )     (246 )     (272 )
Adjustments relating to discontinued operations(c)
    350       639       733  
Merger and restructuring payments(d)
    (293 )     (512 )     (1,284 )
Domestic qualified pension plan contributions
    (632 )     (104 )     (273 )
Net cash received from litigation settlements(e)
    359              
All other, net, including working capital changes
    116       555       (1,105 )
     
     
     
 
 
Cash provided by operations
  $ 6,601     $ 7,032     $ 5,281  
     
     
     
 


(a) Includes interest income received of $61 million, $93 million and $190 million in 2003, 2002 and 2001, respectively.
(b) Includes income tax refunds received of $15 million, $49 million and $45 million in 2003, 2002, and 2001, respectively.
(c) Includes net loss from discontinued operations of $495 million, $1.012 billion and $713 million in 2003, 2002 and 2001, respectively. Amounts also include working capital related adjustments associated with discontinued operations of $845 million, $1.651 billion and $1.446 billion in 2003, 2002 and 2001, respectively.
(d) Includes payments for merger and restructuring costs, as well as payment for certain other merger-related liabilities.
(e) Includes $750 million Microsoft Settlement, partially offset by $391 million payment related to certain litigation settlements.

    Cash provided by operations decreased to $6.601 billion for 2003, compared to $7.032 billion in 2002. The decline in cash flow from operations is related primarily to higher interest and tax payments, lower cash generated from discontinued operations, higher domestic pension contributions and decreased contributions from working capital primarily related to higher production spending at Warner Bros. These factors causing declines were offset in part by an increase in Operating Income before Depreciation and Amortization (excluding non-cash impairment charges of intangible assets), a decrease in cash paid for restructuring and merger liabilities and $359 million of net cash received in connection with litigation settlements and lower cash generated from discontinued operations.

      Cash provided by operations increased to $7.032 billion in 2002, compared to $5.281 billion in 2001. The growth in cash flow from operations related to increased contributions from working capital, lower cash paid for restructuring and merger liabilities, offset in part by a decrease in Operating Income before Depreciation and Amortization (excluding non-cash impairment charges of intangible assets), and an increase in interest payments.

90


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Investing Activities

      Sources of cash provided (used) by investing activities are as follows:

                           
Year Ended December 31,

2003 2002 2001



(millions)
Acquisition of Historic TW cash and equivalents
  $     $     $ 690  
Investment and acquisitions, net of cash acquired
                       
 
WB Network
    (128 )            
 
AOL Europe
          (6,750 )      
 
IPC
                (1,566 )
 
Synapse
    (40 )           (320 )
 
All other, principally funding of joint ventures
    (402 )     (867 )     (1,614 )
Investments and acquisitions of discontinued operations
    (52 )     (162 )     (150 )
Capital expenditures and product development costs from continuing operations
    (2,761 )     (2,843 )     (3,047 )
Capital expenditures and product development costs from discontinued operations
    (126 )     (386 )     (574 )
Proceeds from sale of investment in Hughes
    783              
Proceeds from the sale of other available-for-sale securities
    294       187       30  
Investment in available-for-sale securities
                (527 )
Proceeds from sale of investment in Comedy Central
    1,225              
Proceeds from sale of Warner Manufacturing
    1,050              
All other investment proceeds(a)
    234       361       1,821  
     
     
     
 
 
Cash provided (used) by investing activities
  $ 77     $ (10,460 )   $ (5,257 )
     
     
     
 


(a)  For 2003, includes proceeds from sales of certain international theater investments ($156 million). For 2002, includes proceeds from sales of investments in Columbia House ($125 million) and Kinko’s ($124 million). For 2001, primarily relates to proceeds from the sale of short-term investments, including money market investments sold in 2001 that were held by AOL at the time of the America Online-Historic TW Merger.

    Cash provided by investing activities was $77 million in 2003, compared to cash used by investing activities of $10.460 billion in 2002. The increase in cash provided by investing activities is due primarily to the lower level of cash used for investments and acquisitions than in 2002, when the Company spent $6.75 billion in connection with the acquisition of Bertelsmann’s interest in AOL Europe. In addition, 2003 had higher investment proceeds from the sale of non strategic assets, related primarily to cash proceeds of $1.05 billion from the Company’s sale of Warner Manufacturing, the sale of the Company’s investment in Hughes (cash proceeds of $783 million), as well as cash proceeds of $1.225 billion related to the sale of the Company’s investment in Comedy Central. Capital expenditures and product development costs from continuing operations were essentially flat.

      Cash used by investing activities was $10.460 billion in 2002, compared to $5.257 billion in 2001. The increase in cash used by investing activities was due primarily to the increased cash used for acquisitions and investments in 2002, principally for the acquisition of Bertelsmann’s interest in AOL Europe. Also contributing to the increase was the decline in 2002 of investment proceeds from the sale of short-term investments (primarily money market investments sold in 2001 that were held by AOL at the time of the America Online-Historic TW Merger).

91


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Financing Activities

      Sources of cash provided (used) by financing activities are as follows:

                           
Year Ended December 31,

2003 2002 2001



(millions)
Borrowings
  $ 2,492     $ 23,535     $ 10,692  
Debt repayments
    (7,230 )     (18,984 )     (9,900 )
Redemption of mandatorily redeemable preferred securities of a subsidiary
    (813 )     (255 )     (575 )
Current period repurchases of common stock
          (102 )     (3,031 )
Dividends paid and partnership distributions, net from continuing operations
          (11 )     (59 )
Dividends paid and partnership distributions, net from discontinued operations
                (4 )
Principal payments on capital leases
    (178 )     (61 )      
Proceeds from exercise of stock options
    372       297       926  
Other financing activities
    (11 )     20       36  
     
     
     
 
 
Cash provided (used) by financing activities
  $ (5,368 )   $ 4,439     $ (1,915 )
     
     
     
 

      Cash used by financing activities was $5.368 billion in 2003 compared to cash provided by financing activities of $4.439 billion in 2002. The increase in cash used by financing activities was due principally to incremental debt repayments in 2003. These were pursuant to the Company’s debt reduction plan. This is in contrast to incremental borrowings in 2002 that were used to finance the acquisition of Bertelsmann’s interest in AOL Europe.

      Cash provided by financing activities was $4.439 billion in 2002, compared to cash used by financing activities of $1.915 billion in 2001. The increase in cash provided by financing activities is due principally to incremental borrowings in 2002 that were used to finance the acquisition of Bertelsmann’s interest in AOL Europe and lower payments in 2002 to repurchase the Company’s common stock due to the discontinuance of the Company’s stock repurchase program.

Free Cash Flow

      Time Warner evaluates operating performance based on several measures, including Free Cash Flow. Free Cash Flow is cash provided by operations (as defined by accounting principles generally accepted in the United States) less capital expenditures and product development costs, principal payments on capital leases, dividends paid and partnership distributions, if any. The Company considers Free Cash Flow to be an important indicator of the Company’s ability to reduce debt and make strategic investments. Free Cash Flow should be considered in addition to, and not a substitute for, the Company’s various cash flow measures recorded in accordance with accounting principles generally accepted in the United States (e.g., cash provided by operations).

92


 

TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The following table provides a reconciliation from the Company’s cash provided by operations to Free Cash Flow and free cash flow from Continuing Operations.

                           
Year Ended December 31,

2003 2002 2001



(millions)
Cash provided by operations
  $ 6,601     $ 7,032     $ 5,281  
 
Capital expenditures and product development costs
    (2,887 )     (3,229 )     (3,621 )
 
Dividends paid and partnership distributions
          (11 )     (63 )
 
Principal payments on capital leases
    (178 )     (61 )      
     
     
     
 
Free Cash Flow
    3,536       3,731       1,597  
 
Less: Free Cash Flow from discontinued operations
    (224 )     (242 )     (100 )
     
     
     
 
Free Cash Flow from continuing operations
  $ 3,312     $ 3,489     $ 1,497  
     
     
     
 

Capital Expenditures and Product Development Costs

      Time Warner’s total capital expenditures and product development costs were $2.887 billion in 2003, compared to $3.229 billion in 2002 and $3.621 billion in 2001. Capital expenditures and product development costs from continuing operations were $2.761 billion in 2003, $2.843 billion in 2002 and $3.047 billion in 2001. Capital expenditures and product development costs from continuing operations principally relate to the Company’s Cable segment, which had capital expenditures from continuing operations of $1.637 billion in 2003 and $1.813 billion in both 2002 and 2001.

      The Cable segment’s capital expenditures from continuing operations comprise the following categories:

                             
Year Ended December 31,

2003 2002 2001



(millions)
Cable Segment Capital Expenditures
                       
 
Customer premise equipment
  $ 715     $ 813     $ 962  
 
Scaleable infrastructure
    173       188       106  
 
Line extensions
    214       192       157  
 
Upgrade/rebuild
    175       224       353  
 
Support capital
    360       396       235  
     
     
     
 
   
Total capital expenditures
  $ 1,637     $ 1,813     $ 1,813  
     
     
     
 

      Time Warner’s Cable segment generally capitalizes expenditures for tangible fixed assets having a useful life of greater than one year. Capitalized costs typically include direct material, direct labor, overhead and interest. Sales and marketing costs, as well as the costs of repairing or maintaining existing fixed assets, are expensed as incurred. Types of capitalized expenditures at the Cable segment include plant upgrades, drops (i.e., customer installations), converters (i.e., analog and digital boxes that convert transmitted signals to analog and/or a digital TV signal) and cable modems used in the delivery of high-speed data services. With respect to customer premise equipment, including converters and cable modems, the Cable segment capitalizes direct installation charges only upon the initial deployment of such assets. All costs incurred in subsequent disconnects and reconnects are expensed as incurred. Depreciation on these assets is provided generally using the straight-line method over their estimated useful life. For converters and modems, such life is 3-5 years and for plant upgrades, such useful life is 3-16 years.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Outstanding Debt and Other Financing Arrangements

Outstanding Debt and Available Financial Capacity

      At December 31, 2003, Time Warner had total committed capacity, defined as maximum available borrowings under various existing debt arrangements and cash and short term investments, of $37.210 billion. Of this committed capacity, $11.106 billion was available to fund future contractual obligations and $25.745 billion was outstanding as debt (refer to Note 10 to the accompanying consolidated financial statements for more details on outstanding debt). At December 31, 2003, total committed capacity, unused capacity and outstanding debt were as follows:

                                   
Committed Letters of Unused Outstanding
Capacity Credit(a) Capacity Debt




(millions)
Cash and equivalents
  $ 3,040     $     $ 3,040     $  
Bank credit agreement and commercial paper programs
    11,000       359       8,066       2,575  
Fixed-rate public debt(b)
    22,485                   22,485  
Other fixed-rate obligations
    685                   685  
     
     
     
     
 
 
Total
  $ 37,210     $ 359     $ 11,106     $ 25,745  
     
     
     
     
 


(a) Represents the portion of committed capacity reserved for outstanding and undrawn letters of credit.
(b) Includes debt due within one year of $2.287 billion, which primarily relates to the AOL zero-coupon convertible notes for $1.325 billion and approximately $725 million of public bonds that are due or callable in 2004.

    During 2003, Time Warner amended and/or refinanced certain of its credit facilities. The credit facilities now consist of a $6.0 billion five-year revolving credit facility (maturity date of July 8, 2007) and a $1.5 billion 364-day revolving credit facility (collectively, the “TW Facilities”), and the credit facilities of TWC Inc. now consist of a $2.0 billion five-year revolving credit facility (maturity date of December 9, 2008), a $500 million three-year term loan (maturity date of December 9, 2006) and a $1.0 billion 364-day revolving credit facility (collectively, the “TWC Facilities”). The permitted borrowers under the TW Facilities are Time Warner and Time Warner Finance Ireland. The obligations of both Time Warner and Time Warner Finance Ireland are directly or indirectly guaranteed by America Online, Historic TW Inc., Turner Broadcasting System, Inc., and Time Warner Companies, Inc. The obligations of Time Warner Finance Ireland are guaranteed by Time Warner. The permitted borrowers under the TWC Facilities (other than the term loan, on which TWC Inc. is the sole borrower) are TWC Inc. and TWE, and each guarantees the other’s obligations under the TWC Facilities. Warner Communications Inc. and American Television and Communications Corporation (each indirect wholly-owned subsidiaries of Time Warner, but not subsidiaries of TWC Inc. or TWE) each guarantee a pro rata portion of TWE’s obligations under the TWC Facilities (including TWE’s obligations under its guaranty of TWC Inc.’s obligations). Borrowings under the 364-day facilities may be extended for a period up to one year beyond the respective initial maturity dates of July 6, 2004, for the TW Facilities and December 8, 2004, for the TWC Facilities.

      Borrowings under all of the TW Facilities and the TWC Facilities bear interest at rates based on the credit rating of the respective borrowers, which rates are currently LIBOR plus 0.525% in the case of the 364-day facilities, LIBOR plus 0.500% in the case of the five-year facilities and LIBOR plus 0.625% in the case of the term loan. In addition, the respective borrowers are required to pay a facility fee of 0.10% per annum on the aggregate commitments under the 364-day facilities and 0.125% per annum on the aggregate commitments under the five-year facilities. In the case of Time Warner, an additional usage fee of 0.0625% of the outstanding loans under the TW Facilities is incurred if the aggregate outstanding loans under the TW Facilities and the revolving TWC Facilities on a combined basis exceed 33% of the aggregate committed

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

amounts thereunder, and 0.125% if such outstanding amounts exceed 66%. In the case of TWC Inc., an additional usage fee of 0.0625% of the outstanding loans under the revolving TWC Facilities is incurred if the aggregate outstanding loans under the revolving TWC Facilities exceed 33% of the aggregate committed amounts thereunder, and 0.125% if such outstanding amounts exceed 66%. The TW Facilities and the TWC Facilities provide same-day funding, and the TW Facilities provide multi-currency capability. The TW Facilities contain a maximum leverage ratio covenant of 4.5 times consolidated EBITDA of Time Warner and an interest coverage covenant of 2.0 times consolidated cash interest expense of Time Warner. The TWC Facilities contain a maximum leverage ratio covenant of 5.0 times consolidated EBITDA of TWC Inc., and an interest coverage covenant of 2.0 times consolidated cash interest expense of TWC Inc. Each of these ratios are defined in the agreements. At December 31, 2003, the Company was in compliance with the covenants, with leverage coverage and interest coverage, as calculated in accordance with the applicable agreements, of approximately 2.5 times and 5.1 times, respectively, for Time Warner and 2.6 times and 6.7 times, respectively, for TWC Inc. The credit facilities do not contain any credit ratings-based defaults or covenants, nor any ongoing covenant or representations specifically relating to a material adverse change in Time Warner’s or TWC Inc.’s financial condition or results of operations. Borrowings may be used for general corporate purposes and unused credit is available to support commercial paper borrowings.

Other Financing Arrangements

      From time to time, the Company enters into various other financing arrangements with SPEs that provide for the accelerated receipt of cash on certain accounts receivable and backlog licensing contracts. The Company employs these arrangements because they provide a cost-efficient form of financing, as well as an added level of diversification of funding sources. The Company 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. These facilities generally have relatively short-term maturities (1 to 5 years), which is taken into account in determining the maximum efficiency for the Company’s overall capital structure. The Company’s maturity profile of its outstanding debt and other financing arrangements is relatively long-term, with a weighted maturity of approximately 12 years. The assets and financing associated with these arrangements qualify for off-balance sheet treatment. For more detail, see Note 10 to the accompanying consolidated financial statements.

      The following table summarizes the Company’s financing arrangements with SPEs at December 31, 2003:

                           
Committed Unused Outstanding
Capacity(a) Capacity Utilization



(millions)
Accounts receivable securitization facilities
  $ 955     $ 96     $ 859  
Backlog securitization facility(b)
    500             500  
     
     
     
 
 
Total other financing arrangements
  $ 1,455     $ 96     $ 1,359  
     
     
     
 


(a) Ability to use accounts receivable securitization facilities and backlog securitization facility depends on availability of qualified assets.
(b) The outstanding utilization on the backlog securitization facility is classified as deferred revenue on the accompanying consolidated balance sheet.

Film Sale-Leaseback Arrangements

      From time to time the Company has entered into arrangements where certain film assets are sold to third-party investors which generate tax benefits to the investors which are not otherwise available to the Company. The form of these transactions differ, but is generally that of a sale-leaseback arrangement with a third-party SPE. Such SPEs are capitalized with approximately $1.8 billion of debt and equity from the third-party investors. The Company does not guarantee or is not otherwise responsible for the equity and debt in

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

these SPEs and does not participate in the profits or losses of these SPEs. Accordingly, the Company does not consolidate these SPEs. Instead, the Company accounts for these arrangements based on their substance. That is, the net benefit paid to the Company from these transactions is recorded as a reduction of film costs. These transactions resulted in reductions of film costs totaling $80 million, $60 million, and $40 million for the years ended December 31, 2003, 2002 and 2001, respectively.

Financial Covenants and Rating Triggers

      Each of the Company’s bank credit agreements and financing arrangements with SPEs contain customary covenants. A breach of such covenants in the bank credit agreements that continues beyond any grace period can constitute a default, which can limit the ability to borrow and can give rise to a right of the lenders to terminate the applicable facility and/or require immediate payment of any outstanding debt. A breach of such covenants in the financing arrangements with SPEs that continues beyond any grace period can constitute a termination event, which can limit the facility as a future source of liquidity; however, there would be no claims on the Company for the receivables or backlog contracts previously sold. Additionally, in the event that the Company’s credit ratings decrease, the cost of maintaining the bank credit agreements and facilities and of borrowing increases and, conversely, if the ratings improve, such costs decrease.

      As of December 31, 2003, and through the date of this filing, the Company was in compliance with all covenants. Management does not foresee that the Company will have any difficulty complying with the covenants currently in place in the foreseeable future.

Contractual and Other Obligations

Contractual Obligations

      In addition to the previously discussed financing arrangements, the Company has obligations under certain contractual arrangements to make future payments for goods and services. These contractual obligations secure the future rights to various assets and services to be used in the normal course of operations. For example, the Company is contractually committed to make certain minimum lease payments for the use of property under operating lease agreements. In accordance with applicable accounting rules, the future rights and obligations pertaining to firm commitments such as operating lease obligations and certain purchase obligations under contracts are not reflected as assets or liabilities on the accompanying consolidated balance sheet.

      In 2003, the SEC released Financial Reporting Release No. 67, “Disclosure in Management’s Discussion and Analysis about Off-Balance Sheet Arrangements and Aggregate Contractual Obligations” (“FRR 67”). FRR 67 requires companies to present an overview of certain known contractual obligations in tabular format. Specifically, FRR 67 requires companies to include in a table information related to long-term debt obligations, capital lease obligations, operating lease obligations, purchase obligations and other long-term liabilities reflected on a registrant’s balance sheet under generally accepted accounting principles in the United States (“GAAP”).

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

      The following table summarizes the Company’s aggregate contractual obligations meeting the requirements of FRR 67 at December 31, 2003, and the estimated timing and effect that such obligations are expected to have on the Company’s liquidity and cash flow in future periods.

                                           
2009 and
Contractual Obligations(1) Total 2004 2005-2006 2007-2008 thereafter






(millions)
Outstanding debt obligations (Note 10)
  $ 25,329     $ 2,164     $ 3,578     $ 4,548     $ 15,039  
Capital lease obligations (Note 10)
    343       187       139       7       10  
Operating lease obligations (Note 18)
    4,601       515       929       834       2,323  
Purchase obligations
    10,722       4,428       3,892       1,526       876  
     
     
     
     
     
 
 
Total contractual obligations and outstanding debt
  $ 40,995     $ 7,294     $ 8,538     $ 6,915     $ 18,248  
     
     
     
     
     
 


(1) The table does not include the effects of certain put/call or other buy-out arrangements involving certain of the Company’s investees, which are discussed in more detail in the pages that follow.

    The following is a description of the Company’s material contractual obligations meeting the requirements of FRR 67 at December 31, 2003:

  •  Outstanding debt obligations — represents the principal amounts due on outstanding debt obligations, current and long-term, as of December 31, 2003. Amounts do not include any fair value adjustments, bond premiums, discounts or interest payments.
 
  •  Capital lease obligations — represents the minimum capital lease payments under noncancelable leases, primarily for network equipment at the AOL segment held under capital leases.
 
  •  Operating lease obligations — represents the minimum lease rental payments under noncancelable leases, primarily for the Company’s real estate and operating equipment in various locations around the world.
 
  •  Purchase Obligations — A purchase obligation is defined in FRR 67 as “an agreement to purchase goods or services that is enforceable and legally binding on the Company and that specifies all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction.” The Company expects to receive consideration (i.e., products or services) for these purchase obligations. The purchase obligation amounts do not represent the entire anticipated purchases in the future, but represent only those items for which the Company is contractually obligated. Additionally, the Company also purchases products and services as needed, with no firm commitment. For this reason, the amounts presented in the table will not provide a reliable indicator of the Company’s expected future cash outflows on a stand-alone basis. For purposes of identifying and accumulating purchase obligations, the Company has included all material contracts meeting the definition of a purchase obligation (e.g., legally binding for a fixed or minimum amount or quantity). For those contracts involving a fixed or minimum quantity, but variable pricing, the Company has estimated the contractual obligation based on its best estimate of pricing that will be in effect at the time the obligation is incurred. Additionally, the Company has included only the obligation governed by those contracts that existed at December 31, 2003, and did not assume renewal or replacement of the contract at the end of its term. If a contract includes a penalty for non-renewal, the Company has included that penalty, assuming it will be paid in the period after the contract term expires. If Time Warner can unilaterally terminate an agreement simply by providing a certain number of days notice or by paying a termination fee, the Company has included the amount of the termination fee or the amount that would be paid over the “notice period.” Contracts that can be unilaterally

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

  terminated without incurring a penalty have not been included. The following table summarizes the Company’s purchase obligations at December 31, 2003, and the estimated timing and effect that such obligations are expected to have on the Company’s liquidity and cash flow in future periods:
                                           
2009 and
Purchase Obligations Total 2004 2005-2006 2007-2008 thereafter






(millions)
Network programming obligations(1)
  $ 4,139     $ 1,106     $ 1,522     $ 1,078     $ 433  
Narrowband and broadband network obligations(2)
    1,539       1,054       485              
Creative talent and employment agreements(3)
    1,822       902       699       191       30  
Obligations to purchase paper and to use certain printing facilities for the production of magazines and books
    817       286       450       81        
Obligations to certain investee companies(4)
    584       234       350              
Advertising, marketing and sponsorship obligations(5)
    522       296       174       52        
Obligations to purchase information technology licenses and services
    336       96       80       54       106  
Obligations to purchase cable converters and modems
    221       221                    
Other, primarily general and administrative and distribution obligations(6)
    742       233       132       70       307  
     
     
     
     
     
 
 
Total purchase obligations
  $ 10,722     $ 4,428     $ 3,892     $ 1,526     $ 876  
     
     
     
     
     
 


(1) The Networks segment enters into contracts to license sports programming to carry on its television networks. The amounts in the table above represent minimum payment obligations to sports leagues (e.g., NBA, PGA and MLB) to air the programming over the contract period. The Networks segment also enters into licensing agreements with certain movie studios to acquire the rights to air movies that the movie studios release theatrically (“Studio Movie Deals”). The pricing structure in these contracts differs from one another in that certain agreements can require a fixed amount per movie while others will be based on a percentage of the movie’s box office receipts (with license fees generally capped at specified amounts), or a combination of both. The amounts included herein represent obligations for movies that have been released theatrically as of December 31, 2003 and are calculated using the actual or estimated box office performance or fixed amounts, as applicable.
(2) Narrowband and broadband network obligations relate primarily to minimum purchase commitments that AOL has with various narrowband and broadband network providers.
(3) The Company’s commitments under creative talent and employment agreements include obligations to executives, actors, producers, authors, sports personnel and other talent under contractual arrangements, including union contracts.
(4) Obligations to certain investee companies represent obligations to purchase additional interests in a subsidiary of the Publishing segment and fund investees within the AOL, Networks and Filmed Entertainment segments. Included in this amount is approximately $120 million for the Company’s purchase of an additional interest in Synapse Group Inc. in the second quarter of 2004.
(5) Advertising, marketing and sponsorship obligations includes minimum guaranteed royalty and marketing payments to vendors and content providers of the AOL segment.
(6) Other includes obligations to purchase general and administrative items such as legal, security, janitorial, office equipment, support and maintenance services, office supplies, obligations related to the Company’s postretirement and unfunded defined benefit pension plans, as well as obligations of the AOL segment for distribution of AOL CDs and for the duplication and distribution of Filmed Entertainment products.

    Most of the Company’s other long-term liabilities on the accompanying consolidated balance sheet have already been incorporated in the estimated timing of cash payments provided in the summary of contractual obligations, the most significant of which is an approximate $800 million liability for film licensing obligations. However, certain long-term liabilities have been excluded from the summary because there are no cash outflows associated with them (e.g., deferred revenue and mandatorily convertible preferred stock) or because cash outflows associated with certain other noncurrent liabilities are uncertain (e.g., deferred taxes, minority

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

interests, participations and royalties, deferred compensation, all liabilities from discontinued operations and other miscellaneous items). Contractual capital commitments are also included in the preceding table, but these commitments represent a small part of the Company’s expected capital spending in 2004 and beyond. Additionally, minimum pension funding requirements have not been presented as such amounts have not been determined. The Company does not have a required minimum pension contribution obligation for its defined benefit pension plans in 2004. Thus, Company contributions to its defined benefit pension plans are expected to be largely discretionary in 2004.

Other Contractual Obligations

      In addition to the contractual obligations previously discussed, certain other contractual commitments of the Company entail variable or undeterminable quantities and/or prices and, thus, do not meet the definition of a commitment set forth in FRR 67. As certain of these commitments are significant to our business, the Company has summarized these arrangements below. Given the variability in the terms of these arrangements, significant estimates were involved in the determination of these obligations. Actual amounts, once known, could differ significantly from these estimates.

                                         
2009 and
Other Contractual Commitments Total 2004 2005-2006 2007-2008 thereafter






(millions)
Cable and Network programming and DVD manufacturing obligations
  $ 16,082     $ 2,352     $ 4,760     $ 4,686     $ 4,284  
     
     
     
     
     
 

      The Company’s other contractual commitments at December 31, 2003 primarily consist of Cable programming arrangements, future film licensing obligations and DVD manufacturing obligations. Cable programming arrangements represent contracts that the Company’s Cable segment has with cable television networks to provide programming service to its subscribers. Typically, these arrangements provide that the Company purchase cable television programming for a certain number of subscribers provided that the Company is providing cable services to such number of subscribers. There is generally no obligation to purchase these services if the Company is not providing cable services. The obligation included in the above table represents estimates of future cable programming costs based on subscriber levels at December 31, 2003, and current contractual per subscriber rates. Network programming obligations represent Studio Movie Deal commitments to acquire the right to air movies that will be released in the future (i.e., after December 31, 2003). These arrangements do not meet the description of a purchase obligation under FRR 67 since there are neither fixed nor minimum quantities under the arrangement. The amounts included herein have been estimated giving consideration to historical box office performance and studio release trends. DVD manufacturing obligations relate to a six-year agreement at the Filmed Entertainment segment with a third-party manufacturer to purchase the Company’s DVD requirements. This arrangement does not meet the description of a purchase obligation under FRR 67 since there are neither fixed nor minimum quantities under the arrangement. Amounts were estimated using current DVD manufacturing volumes and minimum pricing per manufactured DVD for each year of the agreement.

      The Company expects to fund the firm commitments and contractual commitments with cash flow from operations generated in the normal course of business.

Contingent Commitments

      The Company also has certain contractual arrangements that would require the Company to make payments or provide funding if certain circumstances occur (“contingent commitments”). For example, the Company has guaranteed certain lease obligations of joint venture investees. In this circumstance, the Company would be required to make payments due under the lease to the lessor in the event of default by the

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

joint venture investee. The Company does not expect that these contingent commitments will result in any material amounts being paid by the Company in the foreseeable future.

      The following table summarizes separately the Company’s contingent commitments at December 31, 2003. The timing of amounts presented in the table represents when the maximum contingent commitment will expire and does not mean that the Company expects to incur an obligation to make any payments during that timeframe.

                                           
Total 2009 and
Nature of Contingent Commitments Commitments 2004 2005-2006 2007-2008 thereafter






(millions)
Guarantees
  $ 2,558     $ 117     $ 185     $ 197     $ 2,059  
Letters of credit and other contingent commitments
    2,658       369       44       16       2,229  
     
     
     
     
     
 
 
Total contingent commitments
  $ 5,216     $ 486     $ 229     $ 213     $ 4,288  
     
     
     
     
     
 

      The following is a description of the Company’s contingent commitments at December 31, 2003:

  •  Guarantees include guarantees the Company has provided on certain lease and operating commitments entered into by (a) formerly owned entities, including guarantees related to the 1998 sale of Six Flags Entertainment Corp., and (b) joint ventures in which Time Warner is or was a venture partner.
 
  •  Generally, letters of credit support performance and payments for a wide range of global contingent and firm obligations including insurance, litigation appeals, import of finished goods, real estate leases and other operational needs. The Cable segment has obtained letters of credit for several of its joint ventures. Should these joint ventures default on their obligations supported by the letters of credit, the Cable segment would be obligated to pay these costs to the extent of the letters of credit. In addition, the Company provides for letters of credit and surety bonds related to insurance premiums and the Cable segment provides for letters of credit and surety bonds that are required by certain local governments when cable is being installed.

      Except as otherwise discussed above and below, Time Warner does not guarantee the debt of any its investments accounted for using the equity method of accounting.

Selected Investment Information

 
Cable Joint Ventures

      On December 1, 2003, the Company announced that TWC Inc. would restructure two joint ventures that it manages, Kansas City Cable Partners (“KCCP”), a 50-50 joint venture between Comcast and TWE serving approximately 304,000 basic video subscribers as of December 31, 2003, and Texas Cable Partners, L.P. (“TCP”), a 50-50 joint venture between Comcast and TWE-A/N serving approximately 1.2 million basic video subscribers as of December 31, 2003. The Company accounts for its investment in these joint ventures using the equity method. Under the restructuring, completion of which is subject to customary conditions (including receipt of applicable regulatory approvals), KCCP will be merged into TCP, which will be renamed “Texas and Kansas City Cable Partners, L.P.” Following the restructuring, the combined partnership will be owned 50% by Comcast, and 50% by TWE and TWE-A/N collectively. Beginning any time after the later of June 1, 2006, and the two-year anniversary of the closing of the restructuring, either TWC Inc. or Comcast can trigger a dissolution of the partnership. If a dissolution is triggered, the non-triggering party has the right to choose and take full ownership of one of two pools of the combined partnership’s systems — one pool consisting of the Houston systems and the other consisting of the Kansas City and south Texas systems — with an arrangement to distribute the partnership’s debt between the two

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

pools. The party triggering the restructuring would own the remaining pool of systems and any debt associated with that pool.

      In December 2003, TWE-A/N (which owns the majority of the Company’s equity stake in TCP) agreed to extend its commitment to provide a ratable share (i.e., 50%) of any funding required to maintain TCP in compliance with its financial covenants under its bank credit facilities (which facilities are otherwise non-recourse to the Company and its other subsidiaries) from January 15, 2004 to January 15, 2005. Funding made in respect of this funding agreement is contributed to TCP in the form of partner subordinated loans. The aggregate amount of subordinated debt provided by TWE-A/N in 2003 in respect of its obligations under the funding agreement was $83 million. Upon closing of the restructuring, the existing TCP bank credit facilities (approximately $1 billion in aggregate principal outstanding as of December 31, 2003) shall remain in place and the funding agreement, and TWE-A/N’s ratable funding obligations thereunder, shall automatically be extended through the earlier of the maturity of the TCP credit facilities in June 2007, and the refinancing thereof pursuant to the dissolution of the partnership. TWE-A/N’s ultimate liability in respect of the funding agreement is dependent upon the financial results of TCP (or, after giving effect to the restructuring, TKCCP).

Time Warner Entertainment

      At any time following the second anniversary of the closing of the restructuring of TWE (i.e., March 31, 2005), Comcast has the right to require TWC to purchase all or a portion of the Comcast’s 4.7% limited partnership interest in TWE at an appraised fair market value, subject to a right of first refusal in favor of Time Warner. Comcast also has the right, at any time following the second anniversary of the closing of the restructuring of TWE, 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 Time Warner and, second, in favor of TWC Inc. If TWC Inc. and Time Warner do not collectively elect to purchase all of Comcast’s offered partnership interest, Comcast 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 Time Warner, if that third party agrees to be bound by the same terms and conditions applicable to Comcast as a limited partner in TWE. The purchase price payable by TWC Inc. or Time Warner as consideration for Comcast’s partnership interest may be cash; common stock, if the common stock of the purchaser is then publicly traded, or a combination of both.

Court TV Joint Venture

      The Company and Liberty Media (“Liberty”) each have a 50% interest in Court TV. Beginning January 2006, Liberty may give written notice to Time Warner requiring Time Warner to purchase all of Liberty’s interest in Court TV (the “Liberty Put”). In addition, as of the same date, Time Warner may, by notice to Liberty, require Liberty to sell all of its interest in Court TV to Time Warner (the “Time Warner Call”). The price to be paid upon exercise of either the Liberty Put or the Time Warner Call will be an amount equal to one half of the fair market value of Court TV, determined by an appraisal. The consideration is required to be paid in cash if the Liberty Put is exercised. If the Time Warner Call is exercised, the consideration is also payable in cash only if Liberty determines that the transaction cannot be structured as a tax efficient transaction, or if Time Warner determines that a tax efficient transaction may either violate applicable law or cause a breach or default under any other agreement affecting Time Warner.

Bookspan Joint Venture

      The Company and Bertelsmann each have a 50% interest in the Bookspan joint venture, which operates the U.S. book clubs, Book-of-the-Month Club, Inc., and Doubleday, jointly. Under the General Partnership Agreement, beginning on June 30, 2005, and then on January 1 of each subsequent year, either Bertelsmann or the Company may elect to terminate the partnership by giving notice during 60-day termination periods. If

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

such an election is made, a confidential bid process will take place, pursuant to which the highest bidder will purchase the other party’s entire venture interest. The Company is unable to predict whether this bid process will occur or the amount that may be paid out or received under it. For the year ended December 31, 2003, the Bookspan joint venture had Operating Income before Depreciation and Amortization and Operating Income of approximately $30 million and $15 million, respectively.

Warrant of Google Inc.

      In June 2002, America Online was issued a five-year warrant to purchase approximately 1.9 million shares of preferred stock of Google Inc. (not taking into account any subsequent stock-splits) for approximately $22 million. The Company’s carrying value for this warrant is $0. The warrant has no anti-dilution provisions. Following exercise, the preferred stock is convertible into common stock of Google at any time at the election of America Online, and converts automatically if Google completes an initial public offering with at least specified minimum offering price and proceeds. If such an offering is consummated before the warrant is exercised, the warrant may then be exercised only for common stock.

      America Online is restricted from transferring the warrant, except to the Company or its wholly-owned subsidiaries. In addition, transfers of the warrant and shares underlying the warrant are subject to a registration statement covering the transfer being in effect or, at the request of Google, delivery of a legal opinion that no registration is required for the transfer. Under the terms of the warrant, America Online may be required to agree to a 180-day restriction on transfers of Google securities following an initial public offering and a 90-day restriction with any subsequent public offerings while it holds the warrant or shares received upon exercise of the warrant. The Company cannot predict whether or when Google may undertake any public offering of its equity securities or what value or percentage of equity the warrant or shares underlying the warrant may represent if Google does undertake a public offering.

Filmed Entertainment Backlog

      Backlog represents the amount of future revenue not yet recorded from cash contracts for the licensing of theatrical and television product for pay cable, basic cable, network and syndicated television exhibition. Backlog for all of Time Warner’s Filmed Entertainment companies was approximately $3.9 billion at December 31, 2003, and approximately $3.3 billion at December 31, 2002, including amounts relating to the licensing of film product to Time Warner’s Networks segment of approximately $740 million at December 31, 2003 and $850 million at December 31, 2002.

      Because backlog generally relates to contracts for the licensing of theatrical and television product which have already been produced, the recognition of revenue for such completed product is principally dependent upon the commencement of the availability period for telecast under the terms of the related licensing agreement. Cash licensing fees are collected periodically over the term of the related licensing agreements or, as referenced above and discussed in more detail in Note 10 to the accompanying consolidated financial statements, on an accelerated basis using a $500 million securitization facility. The portion of backlog for which cash has not already been received has significant off-balance sheet asset value as a source of future funding. Of the approximately $3.9 billion of backlog relating to the Filmed Entertainment segment as of December 31, 2003, Time Warner has recorded $500 million of deferred revenue on the accompanying consolidated balance sheet, representing cash received through the utilization of the backlog securitization facility and other advanced payments. The backlog excludes filmed entertainment advertising barter contracts, which are also expected to result in the future realization of revenues and cash through the sale of advertising spots received under such contracts.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

MARKET RISK MANAGEMENT

      Market risk is the potential loss arising from adverse changes in market rates and prices, such as interest rates, foreign currency exchange rates and changes in the market value of investments.

Interest Rate Risk

      Time Warner has entered into variable-rate debt that, at December 31, 2003, had an outstanding balance of $2.575 billion. Based on Time Warner’s variable-rate obligations outstanding at December 31, 2003, each 25 basis point increase or decrease in the level of interest rates would, respectively, increase or decrease Time Warner’s annual interest expense and related cash payments by approximately $6 million. Such potential increases or decreases are based on certain simplifying assumptions, including a constant level of variable-rate debt for all maturities and an immediate, across-the-board increase or decrease in the level of interest rates with no other subsequent changes for the remainder of the period. Conversely, since almost all of the Company’s cash balance of approximately $3 billion is invested in variable rate interest earning assets, the Company would also earn more (less) interest income due to such an increase (decrease) in interest rates.

      Time Warner has entered into fixed-rate debt that, at December 31, 2003, had an outstanding balance of $22.485 billion and a fair value of $25.190 billion. Based on Time Warner’s fixed-rate debt obligations outstanding at December 31, 2003, a 25 basis point increase or decrease in the level of interest rates would, respectively, decrease or increase the fair value of the fixed-rate debt by approximately $463 million. Such potential increases or decreases are based on certain simplifying assumptions, including a constant level and rate of fixed-rate debt and an immediate across-the-board increase or decrease in the level of interest rates with no other subsequent changes for the remainder of the period.

      From time to time, the Company uses interest rate swaps to strategically manage the fixed to floating rate balance of its debt portfolio. Under the interest rate swap contract, the company agrees to receive a fixed rate payment (in most cases equal to the stated coupon rate of the bond being hedged) for a floating rate payment. The net payment on the swap is exchanged at a specified interval that usually coincides with the bonds underlying coupon payment on the agreed upon notional amount.

      During the fourth quarter of 2003, the Company entered into interest rate swaps with a notional face amount of $300 million to hedge the fair value of certain of its fixed rate debt. The swaps, which mature at different dates ranging from August 2004 to June 2005, effectively convert the fixed rate debt to variable rate instruments indexed to LIBOR. These swaps have been designated as a fair value hedge of the changes in fair value of the Company’s fixed rate debt, attributable to changes in benchmark interest rates. As key terms of the swap match the debt they are intended to hedge, changes in the fair value of the swap are substantially offset in the consolidated statement of operations by changes in the fair value of the hedged item. The fair value of these swaps at December 31, 2003 was not material.

      The Company monitors its positions with, and the credit quality of, the financial institutions, which are party to any of its financial transactions. Credit risk related to interest rate swaps is considered low because swaps are entered into with strong creditworthy counterparties and are limited to the net interest payments due/payable for the remaining life of the swap.

Foreign Currency Risk

      Time Warner uses foreign exchange contracts primarily to hedge the risk that unremitted or future royalties and license fees owed to Time Warner 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. Similarly, the Company enters into foreign exchange contracts to hedge all or certain film production costs abroad. As part of its overall strategy to manage the level of exposure to the risk of foreign currency exchange

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

rate fluctuations, primarily exposure to changes in the value of the British pound, Japanese yen and Euro, Time Warner hedges a portion of its foreign currency exposures anticipated over the ensuing eighteen-month period (the “hedging period”). At December 31, 2003, Time Warner had effectively hedged approximately 70% of the estimated net foreign currency exposures that relate principally to anticipated cash flows for royalties and license fees to be remitted to the U.S. over the ensuing 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 cash revenues back into U.S. dollars. Therefore, the hedging period covers an eighteen-month period. To hedge this exposure, Time Warner uses foreign exchange contracts that generally have maturities of three months to eighteen months providing continuing coverage throughout the hedging period. At December 31, 2003, Time Warner had contracts for the sale of $3.544 billion and the purchase of $1.934 billion of foreign currencies at fixed rates, including net contracts for the sale of $692 million of the British Pound, $633 million of the Euro and $152 million of the Japanese Yen. At December 31, 2002, Time Warner had contracts for the sale of $975 million and the purchase of $911 million of foreign currencies at fixed rates, including net contracts for the sale of $74 million of Japanese yen and $156 million of the Euro, and net contracts for the purchase of $190 million of the British pound.

      Based on the foreign exchange contracts outstanding at December 31, 2003, each 5% devaluation of the U.S. dollar as compared to the level of foreign exchange rates for currencies under contract at December 31, 2003 would result in approximately $81 million of net unrealized losses. Conversely, a 5% appreciation of the U.S. dollar would result in approximately $81 million of net unrealized gains. Consistent with the nature of the economic hedge provided by such foreign exchange contracts, such unrealized gains or losses largely would be offset by corresponding decreases or increases, respectively, in the dollar value of future foreign currency royalty and license fee payments that would be received in cash within the hedging period from the sale of U.S. copyrighted products abroad.

Equity Risk

      The Company is exposed to market risk as it relates to changes in the market value of its investments. The Company invests in equity instruments of public and private companies for operational and strategic business purposes. These securities are subject to significant fluctuations in fair market value due to volatility of the stock market and the industries in which the companies operate. These securities, which are classified in “Investments, including available-for-sale securities” on the accompanying consolidated balance sheet, include equity-method investments, investments in private securities, available-for-sale securities, restricted securities and equity derivative instruments. As of December 31, 2003, the Company had $396 million of cost-method investments, primarily relating to private equity securities, $775 million of fair value investments (including $732 million of investments in unrestricted public equity securities held for purposes other than trading and $43 million of equity derivative instruments) and $2.486 billion of investments accounted for using the equity method of accounting.

      In recent years, Time Warner experienced significant declines in the value of certain investments. As a result, the Company has recorded non-cash pretax charges of $204 million in 2003, $2.199 billion in 2002 and $2.528 billion in 2001. These charges were primarily to reduce the carrying value of certain publicly traded and privately held investments, restricted securities and investments accounted for using the equity method of accounting that had experienced other-than-temporary declines in value. In addition, these charges reflect market fluctuations in equity derivative instruments, which resulted in gains of $8 million in 2003, gains of $13 million in 2002 and losses of $49 million in 2001 (Note 7). While Time Warner has recognized all declines that are believed to be other-than-temporary, it is reasonably possible that individual investments in the Company’s portfolio may experience an other-than-temporary decline in value in the future if the underlying investee company experiences poor operating results or if the U.S. equity markets experience

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

future broad declines in value. See Note 7 to the accompanying consolidated financial statements for additional discussion.

CRITICAL ACCOUNTING POLICIES

      The SEC considers an accounting policy to be critical if it is important to the Company’s financial condition and results, and if it requires significant judgment and estimates on the part of management in its application. The development and selection of these critical accounting policies have been determined by management of Time Warner and the related disclosures have been reviewed with the Audit and Finance Committee of the Board of Directors. For a summary of all of the Company’s significant accounting policies, see Note 1 to the accompanying consolidated financial statements.

Revenue Recognition

      Two areas related to revenue recognition that incorporate significant judgment and estimates by management are the accounting for multiple-element transactions and gross versus net revenue recognition. See Note 1 for additional discussion.

Multiple-Element Transactions

      Multiple-element transactions within Time Warner fall broadly into two categories:

1.  Contemporaneous purchases and sales. In these transactions, the Company is selling a product or service (e.g., advertising services) to a customer and at the same time purchasing goods or services from that customer or making an investment in that customer; and
 
2.  Sales of multiple products or services. In these transactions, the Company is selling multiple products or services to counterparties.

Contemporaneous Purchases and Sales

      In the normal course of business, Time Warner enters into transactions in which it is purchasing a product or service and/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. In prior periods, the accounting judgments associated with these transactions were most significant to the Company’s AOL and Cable segments. Specifically, the AOL segment often negotiated for the sale of advertising at the same time as it purchased goods or services or made an investment in a counterparty. Similarly, when negotiating programming arrangements with cable networks, the Company’s Cable segment may negotiate for the sale of advertising to the cable network.

      These arrangements may be documented in one contract or may be documented in two separate contracts; whether there are one or two contracts, these arrangements generally are negotiated simultaneously. In accounting for these arrangements, the Company looks to the guidance contained in the following authoritative literature:

  •  APB Opinion No. 29, “Accounting for Nonmonetary Transactions” (“APB 29”);
 
  •  Emerging Issues Task Force (“EITF”) Issue No. 02-16, “Accounting by a Customer (Including a Reseller) for Certain Consideration Received from a Vendor” (“EITF 02-16”); and
 
  •  EITF Issue No. 01-09, “Accounting for Consideration Given by a Vendor to a Customer” (“EITF 01-09”).

      The Company accounts for each transaction that has been negotiated simultaneously based on the respective fair values of the goods or services purchased and the goods or services sold. If the Company is

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

unable to determine the fair value of one or more of the elements being purchased, then revenue recognition is limited to the total consideration received for the products or services sold less the amounts paid that can be supported. For example, if the Company sells advertising to a customer for $10 million in cash and contemporaneously enters into an arrangement to acquire software for $2 million from the same customer, but fair value for the software cannot be reliably determined, the Company would limit the amount of revenue recognized related to the advertising sold to $8 million and would ascribe no value to the software acquisition. As another example, if the Company sells advertising to a customer for $10 million in cash and contemporaneously invests $2 million in the equity of that same customer, and the fair value for the equity investment is determined to be $2 million, the Company would recognize revenue in the amount of the advertising sold of $10 million and would ascribe $2 million to the equity investment. Accordingly, the judgments made regarding fair value in accounting for these arrangements impact the amount and period in which revenues, expenses and net income are recognized over the term of the contract.

      In determining the fair value of the respective elements, the Company refers to quoted market prices (where available), historical transactions or comparable cash transactions. For example, in determining the fair value of a non-publicly-traded equity security purchased at the same time the Company sells goods or services to an investee, the Company would evaluate what other investors have paid in the most recent round of financings with the investee. If the investment is publicly traded, fair value would be determined by reference to quoted market prices. In addition, the stated terms of a transaction are considered to be at fair value to the extent that the Company has received price protection in the form of “most favored nation” clauses or similar contractual provisions, which are generally indicative of fair value.

      Further, in a contemporaneous purchase and sale transaction, evidence of fair value for one element of a transaction may provide support for the fair value of the other element of a transaction. For example, if the Company sells advertising to a customer and contemporaneously invests in the equity of that same customer, evidence of the fair value of the investment would implicitly support the fair value of the advertising sold since there are only two elements in the arrangement.

      During 2003, the extent of such arrangements has declined at both the AOL and cable segments. However, the Company encountered similar judgments in accounting for certain disposition transactions during 2003. Specifically, the Company encountered similar judgments in the following transactions:

    Sale of Investment in Comedy Central. Contemporaneous with the sale of its 50% interest in Comedy Central to Viacom, the Company’s Cable segment entered into a long-term programming arrangement with Comedy Central. In accounting for the sale, the Company recorded a one-time gain of $513 million in other income. In contrast, the programming arrangement will be recorded as an expense in operating income over the life of the arrangement. The key judgment is ensuring that both the sale and programming arrangement are at fair value terms.
 
    Sale of Music Manufacturing Operations. Contemporaneous with the sale of its Music manufacturing operations to Cinram (for $1.05 billion), the Company entered into a long-term arrangement where Cinram will manufacture DVDs for the Company over a six-year period. In accounting for the sale, the Company recorded a one-time gain of approximately $560 million in discontinued operations. In contrast, the costs incurred under the manufacturing arrangement will be recorded as an expense in operating income over the life of the arrangement. The key judgment is ensuring that both the sale and manufacturing arrangement are at fair value terms.
 
    Announced Sale of Winter Sports Team Operations. Contemporaneous with the announced sale of the winter sports team assets, the Company entered into an arrangement with the buyer whereby its cable network operations would license the right to telecast games over a six-year period. In accounting for the sale, the Company will record a one-time gain/loss in operating income. In contrast, the costs incurred under the licensing arrangement will be recorded as an expense in operating income over the

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

  life of the arrangement. The key judgment is ensuring that both the sale and licensing arrangement are at fair value terms.
 
    Sale of Time Life Operations. Contemporaneous with the sale of the Time Life operations, the Company entered into arrangements whereby the buyer would license the right to use the Time Life name for a ten-year period (with an additional ten year renewal option) and would secure fulfillment services from Time Inc. in Europe over a five-year period. In accounting for the sale, the Company recorded a one-time loss of $29 million in operating income. In contrast, the amounts received under the licensing and fulfillment arrangements will be recorded as Other revenue as they relate to the licensing of the Time Life name, and as a reduction of expenses over the life of the arrangement as they relate to the fulfillment services agreement. The key judgment is ensuring that the sale, licensing and fulfillment arrangements are at fair value terms.

      In each of these transactions, based on a thorough review of fair value evidence, the Company concluded that the stated terms of each transaction represented fair value, and accordingly, the Company accounted for each contract separately based on its stated terms.

Sales of Multiple Products or Services

      The Company’s policy for revenue recognition in instances where there are multiple deliverables being sold at the same time to the same counterparty is in accordance with EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” and the SEC Staff Accounting Bulletin No. 104, “Revenue Recognition.” Specifically, if the Company enters into sales contracts for the sale of multiple products or services, then the Company evaluates whether it has objective fair value evidence for each deliverable in the transaction. If the Company has objective fair value evidence for each deliverable of the transaction, then it accounts for each deliverable in the transaction separately, based on the relevant revenue recognition accounting policies. However, if the Company is unable to determine objective fair value for one or more undelivered elements of the transaction, the Company generally recognizes advertising revenue on a straight-line basis over the term of the agreement. For example, the AOL division might enter into an agreement to provide a customer with advertising, a co-developed web site and technology development services. Because the AOL division is providing multiple services, and if objective fair value was not available, the revenue from this transaction would be recorded on a straight line-basis over the term of the agreement.

Gross Versus Net Revenue Recognition

      In the normal course of business, the Company acts as or uses an intermediary or agent in executing transactions with third parties. The accounting issue encountered in these arrangements is whether the Company should report revenue based on the “gross” amount billed to the ultimate customer or on the “net” amount received from the customer after commissions and other payments to third parties. To the extent revenues are recorded on a gross basis, any commissions or other payments to third parties are recorded as expenses so that the net amount (gross revenues less expenses) is reflected in operating income. Accordingly, the impact on operating income is the same whether the Company records the revenue on a gross or net basis. For example, if the Company’s Filmed Entertainment segment distributes a film to a theater for $15 and remits $10 to the independent production company, representing their share of proceeds, the Company must determine if the Filmed Entertainment segment should record gross revenue from the theater of $15 and $10 of expenses or if they should record as revenue the net amount recognized of $5. In either case, the impact on operating income is $5.

      Determining whether revenue should be reported gross or net is based on an assessment of whether the Company is acting as the “principal” in a transaction or acting an “agent” in the transaction. To the extent that the Company is acting as a principal in a transaction, the Company reports revenue on a gross basis. To

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

the extent that the Company is acting as an agent in a transaction, the Company reports revenue on a net basis. The determination of whether the Company is acting as a principal or an agent in a transaction involves judgment and is based on an evaluation of the terms of an arrangement.

      In determining whether the Company serves as principal or agent in these arrangements, the Company follows the guidance in EITF 99-19, “Reporting Revenue Gross as a Principal versus Net as an Agent” (“EITF 99-19”). Pursuant to such guidance, the Company serves as the principal in transactions in which it has substantial risks and rewards of ownership. Indicators that the Company has substantial risks and rewards of ownership are as follows:

  •  The Company is the supplier of the products or services to the customer;
  •  The Company has general inventory risk for a product before it is sold;
  •  The Company has latitude in establishing prices;
  •  The Company has the contractual relationship with the ultimate customer;
  •  The Company modifies and services the product purchased to meet the ultimate customer specifications;
  •  The Company has discretion in supplier selection; and
  •  The Company has credit risk.

      Conversely, pursuant to EITF 99-19, the Company serves as agent in arrangements where the Company does not have substantial risks and rewards of ownership. Indicators that the Company does not have substantial risks and rewards of ownership are as follows:

  •  The supplier (not the Company) is responsible for providing the product or service to the customer;
  •  The supplier (not the Company) has latitude in establishing prices;
  •  The amount the Company earns is fixed; and
  •  The supplier (not the Company) has credit risk.

      Specifically, the Company has the following examples of arrangements where it is an intermediary or uses an intermediary:

    The Filmed Entertainment segment distributes films on behalf of independent film producers. The Filmed Entertainment segment will typically provide motion picture distribution services for an independent production company in the worldwide theatrical, home video and television markets. The arrangement will generally cover multiple films that the independent film company has produced and owns the underlying copyright thereto. In addition, the independent film company will work collaboratively with the Filmed Entertainment segment over the distribution, marketing, advertising and publicity of each film in all media, including the timing and extent of the theatrical releases, the pricing and packaging of home video units and approval of all television licenses. The Filmed Entertainment segment has recorded the revenue generated in these distribution arrangements on a gross basis as it is the primary obligor because it is the merchant of record for the licensing arrangements, is the licensor/contracting party, provides the film materials to licensees and handles the billing and collection of all amounts due under such arrangements.
 
    The Publishing segment utilizes subscription agents to generate magazine subscriptions. One of the ways the Publishing segment generates magazine subscriptions is through the use of subscription agencies whereby the agent secures subscriptions and, in exchange, receives a percentage of the subscription price. The Publishing segment has recorded subscription revenue generated by the agent net of any fees paid to the agent because the subscription agent has the primary contact with the customer, performs all of the billing and collection activities and passes the net proceeds from the subscription to the Publishing segment after removing the agent’s commission.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

    The AOL segment sells advertising on behalf of third parties. Oftentimes, AOL will sell advertising on a public website (outside of the AOL service) on behalf of a third party. Generally, AOL records revenue generated from such sales on a gross basis. In other words, AOL records as revenue the proceeds received from the advertiser and records as expense the amount paid to the third-party owner of the website because AOL is responsible for identifying and contracting with third-party advertisers, establishing the selling price of the inventory, serving the advertisements at AOL’s cost and expense, performing all billing and collection activities and bearing sole liability for fulfillment of advertising.
 
    The Cable segment bills for reimbursement of taxes paid to franchising authorities. Included in the monthly bill to the Cable segment’s customer is a line item identifying the reimbursement of taxes being paid by the cable company to the franchising authorities. The Cable segment includes in its determination of revenues the amounts received from the customer representing a reimbursement of franchise taxes paid by the cable company to the franchising authorities because the Cable segment is considered to be the primary obligor with respect to the customer purchasing the service and is assuming the credit risk (i.e., would still be required to remit the tax if the customer does not pay).

Investment Impairments

      The Company’s investments consist of fair value investments, including available-for-sale securities, investments accounted for using the cost method of accounting and investments accounted for using the equity method of accounting. See Note 7 for additional discussion. 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 subjective in nature and dependent on the specific facts and circumstances. Factors that are considered by the Company 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 recognized even if the 20% and 50% criteria are not satisfied (e.g., intent to sell the security in the near term and the fair value is below the Company’s cost basis).

      For investments accounted for using the cost or equity method of accounting, management evaluates information available to it (e.g., budgets, business plans, financial statements, etc.) in addition to quoted market prices, 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 known quantitative and qualitative factors in determining if an other-than-temporary decline in value of an investment has occurred.

      While Time Warner has recognized all declines that are believed to be other-than-temporary, it is reasonably possible that individual investments in the Company’s portfolio may experience an other-than-temporary decline in value in the future if the underlying investee company experiences poor operating results or if the U.S. equity markets experience future broad declines in value. As of December 31, 2003, the

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Company had certain investments for which the fair value of the investment was below carrying value totaling $1 million, but the Company had determined that the decline in value was temporary. Assuming that the fair values of these investments remain at their current levels, and assuming no change in any qualitative factors regarding these investments, the Company would expect to record additional impairment charges of approximately $1 million over the first six months of 2004.

Accounting for Goodwill and Other Intangible Assets

      The Company follows the provisions of FAS 142, which requires that goodwill, and certain other intangible assets deemed to have an indefinite useful life, be assessed for impairment using fair value measurement techniques. Pursuant to FAS 142, goodwill impairment is determined using a two-step process. See Notes 1 and 2 for additional discussion.

      Determining the fair value of a reporting unit under the first step of the goodwill impairment test and determining the fair value of individual assets and liabilities of a reporting unit (including unrecognized intangible assets) under the second step of the goodwill impairment test is judgmental in nature and often involves the use of significant estimates and assumptions. Similarly, estimates and assumptions are used in determining the fair value of other intangible assets. These estimates and assumptions could have a significant impact on whether or not an impairment charge is recognized and also the magnitude of any such charge. To assist in the process of determining goodwill impairment, the Company obtains appraisals from independent valuation firms. In addition to the use of independent valuation firms, the Company performs internal valuation analyses and considers other market information that is publicly available. Estimates of fair value are primarily determined using discounted cash flows, market comparisons and recent transactions. These approaches use significant estimates and assumptions including projected future cash flows (including timing), discount rate reflecting the risk inherent in future cash flows, perpetual growth rate, determination of appropriate market comparables and the determination of whether a premium or discount should be applied to comparables.

      The Company’s annual impairment analysis, which was performed during the fourth quarter, did not result in an impairment charge for 2003. In order to evaluate the sensitivity of the fair value calculations of the Company’s reporting units on the impairment calculation, the Company applied a hypothetical 10% decrease to the fair values of each reporting unit. This hypothetical decrease would result in a first step indication of impairment on the Cable ($1.90 billion), Turner ($1.05 billion), WB Network ($25 million), Time Inc. ($230 million) and the Book Group ($15 million) reporting units. A second step impairment evaluation would need to be performed to determine if goodwill is impaired and to determine the amount of any impairment. In addition, a hypothetical 10% decrease to the fair values of indefinite lived intangible assets would result in an impairment of indefinite lived intangible assets at Cable ($360 million, franchises), Warner Bros. ($15 million, trademarks), Turner ($15 million, franchises) and Time Inc. ($50 million, trademarks).

Consolidation of Partially Owned Entities and Affiliates

      The evaluation of whether a partially owned entity or an affiliate is required to be consolidated involves judgment. The Company considers its ownership interest in the investee, its own voting interest and the voting interests and other rights of other shareholders when making a determination of whether or not to consolidate an investee. During 2003, the FASB issued FIN 46, which requires that VIEs be consolidated if certain criteria are met. As discussed above, the Company has adopted the provisions of FIN 46, effective July 1, 2003, for those VIEs representing lease-financing arrangements with SPEs. The Company has elected to defer the adoption of FIN 46 until March 31, 2004, for its equity investments and joint venture arrangements that may require consolidation pursuant to FIN 46. See the Transactions Affecting Comparability of Results of Operations above and Note 1 to the consolidated financial statements for additional discussion of the current and future impact of the adoption of FIN 46 on the financial statements. A VIE can include certain joint

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OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

venture and equity investment structures. FIN 46 provides that the primary beneficiary of a VIE is required to consolidate the VIE’s operations.

      The determination of whether or not an investee, joint venture arrangement or similar entity is a VIE is detailed and complex, and requires significant judgment in application of the rules. In determining if an entity is a VIE, FIN 46 requires an evaluation as to whether the equity of the entity is sufficient to absorb the expected losses of that entity. This evaluation requires the consideration of qualitative factors and various assumptions, including expected future cash flows and funding needs. Even if the entity’s equity is determined to be sufficient to absorb expected losses, the rules provide that in certain circumstances there needs to be a qualitative assessment whether “substantially all” the benefits of the entity are for the benefit of one of the variable interest holders. In such circumstances the entity would be deemed a VIE. The Company had variable interest in two entities deemed to be VIEs for which the Company is not considered the primary beneficiary. At December 31, 2003, these two entities had total assets of approximately $50 million and total liabilities of approximately $5 million. In addition, in 2003, they had total revenues of approximately $126 million and a net loss of approximately $103 million.

      Similarly, determining who is the primary beneficiary requires the application of judgment. In determining who is the primary beneficiary of a VIE, various assumptions as to the fair value of all variable interests must be evaluated. Specifically, the identification of variable interests requires an economic analysis of the rights and obligations of an entity’s assets, liabilities, equity, and other contracts and determining who holds the majority of the variable interests.

Accounting for Pension Plans

      Time Warner and certain of its subsidiaries have defined benefit pension plans covering a majority of domestic employees and, to a lesser extent, international employees. Pension benefits are based on formulas that reflect the employees’ years of service and compensation during their employment period and participation in the plans. The Company recognized pension expense of $202 million in 2003, $94 million in 2002 and $64 million in 2001. The pension expense recognized by the Company is determined using certain assumptions, including the expected long-term rate of return on plan assets, the discount rate and the rate of compensation increases. See Notes 1 and 15 for additional discussion. The determination of these assumptions is discussed in more detail below.

      The Company’s expected long-term rate of return on plan assets used to compute 2003 pension expense was 8%. In developing the expected long-term rate of return, the Company considered the pension portfolio’s past average rate of earnings, discussions with portfolio managers and comparisons with similar companies. The expected long-term rate of return is based on an asset allocation assumption of 75% equities and 25% fixed-income securities, which approximated the actual allocation as of December 31, 2003. A decrease in the expected long-term rate of return of 25 basis points, from 8.00% to 7.75%, while holding all other assumptions constant, would have resulted in an increase in the Company’s pension expense of approximately $4 million in 2003.

      The Company used a discount rate of 6.75% to compute 2003 pension expense. The discount rate was determined by comparison against ten-year corporate bond rates. A decrease in the discount rate of 25 basis points, from 6.75% to 6.50%, while holding all other assumptions constant, would have resulted in an increase in the Company’s pension expense of approximately $15 million in 2003.

      The Company used an estimated rate of future compensation increases of 4.5% to compute 2003 pension expense. An increase in the rate of 25 basis points while holding all other assumptions constant would have resulted in an increase in the Company’s pension expense of approximately $5 million in 2003.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Filmed Entertainment Revenues and Costs

      The Company accounts for film costs, as well as related revenues, in accordance with the guidance in Statement of Position (“SOP”) 00-2, “Accounting by Producers or Distributors of Films” (“SOP 00-2”). See Note 1 for additional discussion. An aspect of film accounting that requires the exercise of judgment relates to the process of estimating the total revenues to be received throughout a film’s life cycle. Such estimate of a film’s “ultimate revenue” is important for two reasons. First, while a film is being produced and the related costs are being capitalized, it is necessary for management to estimate the ultimate revenues, less additional costs to be incurred including exploitation costs, in order to determine whether the value of a film has been impaired and thus requires an immediate write-off of unrecoverable film costs. Second, the amount of capitalized film costs recognized as cost of revenues for a given film as it is exhibited in various markets, throughout its life cycle, is based upon the proportion of the film’s revenues recognized for such period to the film’s estimated ultimate total revenues. Similarly, the recognition of participations and residuals is based upon the proportion of the film’s revenues recognized for such period to the film’s estimated ultimate total revenues.

      Management bases its estimates of ultimate revenue for each film on the historical performance of similar films, incorporating factors such as the star power of the lead actors and actresses, the genre of the film, prerelease market research (including test market screenings) and the expected number of theaters at which the film will be released. Management updates such estimates based on information available on the progress of the film production and, upon release, the actual results of each film. For example, a film which has resulted in lower-than-expected theatrical revenues in its initial weeks of release would have its theatrical, home video and distribution ultimate revenues adjusted downward; a failure to do so would understate the amortization of capitalized film costs for the period. Since the amount of capitalized film cost to be amortized for a given film is fixed, the estimate of ultimate revenues impacts only the timing of film cost amortization. However, since participation and residuals costs are generally based on the financial results of a film, a reduction in estimated ultimate film revenue would similarly reduce the recognition of participation and residual costs.

Sales Returns and Uncollectible Accounts

      One area of judgment affecting reported revenue and net income is management’s estimate of product sales that will be returned and the amount of receivables that will ultimately be collected. In determining the estimate of product sales that will be returned, management analyzes historical returns, current economic trends and changes in customer demand and acceptance of Time Warner’s products. Based on this information, management reserves a percentage of each dollar of product sales that provide the customer with the right of return. See Note 1 for additional discussion.

      Similarly, management evaluates accounts receivable to determine if they will ultimately be collected. In performing this evaluation, significant judgments and estimates are involved, including an analysis of specific risks on a customer-by-customer basis for larger accounts, and an analysis of receivables aging that determines the percent that has historically been uncollected by aged category. Using this information, management reserves an amount that is believed to be uncollectible. Based on management’s analysis of sales returns and uncollectible accounts, reserves totaling $2.079 billion and $2.085 billion have been established at December 31, 2003 and 2002, respectively. Total gross accounts receivable were $6.987 billion and $6.931 billion at December 31, 2003 and 2002, respectively. See Note 1 for additional discussion.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

RISK FACTORS AND CAUTION CONCERNING FORWARD-LOOKING STATEMENTS

     Risk Factors

      If the events discussed in these risk factors occur, the Company’s business, financial condition, results of operations or cash flows could be materially adversely affected. In such case, the market price of the Company’s common stock could decline.

      The Company’s America Online business faces substantial competition in maintaining and growing its subscriber base, in developing compelling products and services, and in increasing revenues from sources other than fees for the AOL service, and if America Online is unable to meet its competitive challenges, the Company’s financial results could be adversely affected. During the last several years, the online services industry has been changing from one in which the only way for a household to access the Internet was through narrowband (i.e., telephone “dial-up”) Internet access provided by Internet service providers to one in which households can access the Internet through a variety of connection methods, such as cable modems, DSL or wireless connections offered by a number of different providers, including Internet service providers, cable companies and telephone and other telecommunications companies. As a result, significant price and service competition exists. Due to this increased competition, maintaining and growing the AOL service subscriber base and the fees charged the subscribers have become increasingly difficult. In 2003, America Online incurred losses in subscribers throughout the year, ending the year with fewer subscribers. The losses were due to a number of factors, including the maturing of the narrowband Internet access business and the significant competition America Online faces for subscribers both in the narrowband and broadband arenas, as well as actions taken during the year to remove non-paying subscribers pursuant to America Online’s strategy of focusing on member profitability.

      Since late 2002, America Online’s strategy has focused on improving and expanding its Internet products and services, including an enhancement or upgrade to the content and features provided through the flagship AOL service, and introducing premium services, as well as on reducing costs. The success of this strategy will depend on a number of factors, including sustained management focus, accurate forecasting of consumer preferences, and the ability to anticipate and keep up with technological developments. If America Online is unsuccessful, Time Warner’s financial condition, results of operations and cash flows could be adversely affected.

      With respect to “dial-up” narrowband Internet access, America Online faces significant competition from other Internet service providers, particularly those with low-price offerings. To meet this competition through ways other than price reductions, America Online has focused on improving the quality of features and content provided on its flagship AOL service to seek to attract and retain narrowband Internet users, including introducing customized services targeted for kids (KOL) and teens (RED). America Online has also introduced a lower-priced Internet service under the name Netscape Internet service to compete with the low-price ISPs. It is too early to determine whether these actions will be successful in retaining existing and attracting new narrowband subscribers.

      During 2003, America Online introduced its AOL for Broadband product with specialized content and features designed for subscribers with a broadband connection. America Online initially focused on offering a “bundled” service that combined the AOL service with high-speed Internet access provided by third-party broadband Internet access providers such as cable companies and telephone companies. Due primarily to lower prices charged by other broadband Internet access providers, as well as to address geographic areas in which it did not have arrangements with broadband Internet access providers, America Online has changed its strategy to a “Bring Your Own Access” strategy. Under this strategy, members purchase Internet access through another service provider and then subscribe to the AOL service at a monthly subscription fee that is lower than the price charged for the AOL service either with bundled broadband access or with unlimited dial-up access. For this BYOA strategy to be successful in maintaining and increasing subscribers, the AOL for

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Broadband product must be compelling enough that users (whether they are existing AOL members who are moving from narrowband to broadband Internet service or new members) are willing to pay an additional fee on top of their Internet access cost for the AOL for Broadband product. While America Online has experienced a positive initial reaction to its BYOA broadband product, it believes it will need to continue to enhance the broadband product to differentiate it from and compete with the offerings from other broadband online services, and provide enough value and quality to attract and retain subscribers, and there is no assurance that America Online will be successful in doing so or will be able to do so at the current price levels.

      America Online expects to experience further declines in the number of subscribers and may experience increased volatility in its subscriber base. Each year, a significant portion of AOL members cancel their membership or are terminated by America Online either for non-payment of account charges or violation of one of the terms of service that apply to members (for example, sending spam e-mails or violating community guidelines in chat rooms). In addition, maintaining and growing the subscriber base is difficult because the larger the subscriber base, the greater the number of new subscribers required to offset those subscribers who cancel or are terminated. Before 2003, America Online had been able to attract sufficient new members to more than offset cancellations and terminations. In 2003, however, America Online did not register new members in numbers sufficient to replace the subscribers who cancel or are terminated. It expects the decline in subscribers to continue. America Online continues to test new price plans, service offerings and payment methods to identify effective ways to attract and retain members.

      America Online uses a variety of methods to retain members who are considering canceling the AOL service. At the end of 2003, America Online increased certain member retention efforts, which may have resulted in the retention of larger numbers of members and in an increase in the number of members in the fourth quarter as compared to the third quarter who are not currently being billed for the AOL service (“non-billed members”). Retention efforts are currently expected to continue, which may result in a further increase in the number of non-billed members. In addition, if America Online decreases its retention efforts, subscriber losses may increase.

      It is relatively early in the process of introducing the AOL for Broadband product and the BYOA pricing plans, and although the initial reaction has been positive, it may not be indicative of longer-term response rates. In addition, as AOL members test broadband Internet products and pricing plans, AOL may see subscriber shifts among various price plans. This movement could result in increases or decreases in the number of subscribers to various pricing plans, as well as change the relative mix of members in narrowband and broadband plans. Because AOL classifies its broadband and narrowband members on the basis of the price plan to which the member has agreed, rather than the connection speed or method, a member’s classification may not reflect the member’s actual connection method.

      America Online will need to develop other sources of revenues to offset the lower revenues from service fees expected to result from the decline in subscribers, the shift in strategy to a “BYOA” model, and the offering of the lower-priced Netscape Internet service to compete against other narrowband ISPs. As part of its strategy, America Online identified a number of methods to do this and has made progress on a number of these objectives, including the following:

  •  moving AOL Europe to profitability during 2003;
 
  •  reducing costs throughout its operations, especially those costs that relate to the size of the subscriber base such as network service costs, and expects to continue to be able to contain costs; and
 
  •  introducing premium services that provide incremental revenues from members, such as the AOL Call Alert feature, AOL Voicemail, the subscription music service MusicNet, and the computer virus prevention service offered through McAfee.

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Each of these objectives will require continued efforts to extend their success. America Online also must continue to focus on establishing, expanding and renewing relationships with advertisers and improving its advertising business. There have been management changes in that area in recent years, which have had some adverse impacts on its ability to achieve its goals of improving its online advertising business.

      In addition, since many of the premium services are offered via broadband, success with the premium services may depend on how successful the AOL for Broadband product is in the longer term. Revenues from premium services may be adversely affected by pressure to reduce prices for the services or to incorporate them into the standard AOL service offering rather than offering them separately as premium services due to competitors who may offer similar services over time at lower prices or at no additional charge as part of their standard offerings.

      America Online faces risks relating to the expiration of the Internet Tax Freedom Act and other tax risks related to changes in or interpretations of federal, state and local laws and regulations. The taxation of online and Internet access service providers is currently unsettled in many respects. In that regard, a number of proposals have been made at the federal, state and local levels that could impose taxes on Internet access. It is also possible that new interpretations of existing statutes could occur as taxing authorities consider these proposals. Further, the Internet Tax Freedom Act, which placed a moratorium on new state and local taxes on Internet access, expired in November 2003. At present, Congress is considering new legislation that could be enacted in 2004 with retroactive effect to November 1, 2003. If the legislation is not passed or if the provisions of this new legislation allow for increased levels of state taxing authority, America Online’s results of operations could be adversely impacted. In addition, future state and local tax laws or interpretations of existing laws imposing taxes on Internet access could also adversely impact America Online’s results of operations.

      The Company’s Cable segment has begun providing voice services over its cable systems and faces risks inherent to entering into a new line of business, from competition, and from regulatory actions or requirements. Time Warner Cable intends to roll out its Digital Phone service in most, if not all, of its operating divisions during 2004. Coordinating the roll-out of a product with which it has only limited operating experience may present significant challenges. First, although Time Warner Cable has conducted comprehensive tests of VoIP technology in two operating areas, it remains a relatively new technology. Furthermore, the Digital Phone service depends upon interconnections and services provided by certain third parties. Time Warner Cable may encounter unforeseen difficulties as it introduces the product in new operating areas or increases the scale of its offering in areas in which it has launched. Second, Time Warner Cable will face heightened customer expectations for the reliability of voice services as compared with video and high-speed data services. Time Warner Cable will need to undertake significant training of customer service representatives and technicians. If the service is not sufficiently reliable or Time Warner Cable otherwise fails to meet customer expectations, the Digital Phone business could be impacted adversely. Third, the competitive landscape for voice services is expected to be intense, with Time Warner Cable facing competition from other providers of VoIP services, as well as regional telephone companies, cellular telephone service providers, and others, including established long distance companies. The regional telephone companies have substantial capital and other resources, as well as longstanding customer relationships. Finally, the Company expects advances in communications technology, as well as changes in the marketplace and the regulatory and legislative environment to occur in the future. Consequently, the Company is unable to predict the effect that ongoing or future developments in these areas might have on the Cable segment’s voice business and operations.

      The voice services business may also present additional regulatory risks. It is unclear whether and to what extent traditional state and federal telephone regulations will apply to telephony services provided using VoIP technology. In addition, regulators could allow utility pole owners to charge cable operators offering voice

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

services higher rates for pole rental than is allowed for non-voice services. The FCC recently initiated a rulemaking proceeding on the regulatory approach to voice services utilizing VoIP technology, Congress is considering enacting new laws to govern it, there are court case addressing the proper regulatory treatment for the service, and there are rulemakings and various other proceedings under way at the state level. Therefore, the Company cannot be certain what impact regulation will have on the Digital Phone business.

      Ongoing investigations by the Securities and Exchange Commission and the Department of Justice and pending shareholder litigation could affect Time Warner’s operations. The SEC and the DOJ are investigating the Company’s financial reporting and disclosure practices. As of March 1, 2004, there were forty-one putative class action and shareholder derivative lawsuits alleging violations of federal and state securities laws as well as purported breaches of fiduciary duties pending against Time Warner, certain of its current and former executives, past and present members of its Board of Directors and, in certain instances, America Online. There is also a consolidated action making allegations of ERISA violations. The complaints purport to be made on behalf of certain of the Company’s shareholders and allege, among other things, that Time Warner made material misrepresentations and/or omissions of material facts in violation of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act. There are also actions filed by individual shareholders and bondholders pending in federal and state courts. The Company is unable to predict the outcome of the SEC and DOJ investigations and the pending shareholder litigation. The Company is incurring expenses as a result of the SEC and DOJ investigations and the shareholder litigation pending against the Company, and any costs associated with judgments in or settlements of these matters could adversely affect its financial condition and results of operations. See “Other Key 2003 Developments — SEC and DOJ Investigations.”

      Technological developments may adversely affect the Company’s competitive position and limit its ability to protect its valuable intellectual property rights. Time Warner’s businesses operate in the highly competitive, consumer-driven and rapidly changing media and entertainment industries. These businesses, as well as the industries generally, are to a large extent dependent on technological developments, including access to and selection and viability of new technologies, and are subject to potential pressure from competitors as a result of their technological developments. For example:

  •  The Company’s cable business may be adversely affected by more aggressive than expected competition from alternate technologies such as satellite and DSL; by the failure to choose technologies appropriately; by the failure of new equipment, such as digital set-top boxes or digital video recorders, or services, such as digital cable, high- speed data services, voice over Internet protocol and video-on-demand, to appeal to enough consumers or to be available at prices consumers are willing to pay, to function as expected and to be delivered in a timely fashion;
 
  •  The Company’s America Online business may be adversely affected by competitors’ abilities to more quickly develop new technologies, including more compelling features/functionalities and premium services for Internet users, and by the uncertainty of the costs for obtaining rights under patents that may cover technologies and methods used to deliver new services; and
 
  •  The Company’s filmed entertainment and television network businesses may be adversely affected by the fragmentation of consumer leisure and entertainment time caused by a greater number of choices resulting from technological developments, the impact of digital video recorders or other technologies that change the nature of the advertising and other markets for television products, technological developments that facilitate the theft and unlawful distribution of the Company’s copyrighted works in digital form, including via the Internet, and by legal and practical limitations on the ability to enforce the Company’s intellectual property rights.

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

Caution Regarding Forward-Looking Statements

      The SEC encourages companies to disclose forward-looking information so that investors can better understand a company’s future prospects and make informed investment decisions. This document contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, particularly statements anticipating future growth in revenues, Operating Income before Depreciation and Amortization and cash flow. Words such as “anticipates,” “estimates,” “expects,” “projects,” “intends,” “plans,” “believes” and words and terms of similar substance used in connection with any discussion of future operating or financial performance identify forward-looking statements. These forward-looking statements are based on management’s present expectations and beliefs about future events. As with any projection or forecast, they are inherently susceptible to uncertainty and changes in circumstances, and the Company is under no obligation to, and expressly disclaims any obligation to, update or alter its forward-looking statements whether as a result of such changes, new information, subsequent events or otherwise.

      Additionally, Time Warner operates in highly competitive, consumer-driven and rapidly changing media, entertainment and Internet businesses. These businesses are affected by government regulation, economic, strategic, political and social conditions, consumer response to new and existing products and services, technological developments and, particularly in view of new technologies, the continued ability to protect intellectual property rights. Time Warner’s actual results could differ materially from management’s expectations because of changes in such factors. Other factors and risks could adversely affect the operations, business or financial results of Time Warner or its business segments in the future and could also cause actual results to differ materially from those contained in the forward-looking statements, including those identified in Time Warner’s other filings with the SEC and the following:

      For Time Warner’s AOL businesses:

  •  the ability to successfully implement its business strategy;
 
  •  the ability to develop new products and services to remain competitive;
 
  •  the ability to differentiate its products and services from its competitors;
 
  •  the ability to develop, adopt or have access to new technologies;
 
  •  the ability to successfully implement its broadband and multiband strategy;
 
  •  the ability to have access to distribution channels controlled by third parties;
 
  •  the ability to manage its subscriber base profitably;
 
  •  the ability to provide adequate server, network and system capacity;
 
  •  the risk of unanticipated increased costs for network services, including increased costs and business disruption resulting from the financial difficulties being experienced by a number of AOL’s network service providers, such as MCI;
 
  •  increased competition from providers of Internet services, including providers of broadband access;
 
  •  the ability to attract more traditional advertisers to the online advertising medium;
 
  •  the ability to maintain or renew existing advertising or marketing commitments, including the ability to replace large multi-period advertising arrangements with shorter term advertising sales;
 
  •  the risk that the online advertising industry will not improve at all or at a rate comparable to improvements in the general advertising industry;
 
  •  the ability to maintain or enter into new electronic commerce, marketing or content arrangements;

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

  •  risks associated with foreign currency exchange rates;
 
  •  the risks from changes in U.S. and international regulatory environments affecting interactive services; and
 
  •  the ability to reduce losses at the international businesses that are still unprofitable.

      For Time Warner’s cable business:

  •  more aggressive than expected competition, including price competition, from other distributors of video programming, including direct to home satellite distributors and from competitors using new technologies;
 
  •  more aggressive than expected competition, including price competition, from other distributors of high-speed data services, including DSL, satellite and terrestrial wireless distributors and from competitors using new technologies;
 
  •  greater than expected increases in programming or other costs, including costs of new products and services, or difficulty in passing such costs to subscribers;
 
  •  increases in government regulation of video programming rates, the programming it must carry or other terms of service;
 
  •  government regulation of other services, such as high-speed data and voice services;
 
  •  government regulation that dictates the manner in which it operates its cable systems or determines what products to offer, such as the imposition of “forced access” rules or common carrier requirements;
 
  •  increased difficulty in obtaining franchise renewals;
 
  •  the failure of new equipment, such as digital set-top boxes or digital video recorders, or services, such as digital video service, high-speed data service, voice service or video-on-demand, to appeal to enough subscribers or to be available at prices subscribers are willing to pay, to function as expected and to be delivered in a timely fashion;
 
  •  fluctuations in spending levels by advertisers and consumers;
 
  •  changes in technology and failure to anticipate technological developments or to choose technologies appropriately; and
 
  •  unanticipated funding obligations relating to its cable joint ventures.

      For Time Warner’s filmed entertainment businesses:

  •  the ability to continue to attract and select desirable talent and scripts at manageable costs;
 
  •  general increases in production costs;
 
  •  fragmentation of consumer leisure and entertainment time and its possible negative effects on the broadcast and cable networks, which are significant customers of these businesses;
 
  •  continued popularity of merchandising;
 
  •  the uncertain impact of technological developments that facilitate theft and unlawful distribution of the Company’s copyrighted works and by legal and practical limitations on the ability to enforce the Company’s intellectual property rights;
 
  •  the ability to develop and apply adequate protections for filmed entertainment content in a digital delivery environment;

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TIME WARNER INC.
MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

  •  the ability to develop successful business models for the secure delivery of filmed entertainment products in a digital environment;
 
  •  risks associated with foreign currency exchange rates;
 
  •  with respect to feature films, the increasing marketing costs associated with theatrical film releases in a highly competitive marketplace;
 
  •  with respect to television programming, a decrease in demand for television programming provided by non-affiliated producers and increased competition in viewership for broadcast programming due to the increasing number of cable and pay television services;
 
  •  with respect to home video, the ability to maintain relationships with significant customers in the rental and sell-through markets and the ability to maintain key distribution deals in certain geographic markets; and
 
  •  the ability to maintain an ad supported commercial television model in the face of challenges posed by increased consumer usage of digital video recorders or other technologies that change the nature of the advertising and other markets for television products.

      For Time Warner’s network businesses:

  •  greater than expected news gathering, programming or production costs;
 
  •  increased resistance by cable and satellite distributors to wholesale price increases;
 
  •  the negative impact on premium programmers of greater than anticipated basic cable rate increases to consumers;
 
  •  increased regulation of distribution agreements;
 
  •  the sensitivity of network advertising to economic cyclicality and to new media technologies;
 
  •  the negative impact of further consolidation of multiple-system cable operators;
 
  •  theft and unlawful distribution of content by means of interception of cable and satellite transmissions or Internet peer-to-peer file sharing;
 
  •  the impact of digital video recorders or other technologies that change the nature of the advertising and other markets for television products;
 
  •  the development of new technologies that alter the role of programming networks and services; and
 
  •  greater than expected fragmentation of consumer viewership due to an increased number of programming services and/or the increased popularity of alternatives to television.

      For Time Warner’s print media and publishing businesses:

  •  declines in spending levels by advertisers and consumers;
 
  •  the ability in a challenging environment to continue to develop new sources of circulation;
 
  •  unanticipated increases in paper, postal and distribution costs;
 
  •  increased costs and business disruption resulting from instability in the newsstand distribution channel;
 
  •  risks associated with foreign currency exchange rates;
 
  •  changes in government regulation of consumer marketing;
 
  •  receipt of information identifying debit card purchasers which may require changes in payment acceptance procedures for such purchasers, which could decrease subscription renewals; and

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MANAGEMENT’S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

  •  the introduction and increased popularity over the long term of alternative technologies for the provision of news and information.

      For Time Warner generally, the overall financial strategy, including growth in operations, maintaining financial ratios and a strong balance sheet, could be adversely affected by decreased liquidity in the capital markets, including any reduction in the ability to access either the capital markets for debt securities or bank financings, failure to meet earnings expectations, significant acquisitions or other transactions, economic slowdowns, the impact of terrorist acts and hostilities in Iraq and elsewhere in the world, increased expenses as a result of the SEC and DOJ investigations and the shareholder litigation pending against Time Warner, as well as the risk of costs associated with judgments in or settlements of such matters, and changes in the Company’s plans, strategies and intentions. In addition, lower than expected valuations associated with the cash flows and revenues at its segments may result in its inability to realize the value of recorded intangibles and goodwill at those segments.

120


 

TIME WARNER INC.

CONSOLIDATED BALANCE SHEET
December 31,
(millions)
                 
2003 2002


ASSETS
               
Current assets
               
Cash and equivalents
  $ 3,040     $ 1,730  
Receivables, less allowances of $2.079 and $2.085 billion
    4,908       4,846  
Inventories
    1,390       1,376  
Prepaid expenses and other current assets
    1,255       1,130  
Current assets of discontinued operations
    1,675       1,753  
     
     
 
Total current assets
    12,268       10,835  
Noncurrent inventories and film costs
    4,465       3,739  
Investments, including available-for-sale securities
    3,657       5,094  
Property, plant and equipment
    12,559       11,534  
Intangible assets subject to amortization
    4,229       4,189  
Intangible assets not subject to amortization
    39,656       36,355  
Goodwill
    39,459       36,986  
Other assets
    2,858       2,418  
Noncurrent assets of discontinued operations
    2,632       4,368  
     
     
 
Total assets
  $ 121,783     $ 115,518  
     
     
 
 
LIABILITIES AND SHAREHOLDERS’ EQUITY
               
 
Current liabilities
               
Accounts payable
  $ 1,629     $ 2,244  
Participations payable
    1,955       1,689  
Royalties and programming costs payable
    778       600  
Deferred revenue
    1,175       1,159  
Debt due within one year
    2,287       155  
Other current liabilities
    6,120       5,887  
Current liabilities of discontinued operations
    1,574       1,730  
     
     
 
Total current liabilities
    15,518       13,464  
Long-term debt
    23,458       27,354  
Deferred income taxes
    13,291       9,803  
Deferred revenue
    1,793       1,839  
Mandatorily convertible preferred stock
    1,500        
Other liabilities
    3,883       3,867  
Minority interests
    5,401       5,038  
Noncurrent liabilities of discontinued operations
    901       1,336  
Shareholders’ equity
               
Series LMCN-V common stock, $0.01 par value, 171.2 million shares outstanding in each period
    2       2  
Time Warner common stock, $0.01 par value, 4.365 and 4.305 billion shares outstanding
    44       43  
Paid-in capital
    155,578       155,134  
Accumulated other comprehensive loss, net
    (291 )     (428 )
Accumulated deficit
    (99,295 )     (101,934 )
     
     
 
Total shareholders’ equity
    56,038       52,817  
     
     
 
Total liabilities and shareholders’ equity
  $ 121,783     $ 115,518  
     
     
 

See accompanying notes.

121


 

TIME WARNER INC.

CONSOLIDATED STATEMENT OF OPERATIONS
Years Ended December 31,
(millions, except per share amounts)
                           
2003 2002 2001



Revenues:
                       
 
Subscriptions
  $ 20,448     $ 18,959     $ 15,657  
 
Advertising
    6,182       6,299       6,869  
 
Content
    11,446       10,216       8,654  
 
Other
    1,489       1,840       2,327  
     
     
     
 
Total revenues(a)
    39,565       37,314       33,507  
Costs of revenues(a)
    (23,285 )     (22,116 )     (18,789 )
Selling, general and administrative(a)
    (9,862 )     (8,835 )     (7,486 )
Merger and restructuring costs
    (109 )     (327 )     (214 )
Amortization of intangible assets
    (640 )     (557 )     (6,366 )
Impairment of goodwill and other intangible assets
    (318 )     (44,039 )      
Net gain on disposal of assets
    14       6        
     
     
     
 
Operating income (loss)
    5,365       (38,554 )     652  
Interest expense, net(a)
    (1,844 )     (1,758 )     (1,316 )
Other income (expense), net
    1,210       (2,447 )     (3,458 )
Minority interest income (expense)
    (214 )     (278 )     46  
     
     
     
 
Income (loss) before income taxes, discontinued operations and cumulative effect of accounting change
    4,517       (43,037 )     (4,076 )
Income tax provision
    (1,371 )     (412 )     (145 )
     
     
     
 
Income (loss) before discontinued operations and cumulative effect of accounting change
    3,146       (43,449 )     (4,221 )
Discontinued operations, net of tax
    (495 )     (1,012 )     (713 )
     
     
     
 
Income (loss) before cumulative effect of accounting change
    2,651       (44,461 )     (4,934 )
Cumulative effect of accounting change
    (12 )     (54,235 )      
     
     
     
 
Net income (loss)
  $ 2,639     $ (98,696 )   $ (4,934 )
     
     
     
 
Basic income (loss) per common share before discontinued operations and cumulative effect of accounting change
  $ 0.70     $ (9.75 )   $ (0.95 )
Discontinued operations
    (0.11 )     (0.23 )     (0.16 )
Cumulative effect of accounting change
          (12.17 )      
     
     
     
 
Basic net income (loss) per common share
  $ 0.59     $ (22.15 )   $ (1.11 )
     
     
     
 
Average basic common shares
    4,506.0       4,454.9       4,429.1  
     
     
     
 
Diluted income (loss) per common share before discontinued operations and cumulative effect of accounting change
  $ 0.68     $ (9.75 )   $ (0.95