UNITED STATES

FORM 10-Q

For the quarterly period ended: September 30, 2004

Commission File Number: 000-31181

AMERICA ONLINE LATIN AMERICA, INC.

Registrant’s telephone number, including area code: (954) 689-3000

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 o No x

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

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AMERICA ONLINE LATIN AMERICA, INC.

FORM 10-Q

INDEX

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PART I. FINANCIAL INFORMATION

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     Introduction

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

	•		Overview and recent developments. This section provides a general description of AOLA’s businesses, as well as recent developments that we believe are important in understanding our results of operations and future trends in our operations.
	•		Results of operations. This section provides an analysis of AOLA’s results of operations for the three and nine months ended September 30, 2004 relative to the comparable periods in 2003. This analysis is presented on a consolidated basis, but also discusses relevant segment basis figures and results.
	•		Financial condition and liquidity. This section provides an analysis of AOLA’s financial condition as of September 30, 2004 and cash flows for the three and nine months ended September 30, 2004 and 2003.
	•		Critical accounting policies. This section provides a review of our accounting policies and estimates considered most important to our reported financial condition and results.
	•		Forward-looking statements. This section discusses how certain forward-looking statements made by AOLA 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.

     This MD&A may not be indicative of the results for the full year and should be read in conjunction with the sections of our audited financial statements and notes thereto as well as our MD&A that are included in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003.

     Overview and Recent Developments

     America Online Latin America, Inc. (“we,” “us,” “AOLA” or the “Company”) is a provider of interactive services in Latin America. We derive our revenues principally from member subscriptions to our AOLA country services, the AOL-branded service in Puerto Rico and our web-based interactive services. We also generate additional revenues from advertising and other revenue sources. Other revenue sources include programming services provided to America Online, Inc. (“America Online”) for its Latino content area, revenue sharing agreements with certain local telecommunications providers, and call center support services that we provide to America Online’s German subsidiary.

     Our AOLA country services and web-based interactive services provide our members with easy and reliable access to online communities, content and localized versions of certain of America Online interactive products. Our services enable members to access and explore the Internet and encourage members to participate in interactive communities through tools such as Spanish and Portuguese versions of AOL Instant Messenger, Buddy Lists, e-mail, web logs, public bulletin boards, online meeting rooms, conversations, chat and auditorium events. Our AOLA country services require members to use a client software program on their computers, whereas our web-based services do not require this software. Members of most of our services can personalize their online experience through a variety of features, including customized news and e-mail controls. Our interactive services typically also provide members with local and regional content organized into channels, making areas of interest easy to find, and our AOLA country services also provide access to the extensive global content of the AOL service.

     Our main markets in Latin America are Brazil, Mexico and Puerto Rico. We have no current plans to expand to other markets in Latin America. We consider countries in which we have launched our AOLA country services or web-based interactive services as operational segments and internally report our operations on a country-by-country basis. Each of our operating segments, except for Puerto Rico, derives its subscription revenues through the provision of interactive services and also from advertising and other revenue sources. In Puerto Rico, we derive our subscription revenue from our arrangement with America Online whereby America Online transfers it net economic interests from

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members to the AOL-branded service in Puerto Rico to us. Our Puerto Rico segment also derives revenue from advertising and other revenue. Although amounts for Argentina are not material and are not expected to be material in future reporting periods, we have decided not to consolidate Argentina with our corporate and other segment in order to facilitate historical segment comparisons.

     In the table below, we provide the date on which we first launched our country service in each market and our market service coverage as of September 30, 2004.

     Subscribers in Puerto Rico are provided with both English and Spanish language content through the AOL-branded service.

     We launched our web-based content and connectivity services in Brazil, Argentina and Puerto Rico in September 2003, October 2003 and February 2004, respectively. Our web-based services are priced at lower rates than our AOLA country services and are designed to be more competitively priced. Our web-based Internet connectivity service in Brazil is segmented to address four broad categories: AOL Total, which is similar to our full-featured AOLA country service; AOL Executive; AOL Youth; and AOL Lite.

     Unlike Brazil, in Puerto Rico we offer only one web-based product, “Conexis,” which provides basic Internet connectivity, one email address, and minimal content. A web-based service is available in Mexico, although it is not actively promoted. We do not expect this web-based service to become a significant part of our business in Mexico. We are primarily responsible for the technical support, development and billing for our web-based services.

     We believe our web-based services in Brazil will become our primary product there, although at present the majority of our members in Brazil use the AOLA country service. We no longer actively promote the AOLA country service in Brazil, although it is still available and a limited number of new members continue to select it. We no longer promote either the AOLA country service or the web-based service in Argentina, although they are still available. We do not expect our web-based product offering in Puerto Rico to become our primary product offering. We expect to experience migration of membership from our AOL Brazil country services and our AOL-branded service in Puerto Rico to our web-based services. As of September 30, 2004, approximately 20% of active subscribers to our narrowband web-based services have migrated from our AOLA country services in Brazil, Mexico and Argentina and the AOL-branded service in Puerto Rico.

     To date, growth of our web-based services has been slow and we do not expect any significant change in the near future. Approximately 19% of the membership totals as of September 30, 2004 were subscribers to our narrowband web-based interactive services. Results to date in Brazil indicate that membership turnover is slightly lower for our web-based offerings than for our AOLA country services, although we believe this slight improvement is not sufficient to enable us to achieve cash self-sufficiency with available cash.

     We launched our broadband service in Brazil, AOL MAXX, nationally in August 2003. Our broadband service is a full-featured product offering subscribers faster Internet access through DSL and cable and unique content designed for delivery through high-speed channels. Subscribers to our broadband services in Brazil can select either our AOLA country service or our web-based service. The pricing of our broadband service in Brazil varies depending upon our telecommunications partner. We also continue to test broadband products in Mexico, although at present we do not have plans to launch nationally. A decision on whether or not to launch our broadband service in Mexico will depend on our ability to reach agreement with a broadband partner on favorable economic terms. Approximately 7.2% of the membership totals as of September 30, 2004, were subscribers to our broadband interactive services in Brazil.

     In June 2000, we entered into a ten-year strategic agreement with Banco Itaú, one of the largest banks in Latin America. Banco Itaú is obligated to market and promote a co-branded version of our interactive services in Brazil as the principal means of accessing Banco Itaú’s interactive financial services. Banco Itaú customers who become subscribers to the full AOL country services and the AOL Total web-based services are entitled to a 20% discount off the standard price. Subscribers of all of the other prices plans are entitled to smaller discounts, except broadband subscribers who are not entitled to any discount.

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     In January 2003, we entered into a five-year agreement with McDonald’s in Brazil to market our service via kiosks in McDonald’s restaurants in Brazil. We paid McDonald’s an initial fee of approximately $2.1 million and are required to pay an annual maintenance fee of up to approximately $1.3 million over the term of the agreement. The maintenance fee amount is based upon the number of restaurants containing operating kiosks, is denominated in Brazilian reals and is subject to adjustment based on the rate of inflation in Brazil. In addition, we also are required to pay McDonald’s a fee for each new member who becomes a paying member of our service in Brazil. We launched the project in a limited number of restaurants in October 2003, but the implementation of this agreement has been subject to a number of delays and still has not been fully implemented.

     In March 2004, we modified our agreement with McDonald’s under which, among other things, McDonald’s was required to establish functioning kiosks in 550 of its restaurants by August 31, 2004. On that date, we and McDonald’s concluded that only 375 restaurants were functioning. Therefore, McDonald’s paid us a penalty of approximately $0.8 million. For accounting purposes the amount was netted against our initial investment of $2.1 million and will reduce our amortization of the balance of our investment. The next measurement date will be March 31, 2005, at which point the required target is to establish functioning kiosks in 600 of its restaurants.

     Implementation under the terms of the modified agreement remains behind schedule, and we do not expect that McDonald’s will be able to fully implement the agreement or satisfy its other obligations under the agreement by March 31, 2005, as required. To date, the productivity rates have been low in restaurants where kiosks have been established. We no longer expect McDonald’s to become a significant member acquisition channel. If we determine that the McDonald’s marketing agreement were to be non-viable, it would result in a net impairment charge of approximately $0.7 million related to the initial fee we paid McDonald’s in 2003 which is currently being amortized over the life of the agreement. Although failure to successfully implement the McDonald’s agreement will negatively impact our future membership levels, the financial impact is not expected to be material in 2004. Depending upon the results at the next measurement date, management will assess all commercial and legal options. The outcome of these decisions may materially affect our financial results in 2005. Going forward, we expect our primary member acquisition channel in Brazil to be our marketing relationship with Banco Itaú.

     Commencing in the second quarter of 2002, we began to reduce our spending on acquisition marketing activities and we began to increase our reliance on co-branded and joint marketing arrangements, where a third-party partner is responsible for implementing a significant percentage of the marketing effort. Our principal marketing arrangements are our strategic marketing agreement with Banco Itaú and our McDonald’s marketing agreement, both in Brazil. In Mexico and Puerto Rico, we have continued our reliance on existing distribution channels, focusing primarily on targeted increases in the number of kiosks located at retail locations such as shopping malls and general merchandise stores. Our reliance on the marketing efforts of strategic partners has reduced the rate at which we use cash and has lowered our sales and marketing expenses, since costs incurred by our partners are not accounted for in our results. However, reliance on third-party arrangements has also increased the potential for unforeseen events and delays over which we have limited control, as has been the case with McDonald’s in Brazil. Failure to achieve our expected subscriber objectives pursuant to the Banco Itaú agreement would negatively impact our future membership levels.

     At September 30, 2004, our ending membership base was approximately 400,000 members, down from approximately 418,000 members at June 30, 2004. Membership in our Banco Itaú co-branded service was approximately 103,000 members at September 30, 2004, as compared with approximately 108,000 members at June 30, 2004, and accounted for approximately 26% of our total membership base. The decline in total membership during the third quarter of 2004 continued to be driven by low levels of new member registrations, which were insufficient to offset membership losses from attrition. During the third quarter of 2004, the banking system in Brazil experienced a general strike that lasted approximately 30 days. We believe that this event generated a small negative impact in our volume of new member registrations for the Banco Itaú co-branded services. Strong price competition from providers of free and paid Internet services in Brazil, as well as increased competition from broadband providers in Mexico, continue to negatively impact member acquisition and retention. Registration rates also continue to be negatively impacted by the lack of progress in the implementation of the McDonald’s marketing agreement and low productivity in restaurants where kiosks have been established. Although membership turnover rates during the first three quarters of 2004 improved modestly from the comparative prior-year periods, they have remained relatively constant during the first nine months of 2004. Management does not expect improvement in membership turnover rates during the remainder of 2004 and into 2005.

     We expect that our membership base will decrease by as much as 9,000 members in the fourth quarter of 2004, driven by the loss of paying members and strong price competition from providers of free and paid Internet service in Brazil and Mexico. Future membership levels will be significantly influenced by our ability to retain current members and improve productivity in existing membership acquisition channels and our success in identifying alternative member acquisition channels.

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     Total membership counts include members of our AOLA country services, our web-based interactive services and broadband service, as well as members of the co-branded Banco Itaú services. Our membership totals also include members participating in free trial periods and retention programs. As of September 30, 2004, 90% of our members, including members still in their trial periods, had selected credit cards, direct debit and other non-cash payment options, which have a better rate of collection than cash-payment methods, as compared with approximately 81% at December 31, 2003. Approximately 11% of our total subscribers at September 30, 2004 were in free trial periods or member retention programs, compared with 14% at December 31, 2003.

     During the quarter ended September 30, 2004, we experienced a decrease in our subscription revenues as compared with the third quarter of 2003. This reduction was driven by declines in Brazil and Mexico, partially offset by a small increase in Puerto Rico. The losses in Brazil and Mexico were driven primarily by decreases in paying members. Future subscription revenue performance will be highly influenced by the extent of our success in reducing membership turnover and in attracting new members, our ability to improve productivity in existing member acquisition channels and our ability to identify alternative member acquisition channels. To date, our web-based services have not met our expectations for attracting and retaining members. We expect our subscription revenues to decrease in the future, driven by the continued decreases in paying members and by the expected change of the subscriber mix in favor of our lower-priced web-based services, rather than our higher-priced AOLA country services.

     Advertising and other revenue also decreased in the third quarter of 2004, as compared to the third quarter of 2003. We expect our advertising and other revenue to continue to decrease during the balance of 2004, as compared to 2003, as a result of our reduced membership base, our lack of success in attracting significant commitments from traditional media advertisers and the expiration of long-term contracts in 2003. Other revenues are also expected to decrease due to the replacement of our agreement to provide programming services to America Online for their Latino content area with an interim agreement containing different terms.

     We expect our revenues to decrease in the future. However, as a result of lower costs we also expect to further reduce our losses in 2004, as compared with 2003. Hosting expenses and telecommunication costs are expected to decrease, primarily as a result of negotiated reductions in network unit prices and capacity achieved in 2003, while sales and marketing expenses are decreasing as a result of lower average number of kiosks in operation and additional reductions in the distribution of CDs, which contain client software. However, on a sequential quarter basis, excluding one-time items, we expect our losses to increase modestly in the fourth quarter of 2004, as compared with each of the first three quarters of 2004, driven primarily by continued declines in revenues. In the upcoming quarters, management believes that further reductions in costs and expenses will not be sufficient to entirely offset reductions in revenue, and therefore net loss is expected to remain flat or increase modestly on a year-over-year basis. We do not expect to reach cash breakeven with current available funds. Available cash on hand at September 30, 2004 was $25.2 million, as compared with available cash on hand of $27.9 million at June 30, 2004 and of $32.9 million at December 31, 2003. Based upon our current operating budget, we expect that available cash on hand will be sufficient to fund operations into the third quarter of 2005.

     During the quarter ended September 30, 2004, our net loss applicable to common stockholders was $23.6 million, an improvement of $5.0 million as compared with the third quarter of 2003.

     Regulations relating to local telephone pricing in Brazil are currently scheduled to expire in January 2006. At such time, we believe rules governing interconnection fees between telecommunications providers may also be modified. If such rules were to be modified, we would expect our costs to increase because we would not receive payments we currently receive from telecommunications providers for routing our traffic over their lines. During the second quarter of 2004, Brazilian regulators issued for public commentary proposed rules that would accelerate the implementation of changes governing interconnection fees, but no actions have been taken as of this time. We cannot predict at this time whether or not these regulations will be enacted or, if enacted, what form of alternative rate pricing might be adopted, or what any potential effect on our business could be. These changes would also likely impact the competition for interactive services in Brazil, although we cannot predict what the impact may be.

     Results of Operations

     Consolidated Results of Operations

     Table 1 shows the consolidated results from operations for the three and nine month periods ended September 30, 2004 and 2003.

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TABLE 1 — SELECTED OPERATING DATA
(In thousands, except share, per share amounts and percentages)

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     Revenues

     Total revenues. Our total revenues consist principally of subscription revenues, and also include revenues generated from advertising and other revenue sources.

TABLE 2 — REVENUES BY SEGMENT
(In thousands, except percentages)

     Subscription revenues. Table 2 presents our subscription revenues on a consolidated and segment basis for the three and nine months ended September 30, 2004 and 2003.

     We derive our subscription revenues from members paying fees to subscribe to our AOLA country services and to our web-based interactive services, and from revenues received from America Online related to subscribers to the AOL-branded service in Puerto Rico. Subscription revenues do not include amounts paid to us by Banco Itaú on behalf of its customers for subsidies that it chose or was required to make. Such receipts from Banco Itaú were netted against and recorded as a reduction of marketing expense and thus were not accounted for as subscription revenues. Amounts paid directly to us by subscribers that exceeded any usage subsidized by Banco Itaú were included in subscription revenues. Under the terms of the revised marketing agreement, Banco Itaú is no longer required to subsidize its customers who

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are subscribers to the co-branded service. Subsidies have not been received since the second quarter of 2004 and we do not expect to receive any subsidies from Banco Itaú for its customers in future periods. For subscribers that have elected to pay their subscription fees with credit cards, we begin to recognize subscription revenues when the fees become due and are confirmed as collectible. For subscribers that pay through means other than credit cards, we begin to recognize subscription revenues when we receive payment.

     Subscription revenue for the quarter ended September 30, 2004 was $11.6 million, a decrease of 21.2%, or $3.1 million, from $14.8 million in the third quarter of 2003. The decline in subscription revenue versus the prior-year period was driven by the loss of paid members in all operating segments, except Puerto Rico. The loss of paying subscribers was primarily a result of increased competition, which resulted in members lost through attrition. New member registration rates were lower than necessary to replace membership attrition, and have been negatively impacted as well by the problems related to the launch of the McDonald’s initiative in Brazil and the lack of alternative member acquisition channels. For the third quarter of 2004, subscription revenue in Brazil decreased to $3.9 million, down $1.9 million, or 32.6%, from $5.8 million in the quarter ended September 30, 2003. Subscription revenue in Mexico decreased to $3.9 million in the third quarter of 2004, down $1.2 million, or 23.1%, from $5.1 million in the third quarter of 2003. Subscription revenue in Puerto Rico, however, was flat at approximately $3.5 million in the third quarter of 2004 as compared with $3.4 million in the third quarter of 2003.

     Exchange rate fluctuations decreased reported subscription revenue by approximately 2.3%, or by $0.3 million, for the quarter ended September 30, 2004, as compared with the third quarter of 2003. In constant currency terms, subscription revenue decreased by 18.8%, an amount less than the reported decrease of 21.2% during the three months ended September 30, 2004. Information on a constant currency basis excludes the effect of foreign currency translation on reported results and is provided to help explain variations in reported results and provide insight into the underlying operational performance of our business. On a segment basis, in constant currency terms, subscription revenue in the third quarter of 2004 decreased by 31.6% in Brazil and 17.7% in Mexico, as compared with the quarter ended September 30, 2003.

     Sequentially, reported subscription revenue declined by 2.8%, or approximately $0.3 million, from the $12.0 million recorded in the quarter ended June 30, 2004. All segments contributed to the sequential decrease as compared with the second quarter of 2004. The loss of paying members was the main factor resulting in the reduction of subscription revenue as compared with the second quarter of 2004.

     For the nine months ended September 30, 2004, subscription revenue was $37.1 million, a decrease of $8.5 million, or 18.6%, from $45.6 million recorded in the first nine months of 2003. The decline in subscription revenue during the first nine months of 2004 as compared with the prior-year period was driven by decreases in all segments except for Puerto Rico. For the first nine months of 2004, subscription revenue in Brazil and Mexico decreased by $4.9 million and $3.8 million, respectively. The decrease in subscription revenue during the first nine months of 2004 resulted primarily from the loss of paid members, driven by the competitive trends previously described. Currency fluctuation did not have a material impact on reported revenue during the first nine months of 2004.

     Future subscription revenue will be highly influenced by our ability or inability to retain current members and improve productivity in existing acquisition channels and our success or failure in identifying alternative member acquisition channels. Although membership turnover rates during the first three quarters of 2004 improved modestly from the comparative prior-year periods, they have remained relatively constant during the first nine months of 2004. Management does not expect improvement in membership turnover rates during the remainder of 2004 and into 2005. We expect our subscription revenues to continue to decrease, driven by the continued reduction in paid membership and the expected change of the subscriber mix in favor of our lower-priced web-based services, rather than our higher-priced AOLA country services.

     For the three and nine-month periods ending September 30, 2004, we did not have any material subscription revenues from related parties, other than revenues received from America Online for subscribers to the AOL-branded service in Puerto Rico. For the three and nine months ended September 30, 2004, we had subscription revenue from America Online related to members of the AOL-branded service in Puerto Rico of $3.6 million and $10.9 million, respectively. For the three and nine months ended September 30, 2003, our subscription revenue from America Online related to members of the AOL-branded service in Puerto Rico was $3.4 million and $10.2 million, respectively.

     At September 30, 2004 and December 31, 2003, we had deferred subscription revenues of approximately $4.3 million and $4.5 million, respectively. Deferred subscription revenues consist of fees for subscription services received or confirmed as collectible from credit card accounts and prepaid subscription plans in advance of our having earned those subscription revenues. We actively promote prepaid subscription plans in Mexico, and approximately 43% of the active members have selected these prepaid plans.

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     Advertising and other revenues. Table 2 also presents our advertising and other revenues.

     Our advertising and other revenue is derived principally from:

	•		advertising arrangements under which we receive fees for advertisements displayed on our interactive services;
	•		advertising sponsorship or co-sponsorship arrangements that allow advertisers to sponsor an area on our interactive services in exchange for a fee;
	•		fees we receive from America Online for programming services we provide to America Online for use on their Latino content area;
	•		representation fees we receive from America Online for selling advertising on their interactive services;
	•		revenues we receive from providers of Internet search services; and
	•		revenue sharing arrangements with local telecommunications providers. Because local telephone service in Latin America is often metered, the utilization of our AOLA country services and of our web-based interactive services by our members results in incremental revenues to local telecommunications companies. To encourage incremental traffic on their local networks by our members, some local providers of network access have entered into agreements compensating us for routing our traffic on their networks.

     For the quarter ended September 30, 2004, advertising and other revenue declined to $1.2 million, a decrease of $0.4 million, or 23.3%, from $1.5 million in the third quarter of 2003. The overall decrease was driven primarily by decreases in advertising sales. All of our segments, except for Argentina, reported declines in advertising and other revenue. The increase in our Argentina segment was primarily due to revenue received by us from America Online’s German subsidiary for German-language call center support services that we provided to them during the third quarter of 2004. Exchange rate fluctuations decreased reported advertising and other revenues by approximately 8.6%, or by $0.1 million, for the quarter ended September 30, 2004, as compared with the third quarter of 2003. In constant currency terms, advertising and other revenues decreased by 36.7%, an amount greater than the reported decrease of 23.3% during the three months ended September 30, 2004.

     Sequentially, advertising and other revenue in the quarter ended September 30, 2004, experienced a small increase of $0.4 million, or 58.2%, from the second quarter of 2004, driven by increased advertising by Banco Itaú, revenues received from America Online related to an interim agreement to provide programming services for their Latino content area, and revenues received from America Online’s German subsidiary for call center services. We expect advertising and other revenue to decrease from current levels during the fourth quarter of 2004, as compared with 2003, despite an improved online advertising environment in Latin America. The decline will be driven by our reduced membership base, our lack of success in attracting significant commitments from traditional media advertisers. Other revenues are also expected to decrease due to the expiration of our agreement to provide programming services to America Online for its Latino content area, although we are currently negotiating a new agreement with America Online. The new agreement is expected to bring lower revenues than the previous one for a comparable period. There can be no assurance that we will be able to reach agreement with America Online regarding our potential provision of these services.

     For the nine months ended September 30, 2004, advertising and other revenue was $2.4 million, down $2.2 million, or 47.9%, from $4.7 million in the first nine months of 2003. The decrease occurred across all segments, except for Argentina, which experienced a small increase as a result of the provision of call center services to America Online’s German subsidiary. Exchange rate fluctuations decreased reported advertising and other revenues by approximately 3.0%, or by $0.1 million, for the nine months ended September 30, 2004, as compared with the same period of 2003. In constant currency terms, advertising and other revenues decreased by 53.7%, an amount greater than the reported decrease of 51.2% during the nine months ended September 30, 2004.

     During the three and nine months ended September 30, 2004, we had advertising and other revenues from related parties of approximately $0.4 million and $0.7 million, respectively. This compares with $0.4 million and $1.4 million for the three and nine months ended September 30, 2003, respectively. Advertising and other revenue from related parties consists primarily of revenues received from America Online for programming services we provide to them for their Latino content area, representation fees we receive from America Online for selling advertising on their interactive services, call center support services provided to America Online’s German subsidiary and advertising by Banco Itaú on our AOLA country and web-based services in Brazil.

     As of September 30, 2004 and December 31, 2003, we had deferred advertising and other revenues of approximately $0.3 million and $0.3 million, respectively. Deferred advertising and other revenues consist of payments received in advance of our delivery of the related services and are recognized as income as the services are delivered.

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     Costs and Expenses

     Total Costs and Expenses. Table 3 below shows our total costs and expenses on a consolidated and segment basis for the three and nine months ended September 30, 2004 and 2003. Our total costs and expenses consist of cost of revenues, sales and marketing, and general and administrative expenses.

TABLE 3 — COSTS AND EXPENSES
(In thousands, except percentages)

     Cost of Revenues. Our cost of revenues includes:

	•		network-related costs consisting primarily of fees paid to third parties to carry our data over their telecommunications networks;
	•		personnel and related costs for customer support and in-house product and content development;
	•		fees we pay to America Online for use of their servers that run our interactive services (i.e., hosting services);
	•		fees we pay to America Online for technical support and current period product development and maintenance expense;
	•		amortization of capitalized product development costs;
	•		fees paid to third-party content providers; and
	•		collection costs and certain miscellaneous taxes.

     Certain payments received from providers of local network access, who have entered into agreements compensating us for routing our traffic on their networks, are treated as credits and reduce our cost of revenues.

     For the quarter ended September 30, 2004, our cost of revenues was $8.1 million and comprised 29.2% of our total costs and expenses. Compared to the prior-year quarter ended September 30, 2003, cost of revenues decreased by $4.8 million, or 37.0%, from $12.9 million and 36.2% of total costs and expenses. During the quarter ended September 30, 2004, the decrease in cost of revenues was driven primarily by reductions in network and hosting expense ($3.0 million), member services ($1.1 million) and content ($0.7 million). The improvements in network costs reflect the significant reduction in the number of modems that was undertaken to size our network to reduced membership levels and other cost reductions negotiated with local telecommunications providers in 2003. The reduction in hosting expense

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was driven by a lower cost per hour charged by America Online, as well as reduced aggregate hourly usage by our members. America Online agreed to reduce the hosting fees charged to us in August 2004, with retroactive effect to the beginning of 2004. The resulting credits from prior quarters, of approximately $0.7 million, were netted against our hosting expenses for the third quarter. We expect hosting expense over the next two quarters to decrease versus prior year periods but to increase versus the third quarter of 2004. The reduction in member services expense is a result of lower membership levels and actions taken to reduce costs such as outsourcing of call center employees in Brazil and the consolidation of Spanish–language call service centers in Argentina. Exchange rate fluctuations increased reported cost of revenues by approximately 6.3%, or by $0.8 million, for the quarter ended September 30, 2004, as compared with the third quarter of 2003. In constant currency terms, cost of revenues decreased by 43.3%, an amount greater than the reported decrease of 37.0% during the three months ended September 30, 2004.

     Sequentially, costs of revenues declined by $0.6 million, or by 6.4%, from $8.7 million in the quarter ended June 30, 2004, primarily as a result of lower hosting expenses as explained above.

     For the nine months ended September 30, 2004, our cost of revenues was $26.1 million and comprised 30.2% of our total costs and expenses. Compared to the nine-month period ended September 30, 2003, cost of revenues decreased by approximately $18.3 million, or 41.2%, from $44.4 million and 38.6% of total costs and expenses. During the first nine months of 2004, the decrease in cost of revenues reflected the underlying trends affecting the quarter ended September 30, 2004, namely reductions in network and telecommunications expense, hosting and member services expenses. Exchange rate fluctuations increased reported cost of revenues by approximately 13.1%, or by $3.4 million, for the nine month period ended September 30, 2004, as compared with the same period of 2003. In constant currency terms, cost of revenues decreased by 49.1%, an amount less than the reported decrease of 41.4% during the nine month period ended September 30, 2004.

     Management believes that the cost savings from negotiated reductions in network costs, lower hosting expenses charged by America Online, consolidation of Spanish-language member services in Argentina and outsourcing of call center operations in Brazil, have contributed to reduced costs of revenue during the first three quarters of 2004. We believe that cost of revenues will remain stable at current levels through the end of 2004 and into 2005. Management does not expect further opportunities to reduce cost of revenues in the near future. As of September 30, 2004, our network provided coverage to 549 cities in Brazil and Mexico. Service in Puerto Rico is available island-wide. In the near term, we expect to maintain the number of cities in our network at or near current levels.

     Cost of revenues paid to related parties primarily consists of payments made or due to America Online and its affiliates for the costs of hosting, maintenance, product development and other technical support services for our country operations pursuant to our online services agreement with America Online. For the three and nine months ended September 30, 2004, cost of revenues incurred with related parties amounted to $1.3 million and $5.7 million, respectively. For the three and nine months ended September 30, 2003, cost of revenues incurred with related parties amounted to $2.5 million and $8.9 million, respectively.

     Sales and Marketing. Sales and marketing expenses consist of costs to acquire and retain our members, operating expenses for our sales and marketing efforts and other general marketing costs. The costs to acquire and retain our members include direct marketing costs such as the costs to staff and operate kiosks established at retail locations, the payment of bounties to partners who bring qualified registrations to our AOLA country services and our web-based services through their distribution channels and the distribution of our software on CDs to potential customers as well as the costs of brand advertising on television and in newspapers, magazines and other media. Also included in sales and marketing expense is amortization of the value of the shares of our class A common stock issued to Banco Itaú in consideration for its entering into the strategic marketing agreement with us (see “Item 1 – Business — Strategic Alliance with Banco Itaú” in our Annual Report on Form 10-K for the period ended December 31, 2003, as well as Note 5 to our unaudited consolidated financial statements included herein). Through July 2005, we expect to incur approximately $9.3 million of expense each quarter related to the value of shares received by Banco Itaú under our strategic marketing agreement. For the five years following July 2005, we expect to incur approximately $2.2 million of quarterly expense related to this marketing agreement.

     For the quarter ended September 30, 2004, sales and marketing expenses were $13.4 million, a decrease of $3.0 million, or 18.4%, from $16.5 million in the third quarter of 2003. Sales and marketing expenses in the third quarter of 2004 accounted for 48.3% of total costs and expenses, compared with 46.2% in the prior year period. The decrease in sales and marketing expenses in the third quarter of 2004, as compared with the third quarter of 2003, was driven primarily by lower spending in both direct acquisition marketing ($0.8 million) and brand marketing ($1.0 million), as well as reduced amortization of the strategic marketing agreement with Banco Itaú ($1.2 million) as a result of the payments received in lieu of marketing activities they were obligated to undertake. The decrease in direct acquisition marketing costs was due mainly to efforts to reduce unproductive marketing activities which resulted in a reduction in the number

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of kiosks promoting our interactive services. We expect our sales and marketing expenses to decrease modestly during the remainder of 2004 and early 2005 as compared with 2003. Exchange rate fluctuations increased reported sales and marketing expenses by approximately 2.6%, or by $0.4 million, for the quarter ended September 30, 2004, as compared with the third quarter of 2003. In constant currency terms, sales and marketing expenses decreased by 21.0%, an amount greater than the reported decrease of 18.4% during the three months ended September 30, 2004.

     We monitor the productivity of our kiosks located at Banco Itaú branches and have elected not to operate those with expected levels of registrations which are not economically beneficial. This has resulted in the closure of a substantial majority of the kiosks which Banco Itaú is obligated to operate under the revised strategic marketing agreement. In addition, we have also cancelled certain CD distributions Banco Itaú is obligated to make. As per the terms of the revised marketing agreement, we received from Banco Itaú a payment of approximately $1.1 million during the third quarter of 2004 in exchange for advertising on our service and in lieu of these marketing activities they were obligated to undertake. This payment represented the current quarter’s payment and a partial prepayment for the fourth quarter. We expect these payments to continue in the future but the amounts to gradually decrease over time as per the terms of the revised marketing agreement. We expect to receive such a payment in the amount of approximately $0.5 million in the fourth quarter of 2004. Such payments from Banco Itaú are reflected as funds received from financing activities in our statement of cash flows and reduce future marketing expense associated with the amortization of shares given to Banco Itaú under our strategic marketing agreement. We have the right to choose to redeploy or reinstate some of the branches in the future, in which case we would forego such payments from Banco Itaú.

     Sequentially, sales and marketing expenses increased by approximately $1.0 million (8.3%) from $12.4 million in the quarter ended June 30, 2004. This increase was primarily due to an increase in brand marketing related to the launch of version 9.0 of our AOLA country service software in Mexico, as well an increase in the number of points of sale.

     For the nine months ended September 30, 2004, sales and marketing expenses were $37.9 million, a decrease of $12.5 million, or 24.7%, from $50.4 million for the nine months ended September 30, 2003. The decrease in sales and marketing expenses in the first nine months of 2004 was driven primarily by lower spending in both direct acquisition marketing ($6.5 million) and brand marketing ($3.0 million), as well as reduced amortization of the strategic marketing agreement with Banco Itaú ($3.0 million) as a result of the payments received in lieu of marketing activities they were obligated to undertake. As discussed above, the decrease in direct acquisition marketing costs was due mainly to efforts to reduce unproductive marketing activities which resulted in a reduction in the number of kiosks promoting our interactive services. Brand marketing expense reduction during the first three quarters of 2004 was driven primarily by lower media investment. Exchange rate fluctuations increased reported sales and marketing expenses by approximately 2.3%, or by $0.9 million, for the nine month period ended September 30, 2004, as compared with same period of 2003. In constant currency terms, sales and marketing expenses decreased by 26.4%, an amount greater than the reported decrease of 24.7% during the nine month period ended September 30, 2004.

     For the three and nine month periods ended September 30, 2004 and 2003, sales and marketing expenses paid to related parties were not material. For nine months ended September 30, 2004, amounts received from Banco Itaú for subsidies it pays on behalf of its members were approximately $5,000 compared to $0.9 million for the nine months ended September 30, 2003. Subsidies paid by Banco Itaú on behalf of its members largely ceased during the third quarter of 2003 as a result of the revised marketing agreement with Banco Itaú. Amortization expense related to the Banco Itaú marketing agreement was approximately $9.3 million and $10.5 million during the quarters ended September 30, 2004 and 2003, respectively. Amortization expense related to the Banco Itaú marketing agreement for the nine-month periods ended September 30, 2004 and 2003 was approximately $28.2 million and $31.2 million, respectively.

     We expect to continue to focus our member acquisition efforts on existing marketing arrangements with third parties, emphasizing kiosks located in high traffic areas, including bank branches and retail outlets. However, reliance on third-party arrangements has also increased the potential for unforeseen events and delays over which we have limited control, as has been the case with McDonald’s in Brazil and the banking system strike in Brazil.

     General and Administrative. General and administrative expenses consist primarily of personnel-related expenses, office lease payments, legal, tax and travel-related expenses, among others.

     For the three months ended September 30, 2004, our general and administrative costs remained flat at $6.3 million as compared to the third quarter of 2003. Higher legal fees and expenses of financial advisors participating in the process of exploring potential strategic alternatives were offset by reductions due to decreases in staffing levels. Exchange rate fluctuations decreased reported general and administrative expenses by approximately 1.9%, or by $0.1 million, for the quarter ended September 30, 2004, as compared with the third quarter of 2003. In constant currency

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terms, general and administrative expenses remained flat when compared to the same quarter of 2003. On a sequential basis, our general and administrative costs were essentially flat as compared with the second quarter of 2004.

     For the nine months ended September 30, 2004, general and administrative expenses were $18.3 million, a decrease of $1.8 million, or 8.9%, from $20.1 million for the nine months ended September 30, 2003. The decrease in general and administrative expenses in the first nine months of 2004 was primarily driven by lower staffing levels. Exchange rate fluctuations increased reported general and administrative expenses by approximately 0.9%, or by $0.2 million, for the nine months ended September 30, 2004, as compared with the same period of 2003. In constant currency terms, general and administrative expenses increased by 7.39%, an amount less than the reported decrease of 8.9% during the nine months ended September 30, 2004.

     We expect our general and administrative expenses to continue at or near current levels during the balance of 2004 and early 2005. For the quarter and nine months ended September 30, 2004, expenses incurred in general and administrative support services provided by America Online and other related parties were not material. For the quarter and nine months ended September 30, 2004, we incurred fees of approximately $0.1 million and $0.2 million, respectively, for support services provided by America Online.

     Argentina Value-Added Tax Allowance. We no longer promote our interactive services in Argentina and do not expect future growth for this business. During the second quarter of 2004, based on projections of our taxable revenue in Argentina, we determined that it was not likely that we would be able to recover our value-added tax (“VAT”) receivable from the Argentine government with a value of approximately $4.0 million at June 30, 2004. This receivable, which arose in the normal conduct of our business, can only be recovered as we make sales in Argentina and make collections from these sales. As a result, in the quarter ended June 30, 2004, we recorded a non-cash charge to establish a full valuation allowance for this asset.

     Interest Expense. Interest expense consists almost entirely of interest on our senior convertible notes outstanding. During the quarter ended September 30, 2004, interest expense was $4.4 million, down $0.1 million as compared with $4.5 million in the prior-year third quarter. We expect quarterly interest expense to remain at current levels since our average balance of senior convertible notes outstanding is expected to remain constant. For the nine months ended September 30, 2004, interest expense was $12.9 million, compared with $13.3 million in 2003. Interest expense in the first quarter of 2004 benefited from a one time correction of historical interest paid.

     Interest on our senior convertible notes for the third quarter of 2004 was paid through the issuance of 10,304,678 shares of our series B preferred stock to Time Warner. Under the terms of the senior convertible notes, we may choose to make payment of interest through the issuance of shares of our series B preferred stock, with the exception of the last payment, which must be paid in cash (approximately $3.2 million). To the extent we make payment through the issuance of shares, interest expense does not represent a cash outlay. Given our focus on cash preservation, we expect future payments of interest to be undertaken through the issuance of additional shares, except as noted. Consequently, interest expense should not have a cash impact on our financial condition, except for the final interest payment which must be paid in cash. However, depending on market conditions at the time, a decision by us to pay the interest on the senior convertible notes through the issuance of additional shares of stock could result in significant additional dilution to our existing shareholders.

     Other Income (Expense), net. Other income (expense), net consists primarily of foreign currency gains and losses and realized gains and losses on investments. For the quarter ended September 30 2004, other income, net was approximately $0.1 million, as compared with other expenses, net of $0.3 in the quarter ended September 30, 2003. For the nine-month periods ended September 30, 2004 and 2003, other income (expense), net was approximately $0.3 million and $(0.4), respectively.

     Income Taxes. For the three months ended September 30, 2004 and 2003, we had, respectively, an income tax expense of $29,000 and a benefit of $3,000. For the nine months ended September 30, 2004, we had income tax expense of $88,000, as compared with income tax benefit of $1,000 in the comparable prior-year period. We expect similar levels of income tax expense in the future.

     Loss from Operations. For the quarter ended September 30, 2004, our loss from operations was approximately $15.0 million, an improvement of $4.3 million, or 22.4%, from a loss of $19.3 million recorded in the third quarter of 2003. The improvement was driven primarily by reductions in costs and expenses. On a sequential quarter basis, our loss from operations decreased by $3.6 million, down 19.6% from $18.7 million in the second quarter of 2004. The improvement is primarily due to the establishment of the $4.0 million valuation allowance against our Argentina VAT receivable in the second quarter of 2004.

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     For the nine months ended September 30, 2004, our loss from operations was $46.9 million, an improvement of $17.8 million, or 27.5%, from $64.6 million in the comparable prior-year period. The improvement was driven by decreases in our costs and expenses of $32.5 million, partially offset by the reduction in revenues of $10.7 million and the establishment of the $4.0 million valuation allowance against our Argentina VAT receivable.

     Net loss applicable to common stockholders and loss per common share. Our net loss applicable to common stockholders, after interest expense, other expenses and dividends to preferred stockholders, was $23.6 million in the third quarter of 2004, an improvement of approximately $5.0 million, or 17.4%, as compared with a loss of $28.6 million recorded in the third quarter of 2003. Our loss per share, both basic and diluted, was $0.17 per share for the quarter ended September 30, 2004, and compared with losses per share, basic and diluted, of $0.21 in the prior-year quarter. The improvement was driven primarily by reductions in costs and expenses, which more than offset the impact of lower revenues as compared with the prior-year period.

     Net loss applicable to common stockholders includes interest expense and dividends on our preferred shares outstanding. For the quarter ended September 30, 2004, interest expense was approximately $4.4 million, as compared to $4.5 million in the prior-year quarter ended September 30, 2003. We expect interest expense to remain at the rate of $17.6 million per year at least through March 2007, when our senior convertible notes mature. Dividends on preferred stock were approximately $4.3 million, as compared to $4.4 million for the same quarter of the previous year.

     On a sequential quarter basis, our net loss applicable to common stockholders decreased by $3.3 million, or 12.2%, from $26.9 million in the second quarter of 2004. Our loss per share of $0.17 per share in the quarter ended September 30, 2004, both basic and diluted, decreased from $0.20 per share, basic and diluted, as a result of the factors discussed above.

     For the nine months ended September 2004, our net loss applicable to common stockholders was $71.5 million, an improvement of $18.2 million, or 20.2%, as compared with a loss of $89.7 million in the first nine months of 2003. Our loss per share, during the first nine months of 2004, both basic and diluted, was $0.53 per share, as compared with a loss per share, both basic and diluted, of $0.68 for the prior-year period.

     Financial Condition and Liquidity

     Current Financial Condition. Table 4 below highlights our consolidated financial condition at September 30, 2004 and at December 31, 2003.

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TABLE 4 — FINANCIAL CONDITION (As of Balances)
(In thousands, except percentages)

     At September 30, 2004, we had $25.2 million of cash and cash equivalents, long-term debt of $160.0 million and a capital deficiency of $147.5 million. This represented a reduction in our cash and cash equivalents position of $7.7 million as compared to December 31, 2003, and a reduction of $2.6 million as compared with our cash balance on June 30, 2004. For the nine-month period ended September 30, 2004, the decline in our cash and cash equivalents position resulted primarily from the financing of our loss from operations. Our cash position benefited from one-time items, such as partial pre-payment by Banco Itaú in lieu of marketing activities, the collection of old accounts receivable, and an increase in our payables to affiliates. In addition, our cash position also benefited from our receipt of a penalty from McDonald’s for their failure to meet August 2004 targets under our modified marketing agreement. Additionally, as of September 30, 2004, approximately $1.1 million of our cash on hand served to partially collateralize our obligations under executive retention agreements and is not, and will not be available for general corporate use. In total, we may be obligated to make payments amounting up to $1.6 million under these obligations.

     We expect our rate of cash utilization to increase in the fourth quarter of 2004, driven by a modest increase in our losses and a reversal of certain working capital items. Our long-term debt position did not change, and is comprised entirely of our senior convertible notes.

     Our capital deficiency increased by $14.5 million as compared with our position at December 31, 2003. The increase in our capital deficiency reflects our consolidated loss for the nine months ended September 30, 2004 of $59.5 million and the impact on the foreign currency translation adjustment from the appreciation of local currencies since December 31, 2003. These impacts were partially offset by the continued amortization of the Banco Itaú unearned services account during the first nine months of 2004, payments received from Banco Itaú in lieu of marketing activities it was obligated to undertake amounting to $3.5 million and the payment of interest on our senior convertible notes through the issuance of additional stock.

     Our current assets at September 30, 2004 amounted to $35.3 million, a decrease of $8.9 million, or 20.1%, as compared to $44.2 million at December 31, 2003. The decrease in current assets was driven primarily by the decrease in cash and cash equivalents, and by the establishment of the valuation allowance against our Argentine VAT receivable asset during the second quarter of 2004. Current liabilities decreased $1.0 million, or 3.5%, to $26.2 million at September 30, 2004, from $27.2 million at December 31, 2003 driven by reductions in other accrued expenses and liabilities, and trade accounts payable. The reduction in other accrued expenses and liabilities resulted mainly from our reduced spending on marketing activities and operating costs, and the payment of certain historical penalties related to the downsizing of our network.

     Based on our current operating budget, we now expect that available cash on hand will be sufficient to fund operations into the third quarter of 2005. Our expectations underlying our current operating budget and the duration of funding sufficiency are based upon certain estimates that we believe are commercially reasonable in relation to our historical experience. These estimates include paying membership levels and turnover, pricing of our services and ability to maintain costs at expected levels. These

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estimates are subject to a number of risks and uncertainties more particularly described in “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2003, and there can be no assurance that they will turn out to be accurate. We do not expect to reach cash flow breakeven with available cash on hand.

     As of September 30, 2004, approximately $1.1 million of our cash on hand served to partially collateralize our obligations under executive-retention agreements and is not, and will not be, available for general corporate use. In total, the Company may be obligated to make payments amounting up to $1.6 million under these obligations.

     We continue to explore various opportunities that could provide us with additional cash resources in the future to operate our business. During the second quarter of 2004, we hired an investment banking firm to help us explore potential strategic alternatives.

     In addition, we have not identified additional sources of financing necessary to repay the $160.0 million senior convertible notes that will be due in March 2007. There can be no assurance that we will be able to identify additional sources of capital to repay our debt obligations or operate our business. An additional restriction on our ability to obtain additional funding is that the holders of our senior convertible notes can require that the proceeds of any such financing or the sale of assets be used to repay the senior convertible notes. Additionally, there is no commitment or obligation from America Online, the Cisneros Group or Banco Itaú to fund any of our future requirements. Furthermore, Time Warner has stated that it does not intend to provide us with additional funding.

     Cash Flows and Liquidity. Table 5 illustrates our consolidated cash flows and capital spending by segment for the three and nine month periods ended September 30, 2004 and 2003:

TABLE 5 — CASH FLOWS & CAPITAL SPENDING
(Dollars in thousands, except percentages)