Back to GetFilings.com

Table of Contents

SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number 1-15062

AOL TIME WARNER INC.

75 Rockefeller Plaza
New York, New York 10019
(212) 484-8000

(Address, including zip code, and telephone number, including
area code, of registrant’s principal executive offices)

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 (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes   x    No   o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes   x    No   o

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Table of Contents

AOL TIME WARNER INC.
INDEX TO FORM 10-Q

Table of Contents

AOL TIME WARNER INC.

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 AOL Time Warner Inc.’s (“AOL Time Warner” or the “Company”) financial condition, changes in financial condition and results of operations. The MD&A is organized as follows:

	•		Overview. This section provides a general description of AOL Time Warner’s businesses, as well as recent developments that the Company believes are important in understanding the results of operations, as well as to anticipate future trends in those operations.
	•		Results of operations. This section provides an analysis of the Company’s results of operations for the three months ended March 31, 2003 compared to the same period in 2002. This analysis is presented on both a consolidated and 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 financial condition and cash flows as of and for the three months ended March 31, 2003.
	•		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 throughout MD&A and in the consolidated financial statements, are based on management’s current expectations about future events and are inherently susceptible to uncertainty and changes in circumstances.

OVERVIEW

Description of Business

     AOL Time Warner classifies its business interests into six fundamental areas: AOL, consisting principally of interactive services; Cable, consisting principally of interests in cable television systems; Filmed Entertainment, consisting principally of interests in filmed entertainment and television production; Networks, consisting principally of interests in cable television and broadcast network programming; Music, consisting principally of interests in recorded music, music publishing and CD and DVD manufacturing; and Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing.

Use of EBITDA and Free Cash Flow

     AOL Time Warner considers EBITDA an important indicator of the Company’s operational strength and performance of its businesses. In addition, Free Cash Flow is considered an important indicator of the Company’s ability to service its debt and make strategic investments.

     EBITDA is defined as operating income (loss) before non-cash depreciation of tangible assets, amortization of intangible assets and impairment write-downs related to goodwill and intangible assets. EBITDA eliminates the uneven effect across all business segments of considerable amounts of non-cash depreciation of tangible assets and amortization or write-downs of certain intangible assets, including goodwill, that were recognized in business combinations.

     Free Cash Flow is defined as cash provided by operations less capital expenditures and product development costs, dividend payments, partnership distributions, and principal payments on capital leases.

1

Table of Contents

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

     Both EBITDA 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), respectively, as well as other measures of financial performance reported in accordance with accounting principles generally accepted in the United States.

Recent Developments

Update on SEC and DOJ Investigations

     The Company has previously disclosed that the Securities and Exchange Commission (“SEC”) and the Department of Justice (“DOJ”) are conducting investigations into accounting and disclosure practices of the Company. Those investigations have focused on transactions involving the Company’s America Online unit that was entered into after July 1, 1999.

     In its quarterly report on Form 10-Q for the quarter ended June 30, 2002 (filed August 14, 2002, the “June 2002 Form 10-Q”), the Company disclosed that it had recently discovered information that provided a basis to reexamine the accounting for three transactions totaling $49 million in advertising revenue at the Company’s America Online unit. Each of those transactions was a multi-element transaction. A multi-element transaction is one in which, at the same time or within a relatively short period of time, a third party agreed to purchase advertising from America Online and America Online agreed to purchase goods or services from the third party, make an equity investment in the third party, settle a pre-existing dispute with the third party, or exchange other consideration with the third party.

     The information discovered in August 2002 did not call into question whether the advertisements purchased by the third party had in fact been run by America Online, nor did the information call into question whether America Online had in fact received payment associated with the advertisements that were run. Rather, in each case, the information discovered in August 2002 was specific evidence related to the negotiating history of the transaction that called into question whether each element of the multi-element transaction was supported as a separate exchange of fair value. In accounting for such multi-element transactions, it is the policy of the Company (consistent with generally accepted accounting principles) to recognize revenue in the full amount of advertising purchased by the third party only to the extent that both elements of the transaction (both the advertising purchase and the other element) are supportable as a separate exchange of fair value.

     After discovering such information, the Company commenced an internal review under the direction of the Company’s Chief Financial Officer into advertising transactions at the America Online unit (“CFO review”). 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 adjustments 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. At that time, the Company announced that it did not then anticipate that its CFO review would lead to any further restatement by the Company but disclosed that is could not predict the outcome of the separate SEC and DOJ investigations. Since that announcement in October 2002, there have been a number of developments relevant to these matters:

     First, on January 28, 2003, the Company filed amendments to its Annual Report on Form 10-K/A for the year ended December 31, 2001, its quarterly report on Form 10-Q for the quarter ended, March 31, 2002 and June 2002 Form 10-Q that included restated financial statements reflecting the adjustments announced on October 23, 2002.

     Second, the Company has continued its CFO review of advertising transactions at the Company’s America Online unit. Based on that review, the Company has not, to date, determined to make any further restatement.

     Third, as part of the Company’s ongoing discussions with the SEC, in the first quarter of 2003, the staff of the SEC 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. 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,

2

Table of Contents

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

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 or in Company stock or a combination thereof. In the event the Company elected to use stock, the Company was required to deliver stock in 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 interest 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 these advertisements were run (almost entirely at the America Online unit) during the period from the first quarter of 2001 through the first quarter of 2003. 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. In addition, $2.0 million was recognized in the first quarter of 2003. (The remaining approximately $1.6 million is expected to be recognized by the Company during the remainder of 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 has 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 these transactions and the reasons why, to date, both the Company and its auditors continue to believe that these transactions have been accounted for correctly. The Company is engaged in ongoing discussions with the SEC staff on this matter.

     The SEC staff has also informed the Company that it is continuing to investigate a range of other transactions principally involving the America Online unit. 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. 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 the SEC may delay acting on any registration statement, such as the potential initial public offering of Time Warner Cable Inc. (“TWC Inc.”) while its investigation of the Company is pending.

TWE Restructuring

     Prior to the restructuring discussed below, a majority of AOL 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”). AOL 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 Corp. (“Comcast”).

     On March 31, 2003, AOL Time Warner and Comcast completed the restructuring of TWE (the “TWE Restructuring”). As a result of the TWE Restructuring, AOL Time Warner acquired complete ownership of TWE’s content businesses, including Warner Bros., Home Box Office, and TWE’s interests in The WB Network, Comedy Partners (“Comedy Central”) and the Courtroom Television Network (“Court TV”). Additionally, all of AOL 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 AOL Timer Warner called Time Warner Cable Inc. (“TWC Inc.”). As part of the restructuring, AOL 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 AOL Time Warner preferred stock, which will be converted into $1.5 billion of AOL 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 incurred by TWC Inc. as part of the restructuring.

     Comcast’s 21.0% economic interest in TWC Inc.’s cable business, is held through a 17.9% direct ownership interest in TWC Inc. (representing a 10.7% voting interest) and a limited partnership interest in TWE representing a 4.7% residual equity interest. AOL Time Warner’s 79% economic interest in TWC Inc.’s cable business is held through an 82.1% ownership interest in TWC Inc. (representing an 89.3% voting interest) and a partnership interest in TWE representing a 1% residual equity interest. AOL Time Warner also holds a $2.4 billion mandatorily redeemable preferred equity interest in TWE. The additional ownership interests acquired by AOL Time Warner in the TWE Restructuring have been accounted for as a step acquisition and is reflected in the accompanying balance sheet as of March 31, 2003.

3

Table of Contents

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

     The purchase consideration paid by AOL Time Warner in the TWE Restructuring was as follows (in millions):

     The preliminary purchase price allocation eliminates the historical minority interests (at book value) associated with the 27.64% of the TWE’s content businesses and the 6% of the TWE cable business acquired by AOL Time Warner and preliminarily allocates the preliminary purchase consideration paid in excess of the historical minority interest to cable franchise license intangibles and goodwill as follows (in millions):

     In addition to the above amounts recorded, the 17.9% minority interest retained by Comcast in TWC Inc. was stepped up to fair value. The resulting $2.362 billion adjustment is reflected as an increase in cable franchise license intangibles and a corresponding increase in minority interest.

     A deferred tax liability of $1.296 billion and corresponding amount of goodwill was also recorded on the step up of all the cable franchise license intangible.

     The cable franchise license intangible assets are recorded in the Cable segment and are classified as intangible assets not subject to amortization. The goodwill of $1.427 billion is recorded in the Networks and Filmed Entertainment segments of $715 million and $712 million, respectively, while the goodwill of $1.296 billion that resulted from the deferred taxes on the franchise licenses are recorded in the Cable segment.

     Based upon its controlling voting interest in TWC Inc., AOL Time Warner consolidates the results of TWC Inc. for accounting purposes. Subject to market conditions and the registration statement, once filed, being declared effective by the SEC, AOL Time Warner plans to conduct an initial public offering of TWC Inc. later this year (Note 1). It is possible that the SEC may delay acting on the registration statement while the investigation of the Company is pending. (See “Overview-Recent Developments-Update on SEC and DOJ Investigations”). It is anticipated that the first $2.1

4

Table of Contents

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

billion of net proceeds raised in any such offering would be used to repay the $2.1 billion of debt incurred by TWC Inc. Thereafter, Comcast will have certain priority registration rights with respect to its interest in TWC Inc.

Debt Reduction Plan

     In January 2003, the Company announced its intention to reduce its overall level of indebtedness in 2003. Specifically, it is the Company’s intention to reduce debt within a range of 2.25 to 2.75 times ratio of total consolidated net debt to annual EBITDA by the end of 2003. In addition, the Company announced that it intends to reduce total consolidated net debt to approximately $20 billion by the end of 2004. The Company anticipates that the reduction in debt will be achieved through the use of Free Cash Flow and other de-leveraging initiatives, including the sale of non-core assets. As part of this initiative, in January 2003, the Company sold its investment in Hughes Electronics Corp. (“Hughes”) for cash proceeds of $783 million and recognized a gain of approximately $50 million. In addition, in April 2003, the Company agreed to sell its 50% ownership interest in Comedy Central for $1.225 billion in cash and this transaction is expected to close in the second quarter of 2003. Any gain resulting from this transaction is not expected to result in incremental taxes paid as a result of capital losses. Accordingly, substantially all of the proceeds should be available for debt reduction. The Company is also exploring the sale of other non-core businesses.

RESULTS OF OPERATIONS

Transactions Affecting Comparability of Results of Operations

Discontinued Operations

     During 2002, TWE and the Advance/Newhouse Partnership (“Advance/Newhouse”) restructured the TWE-Advance/Newhouse Partnership (“TWE-A/N”) resulting in Advance/Newhouse assuming authority for the day-to-day operations of certain TWE-A/N cable systems. As a result, AOL Time Warner deconsolidated the financial position and operating results of these systems, and has reflected the 2002 operating results as discontinued operations. Revenues and net loss from the discontinued operations totaled $352 million and $1 million for the three months ended March 31, 2002.

Other Items Affecting Comparability

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

     For the three months ended March 31, 2003 these items included (i) merger and restructuring costs of $24 million (Note 2), (ii) non-cash charges of $23 million, which is comprised of $27 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, offset in part by $4 million of gains to reflect market fluctuations in equity derivative instruments (Note 3), and (iii) approximately $109 million in

5

Table of Contents

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

gains on the sale of certain investments, including a $50 million gain from the sale of the Company’s interest in Hughes and a $35 million gain on the sale of the Company’s interest in an international theater chain (Note 3).

     For the three months ended March 31, 2002, these items included (i) merger and restructuring costs of $107 million (Note 2) and (ii) a non-cash charge of $581 million, which is comprised of $590 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, offset in part by $9 million of gains to reflect market fluctuations in equity derivative instruments. Included in the $590 million charge relating to other-than-temporary declines in value is a $571 million non-cash charge to reduce the carrying value of AOL Time Warner’s investment in Time Warner Telecom Inc. (“Time Warner Telecom”), a 44% owned equity investment (Note 3).

Three Months Ended March 31, 2003 Compared to Three Months Ended March 31, 2002

Consolidated Results

     Revenues. Consolidated revenues increased 6% to $9.998 billion. As shown below, this increase was led by growth in both Subscription and Content revenues, offset in part by declines in both Advertising and Other revenues:

     The 10% 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. The 11% increase in Content revenues was principally due to improved results at the Networks and the Filmed Entertainment segments related to improved worldwide home video results, offset in part by lower results at the Music segment related to lower recorded music sales.

     The 5% decline in Advertising revenues was primarily related to 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. The decline in the benefit from prior year contracts at AOL and program vendor advertising at Cable are both expected to continue throughout 2003. The Advertising revenue declines at the AOL and Cable segments were offset in part by growth at the Networks and Publishing segments.

     The 21% decline in Other revenues was primarily due 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. The declines are expected to continue throughout 2003.

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

6

Table of Contents

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

Reconciliation of Consolidated EBITDA to Operating Income

     The following table reconciles EBITDA to operating income and in addition provides the components from operating income to net income (loss) for purposes of the discussions that follow:

     EBITDA. AOL Time Warner’s EBITDA increased 14% to $1.985 billion in 2003 from $1.739 billion in 2002 principally as a result of double-digit increases at the AOL, Filmed Entertainment and Networks segments, offset in part by declines at the Music segment. The segment variations are discussed in detail under “Business Segment Results” below.

     EBITDA included merger and restructuring costs of $24 million in 2003 and $107 million in 2002. The 2003 costs included $4 million at the AOL segment, $8 million at the Networks segment and $12 million at the Publishing segment and related to various employee and contractual terminations. The 2002 costs included $75 million at the AOL segment, $5 million at the Music segment and $27 million at Corporate. The 2002 costs included $43 million related to work force reductions and $64 million for lease obligations of the AOL segment for network modems that are no longer being used because network providers have upgraded their networks to newer technology (Note 2).

     AOL Time Warner’s Corporate EBITDA loss decreased to $101 million in 2003 from $106 million in 2002. The improvement in the EBITDA loss was principally due to the absence in 2003 of merger and restructuring costs noted above. This was offset in part by legal and other professional fees related to the SEC and DOJ investigations into the accounting and disclosure practices of the Company and the defense of various shareholder lawsuits. Costs associated with these matters already made are expected to continue through the year.

     Depreciation Expense. Depreciation expense increased to $639 million in 2003 from $518 million in 2002 principally due to increases at the Cable segment ($330 million in 2003 compared to $274 million in 2002) and the AOL segment ($171 million in 2003 compared to $128 million in 2002). The increase at Cable reflects higher levels of spending related to the rollout of digital services over the past three years and increased spending on customer premise equipment that is depreciated over a shorter useful life. For the AOL segment, the higher expense was due to an increase in network assets acquired under capital leases, as well as a decrease in the estimated useful life of current network asset additions.

     Amortization Expense. Amortization expense increased to $195 million in 2003 from $164 million in 2002. The increase in amortization expense in 2003 is principally due to increases at the Music segment ($63 million in 2003 compared to $43 million in 2002) and the Publishing segment ($40 million in 2003 compared to $29 million in 2002). The increase at the Music segment is principally related to the reduction in the amortization period of music publishing copyrights and record catalog from 20 to 15 years. For the Publishing segment, the increase related to the finalization of purchase price accounting at the end of 2002 relating to the acquisition of Synapse, a subscription marketing company.

7

Table of Contents

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

     Operating Income. AOL Time Warner’s operating income increased to $1.151 billion in 2003 from $1.057 billion in 2002. The improvement in operating income related to an increase in business segment EBITDA noted above and discussed in detail under “Business Segment Results,” offset in part by an increase in depreciation and amortization expense.

     Interest Expense, Net. Interest expense, net, increased to $468 million in 2003, from $376 million in 2002, as a result of a change in the mix of debt from lower rate variable debt to higher rate fixed debt and a higher average level of debt outstanding.

     Other Income (Expense), Net. Other income, net, was $66 million in 2003 compared with other expense, net, of $655 million in 2002.

     In 2003, other income, net, included approximately $109 million in gains on the sale of certain investments, including a $50 million gain from the sale of the Company’s interest in Hughes and a $35 million gain on the sale of the Company’s interest in an international theater chain. This was offset in part by non-cash charges of $23 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in value and to reflect market fluctuations in equity derivative instruments. In 2002, other expense, net includes pretax non-cash charges of $581 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in value and to reflect market fluctuations in equity derivative instruments. Excluding equity method investees, as of March 31, 2003, the fair value and carrying value of the Company’s investment portfolio were $850 million and $794 million, respectively.

     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. AOL Time Warner had $56 million of minority interest expense in 2003, compared to $31 million in 2002. The increase in minority interest expense is primarily related to higher income allocated to the minority owners of TWE prior to the TWE Restructuring, offset in part by a lower level of accretion on preferred securities of AOL Europe due to the redemption of $255 million of redeemable securities in February 2002. The remaining preferred securities of AOL Europe and accrued dividends were redeemed in April 2003 (Note 7).

     Income Tax Provision. AOL Time Warner had income tax expense of $297 million in 2003, compared to $3 million in 2002. The Company’s pretax income was $693 million in 2003 compared to a pretax loss of $5 million in 2002. Applying the 35% U.S. federal statutory rate to pretax income would result in income tax expense of $242 million in 2003 and an income tax benefit of $2 million in 2002. However, the Company’s actual income tax expense (benefit) differs from these amounts primarily as a result of several factors including state and local income taxes and foreign income taxed at different rates.

     During the first quarter of 2003, the Company completed the tax restructuring of certain foreign operations which resulted in the generation of a capital loss of approximately $4 billion that expires in 2008. Capital losses can only be utilized against capital gains. At this time significant uncertainty exists regarding the future realization of this loss; therefore, the Company has recorded a full valuation allowance against the tax benefit of this loss.

     As of March 31, 2003, the Company had net operating loss carryforwards of approximately $10.6 billion, primarily resulting 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 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 assumed 2021. Upon the completion of the planned initial public offering of TWC Inc.’s stock, TWC Inc. would no longer be included in the Company’s consolidated Federal tax returns and it would therefore no longer be able to utilize the Company’s Federal operating loss carryforwards.

     Net Income (Loss) and Net Income (Loss) Per Common Share. AOL Time Warner had net income of $396 million in 2003 compared to a net loss of $54.244 billion in 2002. Basic and diluted net income per common share was $0.09 in 2003 compared to basic and diluted net loss per common share of $12.25 in 2002.

     As noted above, net income for 2003 includes $109 million in pretax gains on the sale of certain investments and pretax non-cash charges of $23 million to reduce the carrying value of certain investments that experienced

8

Table of Contents

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

other-than-temporary declines in value and to reflect market fluctuations in equity/derivative instruments. In addition, net income also reflects $24 million of pretax merger and restructuring costs.

     Net loss for 2002 includes a $54.235 billion charge relating to a cumulative effect of an accounting change in 2002 and a loss from discontinued operations of $1 million. Excluding these items, the Company’s net loss from continuing operations before the cumulative effect of an accounting change was $8 million in 2002. As noted above, net loss from continuing operations before the cumulative effect of an accounting change for 2002 includes pretax charges of $581 million relating to the writedown of investments and pretax charges of $107 million relating to merger and restructuring costs.

     In addition to these items, the 2003 results as compared to 2002 benefited from the overall increase in AOL Time Warner’s operating performance and a reduction of losses from equity method investees, which was slightly more than offset by increased depreciation and amortization expense and higher interest expense.

Business Segment Results

     AOL. Revenues, EBITDA, depreciation, amortization and operating income of the AOL segment for the three months ended March 31, 2003 and 2002 are as follows:

     The 11% growth in Subscription revenues was primarily related to price increases, an approximate $60 million favorable impact of foreign currency exchange rates and subscriber growth in Europe, as well as domestic subscriber growth particularly from the expansion of broadband service in 2003 as compared to the same period in 2002.

     The number of AOL brand subscribers in the U.S. was approximately 26.2 million at March 31, 2003 compared to approximately 26.5 million at December 31, 2002 and 26.1 million at March 31, 2002. The sequential decline in domestic AOL brand subscribers reflects a number of factors, including a maturing narrowband services subscriber universe; subscribers adopting other broadband services; a reduction in direct marketing response rates; a reassessment of various marketing programs, including bulk subscription employee programs, an increase in subscriber cancellations and terminations, including terminations of various non-paying subscribers on unlimited pricing plans; and the Company’s previously stated increased focus on improving the profitability of its narrowband membership base. The Company anticipates that the number of narrowband subscribers will likely continue to decline because of these factors. In addition, the movement toward AOL broadband services could negatively impact future results of operations due to lower margins on basic broadband services. The year over year increase in subscribers is principally related to the growth in broadband subscribers. The average monthly subscription revenue per domestic subscriber (“ARPU”) for the three months ended March 31, 2003 increased 3% to $18.52 as compared to $18.04 in the three months ended March 31, 2002. Domestic subscription ARPU is impacted by changes in the mix of narrowband and broadband product, the level of service provided (full connectivity versus Bring Your Own Access (“BYOA”)), and by changes in the terms of AOL’s relationships with its broadband cable, DSL, and satellite partners.

     The majority of AOL’s domestic subscribers are on unlimited pricing plans. Additionally, AOL has entered into

9

Table of Contents

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

certain bundling programs with Original Equipment Manufacturers (“OEMs”) that generally do not result in subscription revenues during introductory periods, as well as the sale of bulk subscriptions at a discounted rate to AOL’s selected strategic partners for distribution to their employees. As of March 31, 2003, of the 26.2 million domestic AOL members, approximately 80% were on standard unlimited pricing plans (including 10% under various free trial, member service and retention programs), 14% were on lower priced plans, including BYOA plans, bulk employee programs with strategic partners, and limited usage plans (the weighted average monthly rate for these lower priced plans was approximately $11.13), and the remaining 6% were on OEM bundled plans. As of December 31, 2002, of the 26.5 million domestic AOL members, approximately 81% were on standard unlimited pricing plans (including 10% under various free trial, member service and retention programs), 13% were on lower priced plans, including BYOA, bulk employee programs with strategic partners, and limited usage plans (the weighted average monthly rate for these lower priced plans was approximately $10.80), and the remaining 6% were on OEM bundled plans.

     The number of AOL brand subscribers in Europe was 6.3 million at March 31, 2003 and the average monthly subscription revenue per European subscriber for the first three months of 2003 was $17.84. This compares to AOL brand subscribers in Europe of 6.4 million and 5.9 million at December 31, 2002 and March 31, 2002, respectively, and an average monthly subscription revenue per European subscriber for the three months ended December 31, 2002 of $16.38 and $13.57 for the first three months of 2002. The average monthly subscription revenue per European subscriber in 2003 was impacted by price increases implemented in mid-2002 in various European countries offering the AOL service and the positive effect of changes in foreign currency exchange rates related to the strengthening of the Euro relative to that of the U.S. Dollar. The sequential decline in AOL brand subscribers was related to a reduction in inactive subscribers under various pay for usage plans.

     The 42% decline in year over year Advertising revenues is principally due to a reduction in benefits from prior period contract sales of $178 million and weakness in online advertising sales. Domestic contractual commitments received in prior periods contributed advertising revenue of $107 million in the 2003 period compared to $285 million in the comparable prior year period. Of the $285 million of advertising revenue from contractual commitments in 2002, $10 million was recognized as the result of the termination of contractual commitments. There was no such revenue from terminations recognized in 2003. The decline in advertising revenues also reflects a decrease in the intercompany sales of advertising to other business segments of AOL Time Warner in 2003 as compared to 2002 (from $54 million to $33 million). The decline was partially offset by a benefit of $28 million specifically relating to exceeding annual advertising performance thresholds on certain advertising contracts. Of the $226 million of advertising revenue in 2003, $79 million related to the five most significant advertisers. Similarly, of the $389 million of advertising revenue in 2002, $140 million related to the five most significant advertisers, including $80 million related to Bertelsmann (see “Overview — Recent Developments — Update on SEC and DOJ Investigations”). Advertising revenue from the five most significant domestic advertisers is expected to decline in both absolute terms and as a percentage of total advertising revenue as large advertising contracts expire and are replaced with smaller advertising arrangements.

     Domestic advertising commitments for future periods declined to $422 million as of March 31, 2003 as compared with $514 million as of December 31, 2002 and $1.019 billion as of March 31, 2002. During the first three months of 2003, in addition to the $107 million of prior period commitments recognized in revenue, remaining commitments were reduced by $57 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 the first three months of 2002, in addition to the $285 million of prior period commitments recognized in revenue, remaining commitments were reduced by $239 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 $422 million of advertising commitments for future periods as of March 31, 2003 is $201 million for the five largest commitments. Similarly, included in the $1.019 billion of advertising commitments for future periods as of March 31, 2002 is $389 million for the five largest commitments.

     The Company expects to complete performance on more than half of its remaining domestic advertising commitments by the end of 2003. Further declines in future consideration to be received, and revenue that would otherwise be recognized, could occur from additional terminations or restructurings of such commitments. As services under certain large longer term contracts signed in previous periods are completed, the Company expects to enter into fewer long term contracts, to reduce its reliance on long-term arrangements, including arrangements which

10

Table of Contents

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

involve significant non-advertising components. The Company expects that the level of advertising commitments for future periods will decline as traditional advertiser arrangements typically involve shorter terms. The Company is uncertain whether the amount of revenue from the more traditional short-term advertising arrangements will reach the levels of current and prior advertising revenue even if the online advertising market improves. The Company also is uncertain of its ability to renew or replace advertising sales for some of its largest advertisers.

     The 61% decrease in Other revenues is primarily 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. The declines are expected to continue throughout 2003.

     The increase in EBITDA is principally due to lower merger and restructuring costs in 2003 ($4 million) compared to 2002 ($75 million) (Note 2), lower equipment leasing costs and the benefit of a one-time sales tax settlement of $20 million recorded in 2003. Excluding these items, EBITDA decreased primarily due to the decrease in advertising and other revenue, offset in part by improved results at AOL Europe, lower domestic network expenses and higher subscription revenue. The increase in operating income is due to the aforementioned EBITDA increase offset in part by higher depreciation expense primarily due to an increase in network assets acquired under capital leases.

     Cable. Revenues, EBITDA, depreciation, amortization and operating income of the Cable segment for the three months ended March 31, 2003 and 2002 are as follows:

     The 14% increase in Subscription revenues was due to higher basic cable rates and increases in high-speed data services subscribers, digital cable subscribers and basic cable subscribers. In 2003, as compared to the prior year comparable period, high-speed data subscribers increased by 57% to 2.776 million, digital cable subscribers increased by 32% to 3.946 million and basic cable subscribers increased by 1.1% to 10.934 million (including approximately 1.600 million subscribers of unconsolidated investees which are managed by the Company).

     High-speed data subscribers include residential subscribers and commercial subscribers. As of March 31, 2003, high-speed data subscribers totaled 2.686 million residential and 90 thousand commercial subscribers.

     The 33% 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 $41 million to $2 million) and a decrease in the intercompany sale of advertising to other business segments of AOL Time Warner (from $27 million to $2 million), offset in part by a 15%, or $13 million, increase in general third-party advertising sales. The Company expects Cable’s Advertising revenues to continue to decline throughout 2003 related to a decrease in

11

Table of Contents

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

intercompany advertising revenue and a more than 70% decline in advertising purchased by programming vendors, primarily due to fewer new channel launches.

     EBITDA increased principally as a result of the Subscription revenue gains and lower high speed data network expenses, offset in part by increases in programming and other operating costs and reduced program vendor and intercompany advertising revenues. The increase in video programming costs of 18% was primarily attributable to two factors: first, sports programming cost increases, which reflect launches of new sports services and contractual rate increases for existing sports services; and second, the impact of having added numerous non-sports services to many of the Company’s lineups over recent years, including new services and expanded distribution of existing services. Video programming costs have risen in recent years and will continue to rise, although at a lower rate than during 2002, primarily due to the expiration of introductory and promotional periods under programming affiliation agreements, the need to obtain additional quality programming for more extensive programming packages, the migration of premium channels to the standard tier, industry-wide programming cost increases (especially for sports programming) and inflation-indexed or negotiated license fee increases. Other operating costs increased as a result of the roll out of new services, higher property taxes associated with the upgrade of cable plants, higher pension expense and higher development spending in the Interactive Personal Video division (from $5 million to $8 million). The decrease in operating income was primarily due to the increase in depreciation expense, reflecting higher levels of capital spending related to the roll-out of digital services over the past three years and increased capital spending on customer premise equipment that is depreciated over a shorter useful life, offset in part by the increase in EBITDA described above.

     Filmed Entertainment. Revenues, EBITDA, depreciation, amortization and operating income of the Filmed Entertainment segment for the three months ended March 31, 2003 and 2002 are as follows:

     The 11% increase in total revenues was driven by a 10% increase in Content revenues. This increase was primarily related to improved worldwide home video results, primarily related to DVD sales, and improvements in television, primarily related to the timing of deliveries of network series and the timing of international television availabilities. These increases were offset in part by declines in theatrical performance, related to fewer releases in 2003 and difficult comparisons to the prior year, which benefited from the strong carryover international results of Harry Potter and the Sorcerer’s Stone.

     EBITDA and operating income increased due primarily to the higher revenues described above and improved margin contribution from the theatrical and television businesses, as well as lower print and advertising expenses principally related to the decrease in the number of theatrical releases in the period, offset in part by fair value adjustments on certain future theatrical releases.

12

Table of Contents

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

     Networks. Revenues, EBITDA, depreciation, amortization and operating income of the Networks segment for the three months ended March 31, 2003 and 2002 are as follows:

     The 5% increase in Subscription revenues was due to an increase in the number of subscribers and from higher rates at both the Turner cable networks and at HBO. The 8% increase in Advertising revenues was driven by higher sellouts and advertising rates at Turner’s entertainment networks, reflecting continued improvement in the cable television advertising market, and at The WB Network, from higher advertising rates, higher ratings and the impact of an expanded Sunday night schedule that began in September 2002. This was offset in part by lower advertising revenues at Turner’s news networks primarily related to the coverage of the war in Iraq. The 134% increase in Content revenue was primarily due to higher home video sales at HBO, including My Big Fat Greek Wedding (released in February 2003) and HBO’s original programming.

     EBITDA and operating income increased primarily due to the increase in total revenues described above as well as lower marketing expenses and the settlement of certain legal liabilities at Turner. This was offset in part by higher programming costs at Turner, HBO and The WB Network, higher newsgathering costs at Turner and higher participations related to the increase in Content revenues at HBO. In addition, there were $8 million of restructuring costs in 2003 at Turner.

     Music. Revenues, EBITDA, depreciation, amortization and operating income (loss) of the Music segment for the three months ended March 31, 2003 and 2002 are as follows:

     The 10% decline in Content revenues was primarily related to the industry-wide impact of piracy on worldwide music sales, which is expected to continue. This decrease was partially offset by an approximate $50 million favorable impact of foreign currency exchange rates primarily related to the strengthening of the Euro relative to that of the U.S. dollar. The 23% increase in Other revenues was primarily related to an increase in the worldwide DVD manufacturing volume, due in part from the timing of certain key releases, and an approximate $10 million favorable impact of foreign currency exchange rates, offset in part by lower DVD manufacturing prices. As of March 31, 2003, the Music segment had year-to-date domestic album market share of 17.8% as compared to year-to-date market share of 17.0% at December 31, 2002 and 18.0% as of March 31, 2002.

13

Table of Contents

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

     The decrease in EBITDA is due primarily to the overall decline in recorded music sales, partially offset by increased DVD manufacturing volume and lower overhead costs resulting from the restructuring of the recorded music operations. In addition, EBITDA reflects a $12 million net benefit related to accrual reversals, including lower than expected employee compensation costs related to the restructuring of compensation plans, partially offset by increased reserves related to certain music publishing advances. The operating loss in 2003 is due primarily to the aforementioned changes in EBITDA as well as higher depreciation and amortization expense. The increase in amortization expense is principally related to the reduction in the amortization period of recorded music catalog and music publishing copyrights from 20 to 15 years.

     Publishing. Revenues, EBITDA, depreciation, amortization and operating income of the Publishing segment for the three months ended March 31, 2003 and 2002 are as follows:

     The 21% increase in Subscription revenues was primarily due to a $37 million reduction in subscription agents’ commissions (which are netted against revenue). The 10% increase in Advertising revenues reflects soft comparisons to the first quarter of 2002 resulting from the aftermath of the events of September 11th and improvements in the advertising market during the early part of this year. The 7% decline in Content revenues was primarily related to lower sales at the AOL Time Warner Book Group due to difficult comparisons to the 2002 period, which included Life: One Nation and the release of Nelson Demille’s Up Country. The 8% decline in Other revenues was primarily related to significantly lower results at Time Life.

     The increase in EBITDA reflects the impact of increased revenue discussed above. This was largely offset by higher marketing costs, a $17 million decline at Time Life, an increase in pension related expenses of approximately $10 million, which is expected to continue throughout the year and a $12 million restructuring charge recorded in the current quarter. As a result of the recent decline in operating performance, management conducted a review of the Time Life business and expects to restructure the business over the next two years with such restructuring resulting in costs ranging from $20 million to $40 million. The decrease in operating income was primarily due to higher amortization expense related to the finalization of purchase price accounting during the fourth quarter of 2002 relating to the acquisition of Synapse, a subscription marketing company, offset in part by the higher EBITDA discussed above.

FINANCIAL CONDITION AND LIQUIDITY
March 31, 2003

Current Financial Condition

     At March 31, 2003, AOL Time Warner had $30.0 billion of debt, $3.7 billion of cash and equivalents (net debt of $26.3 billion, defined as total debt less cash and cash equivalents) and $54.8 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. In addition, as of March 31, 2003, AOL Europe had $813 million, including accrued dividends, of redeemable preferred securities outstanding, which are classified as minority interest in the accompanying consolidated balance sheet. In April 2003, these redeemable preferred securities were repurchased by the Company for cash (Note 7).

14

Table of Contents

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

     In January 2003, pursuant to a previously negotiated agreement, TWE acquired an additional 11% interest in The WB Network from certain executives for $128 million in cash. Also during the quarter, the Company also made cash contributions to its own defined benefit pension plans for $279 million. In addition, in January 2003, the Company redeemed $372 million principal amount outstanding of 6.85% debentures due 2026 of Time Warner Companies, Inc., a wholly owned subsidiary of the Company. The Company paid $384 million to redeem the debentures, including accrued and unpaid interest to the date of redemption.

     In addition, in April 2003, the Company agreed to sell its 50% interest in Comedy Central for $1.225 billion in cash. This transaction is expected to close in the second quarter of 2003. Also during April 2003, the Company paid $391 million related to the settlement of certain litigation (Note 10).

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

Cash Flows

     Cash and cash equivalents increased to $3.687 billion as of March 31, 2003 from $1.730 billion as of December 31, 2002. See below for a discussion of the change.

Operating Activities

     Cash provided by operations decreased to $1.545 billion for the first three months of 2003, compared to $1.759 billion in 2002. The decline in cash flow from operations is primarily related to lower cash generated by working capital and the impact in 2002 of cash provided by the discontinued operations, offset in part by an increase in EBITDA. The changes in working capital are subject to wide fluctuations based on the timing of cash transactions related to production schedules, the acquisition of programming, collection of sales proceeds and similar items.

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

Investing Activities

     Cash provided by investing activities was $123 million for the first three months of 2003, compared to cash used by investing activities of $6.311 billion in 2002. The increase in cash provided by investing activities is primarily due to the lower level of cash used for investments and acquisitions, principally $5.3 billion of cash used in 2002 in connection with the acquisition of 80% of Bertelsmann’s interest in AOL Europe. In addition, 2003 had higher investment proceeds from available for sale securities, primarily related to cash proceeds of $783 million related to the sale of the Company’s investment in Hughes during the quarter. Capital expenditures and product development costs have declined primarily related to the absence in 2003 of the TWE-A/N discontinued operations, which had capital expenditures of $77 million in 2002.

15

Table of Contents

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

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

Financing Activities

     Cash provided by financing activities was $289 million for the first three months of 2003 compared to $4.719 billion in 2002. The decrease in cash provided by financing activities is principally due to incremental borrowings in 2002 that were used to finance the acquisition of 80% of Bertelsmann’s interest in AOL Europe.

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

Free Cash Flow

     AOL Time Warner evaluates operating performance based on several measures including free cash flow, which is defined as cash provided by operations less capital expenditures and product development costs, dividend payments and partnership distributions, and principal payments on capital leases. Free cash flow in 2003 was $960 million, compared to $1.069 billion in 2002. The following table provides a reconciliation of the Company’s cash provided by operations and free cash flow.

     The decrease in free cash flow was primarily the result of the decline in cash provided by operations as described above, offset in part by lower capital expenditures and product development costs. In addition, the prior year period was also impacted by discontinued operations, which positively impacted free cash flow by $62 million.

     Free cash flow in the second quarter of 2003 will be impacted by a $391 million payment associated with the satisfaction of certain pre-merger legal liabilities, which were fully accrued for as of December 31, 2002.

16

Table of Contents

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

Credit Agreements

     As part of the closing of the TWE Restructuring, AOL Time Warner, together with certain of its consolidated subsidiaries, amended its aggregate $10 billion unsecured long-term revolving bank credit agreements (the “Credit Agreements”). The Credit Agreements now consist of a $6 billion five-year revolving credit facility, a $2.5 billion 364-day revolving credit facility, and a $1.5 billion 364-day revolving credit facility. The borrowers under the $6 billion and $2.5 billion facilities (the “AOLTW Facilities”) are AOL Time Warner and AOL Time Warner Finance Ireland. The obligations of each of AOL Time Warner and AOL Time Warner Finance Ireland are directly or indirectly guaranteed by America Online, Time Warner, Turner Broadcasting System, Inc. (“TBS”) and Time Warner Companies, Inc. (“TW Companies”). The obligations of AOL Time Warner Finance Ireland are guaranteed by AOL Time Warner. The borrower under the $1.5 billion facility is TWE (and TWC Inc. following any initial public offering of its stock or registered public debt) (the “TWE Facility”). Borrowings under the $2.5 billion facility may be extended for a period up to two years beyond the initial maturity of July 7, 2003. The maturity of the TWE Facility is January 7, 2004 with an optional extension period of one year beyond such maturity date.

     Borrowings bear interest at rates generally based on the credit rating of the respective borrowers, which rate is currently equal to LIBOR plus 0.525% in the case of the $2.5 billion and $1.5 billion 364-day facilities, and 0.500% in the case of the $6.0 billion five-year facility. In addition, the Company is required to pay a facility fee of 0.10% per annum on the aggregate commitments under its 364-day facility and 0.125% per annum on the aggregate commitments under the 5-year facility, and an additional usage fee of ..0625% if the aggregate outstanding loans under the AOLTW Facilities exceed 33% of the aggregate committed amounts thereunder and 0.125% if such outstanding amounts exceed 66%. TWE is required to pay an additional facility fee of 0.10% per annum on the aggregate commitments under the TWE Facility and an additional usage fee of 0.0625% on outstanding principal amounts, which fee increases to 0.125% if the outstanding amounts exceed 66% of the total committed amounts under the TWE Facility. The AOLTW Facilities and the TWE Facility provide same-day funding and multi-currency capability. The AOLTW Facilities contain a maximum leverage ratio covenant of 4.5 times EBITDA, and an interest coverage covenant of 2.0 times cash interest expense for AOL Time Warner, and the TWE Facility contains a maximum leverage ratio covenant of 5.0 times EBITDA and an interest coverage covenant of 2.0 times cash interest expense for TWE. The Credit Agreements do not contain any credit ratings-based defaults or covenants, nor any ongoing covenant or representations specifically relating to a material adverse change in the Company’s or TWE’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.

     As previously noted, there was $2.1 billion of pre-existing debt of a Comcast subsidiary which was incurred by TWC Inc. The form of this debt is a one-year term loan with an optional extension for an additional year. The loan is guaranteed by TWE and is prepayable. The term loan contains a maximum leverage ratio covenant (including amounts owing to preferred equity interests and net of cash balances in excess of $25 million) and a minimum interest coverage covenant for TWC Inc. of 3.5 times EBITDA and 2.0 times cash interest expense, respectively. A total of $400 million of quarterly amortization commences on December 31, 2003 prior to final repayment of the remaining $1.7 billion on March 31, 2005, assuming the optional extension is exercised. Borrowings bear interest at specific rates, based on the credit rating for TWC Inc. or TWE, which is currently equal to LIBOR plus 0.875%.

Capital Expenditures and Product Development Costs

     AOL Time Warner’s total capital expenditures and product development costs were $554 million for the first three months of 2003 compared to $666 million in 2002. Capital expenditures and product development costs from continuing operations were $589 million in 2002. 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 $346 million in 2003 and $358 million in 2002. The Cable segment, over the past several years, has been engaged in a plan to upgrade the technological capability and reliability of its cable television systems and develop new services. The Company has completed such upgrades and therefore anticipates a decrease in capital expenditures and product development costs at the Cable segment throughout the remainder of 2003. Also contributing to capital expenditures and product development costs are product development costs incurred by the AOL segment, which amounted to $41 million in 2003 and $58 million in 2002. The decrease in product development costs incurred by the AOL segment in 2003, compared to 2002, related primarily to a decrease in spending related to non-core projects. In addition, capital expenditures in 2003 for the Company are expected to be impacted by costs associated with the completion of the Company’s new corporate headquarters.

17

Table of Contents

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

     The Cable segment’s capital expenditures from continuing operations are comprised of the following categories:

     AOL 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., equipment that converts transmitted signals to analog and/or a digital TV signal; a.k.a. analog and digital boxes) 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 up to 16 years. As of March 31, 2003, the total net book value of capitalized labor and overhead costs associated with the installation of converters and modems was approximately $160 million. As of that same date, the net book value of all capitalized costs associated with converters and modems, including equipment costs, was approximately $1.4 billion.

     Included in the AOL segment’s product development costs are costs incurred for the production of technologically feasible computer software that generates additional functionality to its existing software products. Capitalized costs typically include direct labor and related overhead for software produced by AOL as well as the cost of software purchased from third parties. Costs incurred on a product prior to the determination that the product is technologically feasible, as well as maintenance costs of established products, are expensed as incurred. All costs in the software development process, which are experimental in nature, are classified as research and development and are expensed as incurred until technological feasibility has been established. Once technological feasibility has been established, such costs are capitalized until the software has completed testing and is mass-marketed. Amortization is provided on a product-by-product basis using the greater of the straight-line method or the current year revenue as a percentage of total revenue estimates for the related software product, not to exceed five years, commencing the month after the date of the product release. The total net book value related to capitalized software costs was approximately $287 million as of March 31, 2003.

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 AOL Time Warner’s Filmed Entertainment companies was approximately $3.6 billion at March 31, 2003 and approximately $3.3 billion at December 31, 2002, including amounts relating to the licensing of film product to AOL Time Warner’s Networks segment of approximately $785 million at March 31, 2003 and $850 million at December 31, 2002.

Cable Joint Ventures

     The Company has an interest in and manages two cable joint ventures, Kansas City Cable Partners, L.P. (serving approximately 300,000 basic subscribers as of March 31, 2003) and Texas Cable Partners, L.P. (serving approximately 1.2 million basic subscribers as of March 31, 2003), both of which are 50%-owned by TWE and 50%-owned by Comcast. Under the terms of the two joint venture agreements, either partner may after August 31, 2003 with respect to Kansas City Cable Partners, L.P. and after December 31, 2003 with respect to Texas Cable Partners, L.P., initiate buy-sell procedures based on the market value of the joint venture interests. The Company does not have current plans to initiate the buy-sell procedure in either joint venture. If a buy-sell procedure were initiated by Comcast with respect to either joint venture, TWE would have a choice either to buy Comcast’s interests in the joint venture or to sell its interest in the joint venture to Comcast. However, in such an event, the Company would be under no obligation to purchase Comcast’s interest. Additionally, in 2005, under the terms of both joint venture agreements, either partner may trigger the dissolution of the joint ventures resulting in the distribution of the net assets of the joint ventures to the partners. Any actions to be taken by the Company under the buy-sell or dissolution procedures will be evaluated in the context of the Company’s strategy for its Cable operations and its overall debt reduction plans.

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

18

Table of Contents

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

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 may be adversely affected by competitive market conditions and may not be able to execute its business strategy. The Company’s America Online business has recently announced its strategy to revitalize the business and respond to the changing competitive environment. The strategic plan focuses on improving the products and services it offers consumers, and includes the following primary components:

	•		continuing to focus on the profitability of those members who use narrowband Internet access;
	•		managing the migration of members to broadband and multiband by improving the broadband and multiband product;
	•		focusing on the member experience with new features, content, community and customer service;
	•		growing non-subscription revenues by stabilizing and expanding its advertising business, developing premium services such as online games and voice services, and identifying and developing commerce marketplaces such as online liquidations of goods;
	•		taking steps to continue to reduce losses at the international businesses and working to bring them to profitability; and
	•		continuing cost management.

     America Online is in the beginning stages of implementation of the strategy. Each of these initiatives requires sustained management focus, organization and coordination over time, as well as success in building relationships with third parties and success in anticipating and keeping up with technological developments and consumer preferences. The results of the strategy and implementation will not be known for some time in the future. If America Online is unable to implement the strategy successfully or properly react to changes in market conditions, AOL Time Warner’s financial condition, results of operations and cash flows could be adversely affected. Successful implementation of the strategy may require material increases in costs and expenses, and some of the new strategy components, if successful, may result in lower profit margins (for example, broadband members generally generate lower profit margins than narrowband members).

     Each year a significant portion of AOL subscribers cancel or are terminated. In the past, AOL has been able to attract sufficient new members to more than offset cancellations and terminations. It is uncertain whether America Online can continue to register new subscribers in numbers sufficient to replace those subscribers who cancel or are terminated and may experience increased volatility in its subscriber base as well as declines in the number of subscribers. America Online recently has experienced declines in the number of U.S. subscribers, to approximately 26.2 million at March 31, 2003 and 26.5 million at December 31, 2002, and anticipates that it will experience further declines due to the maturing narrowband services subscriber universe, subscribers adopting broadband service, 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. In addition, as the overall size of the subscriber base becomes larger, the difficulty in maintaining and growing the subscriber base increases because the number of new subscribers required to offset those subscribers who terminate or are cancelled also becomes larger. America Online faces increased competition from other providers of Internet services, including both online services such as Microsoft MSN and AT&T Worldnet and providers of broadband access such as cable and telephone companies who have greater access to and control of the methods used to provide Internet services to users.

     Maintaining and growing the subscriber base has become more challenging as the popularity of broadband Internet access has increased. As more people switch to broadband, especially as offered by other providers, America Online will need to develop a compelling broadband product to attract members who are willing to pay additional amounts for the content and functionality provided by America Online. Since many of the premium services will be provided via broadband, a successful premium services strategy may be linked to success with its broadband strategies. It is also unclear how successful America Online will be in promoting and selling its new premium services to members generally. In addition, other Internet service providers may have more resources to devote to development and marketing of their services, or may be able to offer low-priced alternatives to the AOL service. To be successful in its broadband strategy, America

19

Table of Contents

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

Online will need to maintain and further its existing arrangements with certain cable and telephone companies, as well as develop successful business relationships with additional large broadband access providers. Further, changes in the current regulatory environment may adversely impact America Online’s ability to provide broadband services at competitive prices.

     Ongoing investigations by the Securities and Exchange Commission and the Department of Justice and pending shareholder litigation could affect AOL Time Warner’s operations. The Securities and Exchange Commission (the “SEC”) and the Department of Justice (the “DOJ”) are investigating the Company’s financial reporting and disclosure practices. As of May 12, 2003, there were approximately forty 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 AOL 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 are also three actions 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 AOL 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. As noted, there are also related derivative actions and ERISA actions. 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 “Overview – Recent Developments – Update on SEC and DOJ Investigations.”

     An inability to achieve the Company’s debt-reduction goals could adversely affect the Company’s common stock price. The Company has announced a goal of decreasing its total consolidated debt (net of cash) over the period ending December 2004. If it is unable to achieve this goal, including by using free cash flow, completing the planned initial public offering of its cable business, selling non-core assets and using other de-leveraging initiatives, the price of its common stock could be adversely affected.

     Technological developments may adversely affect the Company’s competitive position and limit its ability to protect its valuable intellectual property rights. AOL 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 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;
	•		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 personal video recorder or other technologies that have “ad-stripping” functions, and technological developments that facilitate the piracy of its copyrighted works; and
	•		The Company’s music business may be adversely affected by technological developments, such as Internet peer-to-peer file sharing and CD-R activity, that facilitate the piracy of music; by its inability

20

Table of Contents

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

to enforce the Company’s intellectual property rights in digital environments; and by its failure to develop a successful business model applicable to a digital online environment.

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, EBITDA 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.

     AOL 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. AOL 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 AOL 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 AOL Time Warner’s other filings with the SEC and the following:

     For AOL Time Warner’s AOL businesses:

	•		the ability to successfully implement a new strategy;
	•		the ability to develop new products and services to remain competitive;
	•		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 retain and grow 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 WorldCom;
	•		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 renew or replace large multi-period advertising arrangements with similar commitments or with shorter term advertising sales;
	•		the risk that 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;
	•		the risks from changes in U.S. and international regulatory environments affecting interactive services; and
	•		the ability to reduce losses at its international businesses and bring them to profitability.

21

Table of Contents

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

     For AOL Time Warner’s cable business:

	•		more aggressive than expected competition from new technologies and other distributors of video programming and high-speed data services such as satellite, terrestrial wireless and DSL;
	•		increases in government regulation of video programming rates or other terms of service, such as “digital must-carry,” “forced access” or common carrier requirements; government regulation of other services, such as high-speed data service;
	•		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 or 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;
	•		fluctuations in spending levels by advertisers and consumers;
	•		unanticipated funding obligations relating to the cable joint ventures; and
	•		greater than expected increases in programming or other costs, including costs of its new products and services, or difficulty in passing such costs to subscribers.

     For AOL 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 may facilitate piracy of its copyrighted works;
	•		the ability to develop and apply adequate protections for filmed entertainment content in a digital delivery environment;
	•		the ability to develop a successful business model for delivery of feature films in a digital online 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
	•		with respect to home video, the ability to maintain relationships with significant customers in the rental and sell-through markets.

     For AOL Time Warner’s network businesses:

	•		greater than expected news gathering, programming or production costs;
	•		public or cable operator resistance to price increases and the negative impact on premium programmers of increases in basic cable rates;
	•		increased regulation of distribution agreements;
	•		the sensitivity of network advertising to economic cyclicality and to new media technologies;
	•		the negative impact of consolidation among cable and satellite distributors;
	•		piracy of content by means of interception of cable and satellite transmissions or Internet peer-to-peer file sharing;
	•		the impact of personal video recorder “ad-stripping” functions on advertising sales and network branding;
	•		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 or the increased popularity of alternatives to television.

22

Table of Contents

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

     For AOL Time Warner’s music business:

	•		the ability to continue to attract and select desirable talent at manageable costs; the popular demand for particular artists and albums; the timely completion of albums by major artists;
	•		the ability to continue to enforce its intellectual property rights in digital environments; piracy of music by means of Internet peer-to-peer file sharing and organized and home CD-R activity;
	•		the ability to develop a successful business model applicable to a digital online environment;
	•		the ability to maintain retail product pricing in a competitive environment;
	•		the potential loss of catalog if it is determined that recording artists have a right to recapture sound recordings under the United States Copyright Act;
	•		the potential repeal of Subsection (b) of California Labor Code Section 2855, a Section which prescribes a maximum length for personal service contracts;
	•		the risk that there will be other federal and state statutes enacted which are similar to California Labor Code Section 2855, a Section which prescribes a maximum length for personal service contracts;
	•		risks from disruptions in the retail environment from bankruptcies, store closings and liquidity problems of record retailers;
	•		risks associated with foreign currency exchange rates;
	•		the ability to utilize DVD manufacturing capacity fully and to maintain current DVD manufacturing pricing; and
	•		the overall strength of global music sales.

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

     For AOL 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 the war with Iraq, increased expenses as a result of the SEC and Department of Justice investigations and the shareholder litigation pending against AOL 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.

Item 4. Controls and Procedures

     Within the 90-day period prior to the filing of this report, 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-14(c) under the Securities Exchange Act of 1934 (the “Exchange Act”)). Based on that evaluation, the Chief Executive Officer and the Chief Financial Officer 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

23

Table of Contents

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

more limited than those it maintains with respect to its consolidated subsidiaries. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect the internal controls subsequent to the date the Company completed its evaluation.

24

Table of Contents

AOL TIME WARNER INC.