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SECURITIES AND EXCHANGE COMMISSION

Washington, D. C. 20549

FORM 10-Q

OR

1-15062
Commission file number

AOL TIME WARNER INC.

(Exact name of registrant as specified in its charter)

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 [ ]

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

AOL TIME WARNER INC. AND
TIME WARNER ENTERTAINMENT COMPANY, L.P.

INDEX TO FORM 10-Q

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

INTRODUCTION

            Management’s discussion and analysis of results of operations and financial condition (“MD&A”) is provided as a supplement to the accompanying consolidated financial statements and footnotes to help provide an understanding of 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 and six months ended June 30, 2002 relative to the comparable periods in 2001. This analysis is presented on both a consolidated and segment basis. In addition, a brief description is provided of 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 as of June 30, 2002 and cash flows for the six months ended June 30, 2002.

• Caution concerning forward-looking statements and risk factors. This section discusses how certain forward-looking statements made by the Company 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 is the world’s leading media and entertainment company. The Company was formed in connection with the merger of America Online, Inc. (“America Online”) and Time Warner Inc. (“Time Warner”), which was consummated on January 11, 2001 (the “Merger”). As a result of the Merger, America Online and Time Warner each became a wholly owned subsidiary of AOL Time Warner.

            AOL Time Warner classifies its business interests into six fundamental areas: AOL, consisting principally of interactive services, Web properties, Internet technologies and electronic commerce 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 and music publishing; and Publishing, consisting principally of interests in magazine publishing, book publishing and direct marketing.

            The Company has undertaken a number of business initiatives to advance cross-divisional activities, including shared infrastructures and cross-promotions of the Company’s various products and services, as well as cross-divisional and cross-platform advertising and marketing opportunities for significant advertisers. The Company’s integrated Global Marketing Solutions Group develops individualized advertising programs through which major brands can reach customers over a combination of the Company’s print, television and Internet media.

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

Use of EBITDA

            AOL Time Warner evaluates operating performance based on several factors, including its primary financial measure of operating income (loss) before noncash depreciation of tangible assets and amortization of intangible assets (“EBITDA”). AOL Time Warner considers EBITDA an important indicator of the operational strength and performance of its businesses, including the ability to provide cash flows to service debt and fund capital expenditures. In addition, EBITDA eliminates the uneven effect across all business segments of considerable amounts of noncash depreciation of tangible assets and amortization of certain intangible assets deemed to have finite useful lives that were recognized in business combinations accounted for by the purchase method. As such, the following comparative discussion of the results of operations of AOL Time Warner includes, among other measures, an analysis of changes in EBITDA. However, EBITDA should be considered in addition to, not as a substitute for, operating income (loss), net income (loss) and other measures of financial performance reported in accordance with generally accepted accounting principles.

Recent Developments

Securities Matters

            Recently, the Securities and Exchange Commission and the Department of Justice began investigating the financial reporting and disclosure practices of the Company. The Company is cooperating in the investigations. Refer to Note 12 and Part II, Item 1 for additional information.

Investment in Time Warner Entertainment Company, L.P.

            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, are held through Time Warner Entertainment Company, LP (“TWE”). As of March 31, 2002, AOL Time Warner owned general and limited partnership interests in TWE consisting of 74.49% of the pro rata priority capital (“Series A Capital”) and residual equity capital (“Residual Capital”), and 100% of the junior priority capital (“Series B Capital”). The remaining 25.51% limited partnership interests in the Series A Capital and Residual Capital of TWE were held by MediaOne TWE Holdings, Inc., a subsidiary of AT&T Corp. (“AT&T”).

            During the second quarter of 2002, AT&T exercised a one-time option to increase its ownership in the Series A Capital and Residual Capital of TWE. As a result, on May 31, 2002, AT&T’s interest in the Series A Capital and Residual Capital of TWE increased by approximately 2.13% to approximately 27.64% and AOL Time Warner’s corresponding interest in the Series A Capital and Residual Capital of TWE decreased by approximately 2.13% to approximately 72.36%. In accordance with Staff Accounting Bulletin No. 51, “Accounting for Sales of Stock of a Subsidiary”, AOL Time Warner has reflected the pretax impact of the dilution of its interest in TWE of approximately $690 million as an adjustment to paid-in capital (Note 6).

            AT&T has the right, during 60-day exercise periods occurring once every 18 months, to request that TWE incorporate and register its stock in an initial public offering. If AT&T exercises such right, TWE can decline to incorporate and register its stock, in which case AT&T may cause TWE to purchase AT&T ’s interest at the price at which an appraiser believes such stock could be sold in an initial public offering, subject to certain adjustments. In February 2001, AT&T delivered to TWE a notice requesting that TWE reconstitute itself as a corporation and register AT&T’s partnership interests for public sale. In June 2002, AT&T and TWE engaged Banc of America Securities LLC (“Banc of America”) to perform appraisals and make other determinations under the TWE Partnership Agreement. In July 2002, AOL Time Warner and AT&T agreed to temporarily suspend the registration rights process so that they can pursue discussion of an alternative transaction. For the time being, AOL Time Warner and AT&T have asked Banc of America not to deliver the determinations. The Company cannot at this time predict the outcome or effect, if any, of these discussions or the registration rights process, if resumed.

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

Restructuring of TWE-Advance/Newhouse Partnership and Road Runner

            As of June 30, 2002, the TWE-Advance/Newhouse Partnership (“TWE-A/N”) was owned approximately 64.8% by TWE, the managing partner, 33.3% by the Advance/Newhouse Partnership (“Advance/Newhouse”) and 1.9% indirectly by AOL Time Warner. As of June 30, 2002, TWE-A/N owned cable television systems (or interests therein) serving approximately 7.0 million subscribers, of which 5.9 million subscribers were served by consolidated, wholly owned cable television systems and 1.1 million subscribers were served by unconsolidated, partially owned cable television systems. The financial position and operating results of TWE-A/N are currently consolidated by AOL Time Warner and TWE, and the partnership interest owned by Advance/Newhouse is reflected in the consolidated financial statements of AOL Time Warner and TWE as minority interest.

            As of June 30, 2002, Road Runner, a high-speed cable modem Internet service provider, was owned by TWI Cable Inc. (a wholly owned subsidiary of AOL Time Warner), TWE and TWE-A/N, with AOL Time Warner owning approximately 65% on a fully attributed basis (i.e., after considering the portion attributable to the minority partners of TWE and TWE-A/N). AOL Time Warner’s interest in Road Runner is accounted for using the equity method of accounting because of certain approval rights currently held by Advance/Newhouse, a partner in TWE-A/N.

            On June 24, 2002, TWE and Advance/Newhouse agreed to restructure TWE-A/N, which will result in Advance/Newhouse taking a more active role in the day-to-day operations of certain TWE-A/N cable systems serving approximately 2.1 million subscribers located primarily in Florida (the “Advance/Newhouse Systems”). The restructuring is anticipated to be completed by the end of 2002, upon the receipt of certain regulatory approvals. On August 1, 2002 (the “Debt Closing Date”), Advance/Newhouse and its affiliates arranged for a new credit facility to support the Advance/Newhouse Systems and repaid approximately $780 million of TWE-A/N’s senior indebtedness. As of the Debt Closing Date, Advance/Newhouse assumed management responsibilities for the Advance/Newhouse Systems, to the extent permitted under applicable government regulations, and, accordingly, AOL Time Warner and TWE will deconsolidate the financial position and operating results of these systems effective in the third quarter of 2002. Additionally, all prior period results associated with the Advance/Newhouse Systems will be reflected as a discontinued operation beginning in the third quarter of 2002. Under the new TWE-A/N Partnership Agreement, effective as of the Debt Closing Date, Advance/Newhouse’s partnership interest tracks only the performance of the Advance/Newhouse Systems, including associated liabilities, while AOL Time Warner retains all of the interests in the other TWE-A/N assets and liabilities. As part of the restructuring of TWE-A/N, on the Debt Closing Date, AOL Time Warner acquired Advance/Newhouse’s interest in Road Runner, thereby increasing its ownership to approximately 82% on a fully attributed basis. As a result, beginning in the third quarter of 2002, AOL Time Warner will consolidate the financial position and results of operations of Road Runner with the financial position and results of operations of AOL Time Warner’s Cable segment, retroactive to the beginning of the year. See Footnote 7 to the accompanying consolidated financial statements for more information regarding the impact of the deconsolidation of the Advance/Newhouse Systems and the consolidation of Road Runner on the revenues, EBITDA and operating income of the Cable segment and consolidated AOL Time Warner.

            Exclusive of any gain or loss associated with these transactions, the impact of the TWE-A/N restructuring on AOL Time Warner’s consolidated net income will be substantially mitigated because the earnings of TWE-A/N attributable to Advance/Newhouse’s current one-third interest are reflected as minority interest expense in the accompanying consolidated statement of operations. Additionally, because AOL Time Warner had previously accounted for its investment in Road Runner using the equity method of accounting, the impact on AOL Time

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

Warner’s consolidated net income of consolidating Road Runner will be equal to the portion of Road Runner’s losses previously attributable to Advance/Newhouse. This impact is not expected to be material to AOL Time Warner’s net income.

            As of June 30, 2002, the Advance/Newhouse Systems had total assets of approximately $2.7 billion and had been allocated approximately $780 million of debt, which, upon the deconsolidation of the Advance/Newhouse Systems, will no longer be included in the consolidated assets and liabilities of AOL Time Warner. Additionally, as of June 30, 2002, Road Runner had total assets of approximately $180 million and no debt, which, upon the consolidation of Road Runner, will be included in the consolidated assets of AOL Time Warner.

Sale of Columbia House

            In June 2002, AOL Time Warner and Sony Corporation of America reached a definitive agreement to each sell 85% of its 50% interest in the Columbia House Company Partnerships (“Columbia House”) to Blackstone Capital Partners III LP (“Blackstone”), an affiliate of The Blackstone Group, a private investment bank. The sale has resulted in the Company recognizing a pretax gain of approximately $59 million, which is included in other expense, net, in the accompanying consolidated statement of operations. In addition, the Company has deferred an approximate $28 million gain on the sale. As a result of the sale, the Company’s interest in Columbia House has been reduced to 7.5%. As part of the transaction, AOL Time Warner will continue to license music and video product to Columbia House for a five-year period (Note 4).

$10 Billion Revolving Credit Facilities

            In July 2002, AOL Time Warner, together with certain of its consolidated subsidiaries, entered into two new, senior unsecured long-term revolving bank credit agreements with an aggregate borrowing capacity of $10 billion (the “2002 Credit Agreements”) and terminated three financing arrangements under certain previously existing bank credit facilities with an aggregate borrowing capacity of $12.6 billion (the “Old Credit Agreements”) which were to expire during 2002. The 2002 Credit Agreements are comprised of a $6 billion five–year revolving credit facility and a $4 billion 364–day revolving credit facility, borrowings under which may be extended for a period up to two years following the initial term. The borrowers under the 2002 Credit Agreements include AOL Time Warner, TWE, TWE–A/N and AOL Time Warner Finance Ireland. Borrowings will bear interest at specific rates, generally based on the credit rating for each of the borrowers, which is currently equal to LIBOR plus .625%, including facility fees of .10% and .125% on the total commitments of the 364-day and five-year facilities, respectively. The 2002 Credit Agreements provide for same-day funding, multi-currency capability and letter of credit availability. They contain maximum leverage and minimum GAAP net worth covenants of 4.5 times and $50 billion, respectively, for AOL Time Warner and maximum leverage covenant of 5.0 times for TWE and TWE-A/N, but do not contain any ratings-based defaults or covenants, nor an ongoing covenant or representation specifically relating to a material adverse change in the Company’s financial condition or results of operations. Borrowings may be used for general business purposes and unused credit will be available to support commercial paper borrowings (Note 9).

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

RESULTS OF OPERATIONS

Transactions Affecting Comparability of Results of Operations

Pro Forma Items

            AOL Time Warner’s results for 2002 have been impacted by certain transactions and events that cause them not to be comparable to the results reported in 2001. In order to make the 2001 operating results more comparable to the 2002 presentation and make an analysis of 2002 and 2001 more meaningful, the following discussion of results of operations and changes in financial condition and liquidity is based on pro forma financial information for 2001 that has been adjusted for the items discussed in the following paragraphs.

• New Accounting Standard for Goodwill and Other Intangible Assets . During 2001, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 142 “Goodwill and Other Intangible Assets” (“FAS 142”), which requires that, effective January 1, 2002, goodwill, including the goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have an indefinite useful life, cease amortizing (Note 3). FAS 142 does not require retroactive restatement for all periods presented, however, the accompanying pro forma information for 2001 assumes that FAS 142 was in effect beginning January 1, 2001.

• Consolidation of AOL Europe, S.A. (“AOL Europe”) . On January 31, 2002, AOL Time Warner acquired 80% of Bertelsmann AG’s (“Bertelsmann”) 49.5% interest in AOL Europe for $5.3 billion in cash and on July 1, 2002 acquired the remaining 20% of Bertelsmann’s interest for $1.45 billion in cash (Note 5). As a result of the purchase of Bertelsmann’s interest in AOL Europe, AOL Time Warner has a majority interest in and began consolidating AOL Europe, retroactive to the beginning of 2002. The pro forma information for 2001 assumes the interests in AOL Europe were acquired on January 1, 2001.

• Consolidation of IPC Group Limited (“IPC”) . In October 2001, AOL Time Warner’s Publishing segment acquired IPC, the parent company of IPC Media, from Cinven, one of Europe’s leading private equity firms, for approximately $1.6 billion. The pro forma information for 2001 assumes that IPC was acquired on January 1, 2001.

New Accounting Standards

            In addition to the pro forma adjustments previously discussed, in the first quarter of 2002, the Company adopted new accounting guidance in several areas that require retroactive restatement of all periods presented to reflect the new accounting provisions; therefore, these adjustments impact both pro forma and historical results. These adjustments are discussed below.

“Out-of-Pocket” Expenses

            In November 2001, the FASB Staff issued as interpretive guidance Emerging Issues Task Force (“EITF”) Topic No. D-103, “Income Statement Characterization of Reimbursements Received for ‘Out-of-pocket’ Expenses Incurred” (“Topic D-103”). Topic D-103 requires that reimbursements received for out-of-pocket expenses be classified as revenue on the income statement and was effective for AOL Time Warner in the first quarter of 2002. The new guidance requires retroactive restatement of all periods presented to reflect the new accounting provisions. This change in revenue classification impacts AOL Time Warner’s Cable and Music segments, resulting in an

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

increase in both revenues and costs of approximately $122 million on both a pro forma and historical basis for the second quarter of 2001 and $221 million on both a pro forma and historical basis for the first six months of 2001.

Emerging Issues Task Force Issue No. 01-09

            In April 2001, the FASB’s EITF reached a final consensus on EITF Issue No. 00-25, “Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendor’s Products,” which was later codified along with other similar issues, into EITF 01-09, “Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendor’s Products” (“EITF 01-09”). EITF 01-09 was effective for AOL Time Warner in the first quarter of 2002. EITF 01-09 clarifies the income statement classification of costs incurred by a vendor in connection with the reseller’s purchase or promotion of the vendor’s products, resulting in certain cooperative advertising and product placement costs previously classified as selling expenses to be reflected as a reduction of revenues earned from that activity. The new guidance impacts AOL Time Warner’s AOL, Music and Publishing segments. As a result of applying the provisions of EITF 01-09, the Company’s revenues and costs each were reduced by an equal amount of approximately $48 million on both a pro forma and historical basis in the second quarter of 2001 and $110 million on both a pro forma and historical basis for the first six months of 2001.

Other Significant Transactions and Nonrecurring Items

            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 nonrecurring items in each period.

            AOL Time Warner’s operating results for the six months ended June 30, 2002 included (i) merger and restructuring costs of $107 million in the first quarter (Note 2), (ii) a noncash pretax charge of $945 million ($364 million in the second quarter) to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value (Note 4), (iii) an approximate $59 million gain in the second quarter on the sale of a portion of the Company’s interest in Columbia House (Note 4) and (iv) an approximate $31 million gain in the second quarter on the redemption of a portion of the Company’s interest in TiVo Inc. (“TiVo”) (Note 4 ).

            For the six months ended June 30, 2001, AOL Time Warner’s operating results included (i) merger-related costs of approximately $71 million in the first quarter (Note 2) and (ii) a noncash pretax charge of approximately $620 million in the first quarter to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value (Note 4).

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

            The impact of the significant transactions and nonrecurring items discussed above on the operating results for the three and six months ended June 30, 2002 and 2001 is as follows:

            In addition, the Company adopted, effective January 1, 2002, new accounting rules for goodwill and certain intangible assets. Among the requirements of the new rules is that goodwill and certain intangible assets be assessed for impairment using fair value measurement techniques. During the first quarter of 2002, the Company completed its impairment review and recorded a $54 billion noncash pretax charge for the impairment of goodwill, substantially all of which was generated in the Merger. The charge reflects overall market declines since the Merger was announced in January 2000, is non-operational in nature and is reflected as a cumulative effect of an accounting change in the accompanying consolidated financial statements (Note 3). In order to enhance comparability, the Company compares current year results to the prior year exclusive of this charge.

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

            Revenues and EBITDA by business segment are as follows (in millions):

______________

Three Months Ended June 30, 2002 Compared to Three Months Ended June 30, 2001

Consolidated Results

            AOL Time Warner had revenues of $10.575 billion and net income of $394 million in 2002, compared to revenues of $9.606 billion and net income of $592 million on a pro forma basis in 2001 (revenues of $9.276 billion and net loss of $734 million on a historical basis). AOL Time Warner had basic and diluted net income per common

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

share of $0.09 in 2002 compared to basic and diluted net income per common share of $0.13 on a pro forma basis in 2001 (basic and diluted net loss per common share of $0.17 on a historical basis).

            As previously described, the comparability of AOL Time Warner’s operating results for 2002 have been affected by the recognition of certain significant and nonrecurring items. These items totaled $274 million of pretax losses in 2002. If these items were excluded from earnings in 2002, the aggregate net effect would be to increase basic net income per common share by $0.04 to $0.13 and diluted net income per common share by $0.03 to $0.12.

             Revenues . AOL Time Warner’s revenues increased to $10.575 billion in 2002, compared to $9.606 billion on a pro forma basis in 2001 ($9.276 billion on a historical basis). This overall increase in revenues was driven by an increase in Subscription revenues of 15% to $5.028 billion and an increase in Content and Other revenues of 20% to $3.477 billion, offset in part by a decrease in Advertising and Commerce revenues of 11% to $2.070 billion.

            As discussed more fully below, the increase in Subscription revenues was principally due to increases in the number of subscribers and in subscription rates at the AOL, Cable and Networks segments. The increase in Content and Other revenues was principally due to increased revenue at the Filmed Entertainment segment related to improved international theatrical and worldwide home video results, offset in part by lower results at the AOL segment, primarily related to the termination of the iPlanet alliance with Sun Microsystems, Inc. (“Sun Microsystems”) in the third quarter of 2001. The decline in Advertising and Commerce revenues was due to lower advertising revenues principally related to the continued weakness in the online advertising market, which is expected to continue through at least the end of the year.

             Depreciation and Amortization . Depreciation and amortization increased to $801 million in 2002 from $657 million on a pro forma basis in 2001 ($2.261 billion on a historical basis). This increase was primarily due to an increase in depreciation, reflecting higher levels of capital spending at the Cable segment related to the roll-out of digital services over the past three years, as well as increased capital spending that varies based on the number of new subscribers, which is depreciated over a shorter useful life. In addition, depreciation at the AOL segment increased primarily due to an increase in network assets acquired.

             Interest Expense, Net . Interest expense, net, decreased to $444 million in 2002, from $469 million on a pro forma basis in 2001 ($352 million on a historical basis), due principally to lower market interest rates in 2002.

             Other Expense, Net . Other expense, net, increased to $376 million in 2002 from $121 million on a pro forma basis in 2001 ($233 million on a historical basis). Other expense, net, in each period included pretax noncash charges to reduce the carrying value of certain investments that experienced an other-than-temporary decline in value. In 2002, this charge was approximately $364 million, primarily related to AOL Time Warner’s investments in Time Warner Telecom and Gateway, Inc., which was offset in part by an approximate $59 million gain on the sale of a portion of the Company’s interest in Columbia House and an approximate $31 million gain on the redemption of a portion of the Company’s interest in TiVo. In 2001, on a pro forma and historical basis, AOL Time Warner recorded a charge of approximately $54 million, which was almost entirely offset by pretax gains related to equity derivative instruments and the sale of certain investments. Excluding these charges and the Columbia House and TiVo gains, other expense, net, decreased by $19 million in 2002 primarily due to lower losses on equity method investees, offset in part by the absence of prior year net pretax investment-related gains, including gains related to the exchange of various unconsolidated cable television systems at TWE (attributable to AT&T’s minority interest). Depending upon general market conditions and the performance of individual investments in the Company’s portfolio, the Company may be required in the future to record a noncash charge to reduce the carrying value of

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

individual investments to their fair value for other-than-temporary declines. Any such charge would be unrelated to the Company’s core operations and would be recorded in other expense, net (Note 4).

             Minority Interest Expense . Minority interest expense was $147 million in 2002, compared to $150 million on a pro forma basis in 2001 ($76 million on a historical basis). Minority interest expense decreased slightly as the allocation of higher income at TWE and TWE-A/N to their minority owners was more than offset by the absence of prior year pretax gains related to the exchange of various unconsolidated cable television systems that were attributable to AT&T’s minority interest in TWE.

             Income Tax Provision. The relationship between income before income taxes and income tax expense of AOL Time Warner is principally affected by certain financial statement expenses that are not deductible for income tax purposes, foreign income taxed at different rates and foreign losses with no U.S. tax benefit. AOL Time Warner had income tax expense of $301 million in 2002, compared to $424 million on a pro forma basis in 2001 ($349 million on a historical basis). While the effective tax rate in each period was comparable, slight differences are attributable to differing sources of foreign income taxed at different rates and foreign losses with no U.S. tax benefit in each period. As of June 30, 2002, the Company had net operating loss carryforwards of approximately $12.6 billion, primarily resulting from stock option exercises. These carryforwards are available to offset future US Federal taxable income and are, therefore, expected to reduce Federal taxes paid by the Company. If the net operating losses are not utilized, they expire in varying amounts, starting in 2010 through 2021.

             Net Income Applicable to Common Shares and Income Per Common Share. AOL Time Warner’s net income decreased by $198 million to $394 million in 2002, compared to $592 million on a pro forma basis in 2001 (net loss of $734 million on a historical basis). However, excluding the after-tax effect of the significant and nonrecurring items referred to earlier, normalized net income decreased by $34 million to $558 million in 2002 from $592 million on a pro forma basis in 2001. Similarly, excluding the effect of significant and nonrecurring items, normalized basic and diluted net income per common share was $0.13 and $0.12, respectively in 2002 compared to $0.13 in 2001. The decrease in earnings principally resulted from higher depreciation expense, offset in part by an overall increase in AOL Time Warner’s EBITDA and lower interest expense, net.

Business Segment Results

             AOL. Revenues decreased to $2.266 billion in 2002, compared to $2.327 billion on a pro forma basis in 2001 ($2.133 billion on a historical basis). EBITDA decreased 27% to $473 million in 2002, compared to $652 million on a pro forma basis in 2001 ($801 million on a historical basis).

            Although total revenues decreased slightly, the mix in revenues changed. Specifically, revenues benefited from a 20% increase in Subscription revenues (from $1.489 billion to $1.786 billion), which was more than offset by a 42% decrease in Advertising and Commerce revenues (from $715 million to $412 million) and a 45% decrease in Content and Other revenues (from $123 million to $68 million).

            During the quarter, Subscription revenues in the US and Europe increased by 18% and 34%, respectively. The growth in Subscription revenues was principally due to membership growth and price increases in both the US and Europe. The number of AOL brand subscribers in the US and Europe was 26.5 million and 6.0 million,

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

respectively, at June 30, 2002 compared to 23.4 million and 4.8 million, respectively, at June 30, 2001. The average monthly subscription revenue per domestic subscriber for the quarter increased 5% to $18.18 as compared to $17.26 in the prior year quarter. The domestic increase reflects price increases in the standard unlimited rate plan of $1.95 per month to $23.90 (effective beginning in July 2001) and the Bring Your Own Access (BYOA) plan of $5 to $14.95 (which began rolling out in October 2001). These domestic rate plan increases were offset in part by new member acquisition programs and member service and retention programs that offer incentives in the form of discounts and free months to AOL’s members. In addition, AOL has entered into certain bundling programs with computer manufacturers (OEM) 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 June 30, 2002, of the 26.5 million domestic AOL members, approximately 79% were on standard unlimited pricing plans (including 12% under various free trial, member service and retention programs), 16% were on lower priced plans, including BYOA, bulk employee programs with strategic partners, and limited usage plans (weighted average monthly rate of approximately $11.50), with the remaining 5% on OEM bundled plans. As a result of price increases in various European countries offering the AOL service, the average monthly subscription revenue per European subscriber for the quarter increased 10% to $14.07 as compared to $12.78 in the prior year quarter.

            The decline in Advertising and Commerce revenues resulted from a decline in advertising revenues (from $648 million to $342 million) as commerce revenues remained relatively flat. The decline in advertising revenues is principally due to continued weakness in the online advertising market, which is expected to continue at least through the end of this year. Also contributing to the decline in advertising revenues was a decline in revenues recognized from commitments received in prior periods. Domestic contractual commitments received in prior periods contributed advertising revenue of $220 million in the 2002 period as compared to $468 million in the comparable prior year period. This advertising revenue decline was in part mitigated by an increase in intercompany sales of advertising to other business segments of AOL Time Warner ($50 million in 2002 versus $29 million in 2001). During the quarter, advertising commitments declined to $860 million as of June 30, 2002 from $1.044 billion as of March 31, 2002. This compares to advertising commitments of $1.804 billion as of June 30, 2001 and $2.313 billion as of March 31, 2001. The Company expects to recognize a majority of the existing advertising commitments over the next four quarters.

            The decrease in Content and Other revenues is primarily due to the termination of AOL’s iPlanet alliance with Sun Microsystems in the third quarter of 2001, which contributed approximately $86 million of revenue and approximately $58 million of EBITDA during the second quarter of 2001. This was offset in part by $26 million of network revenues which are derived primarily through network services provided to Road Runner, which began in November 2001.

            The decline in EBITDA is primarily due to the advertising revenue shortfall, the absence of revenues from the iPlanet alliance and an increase in domestic marketing expenses, offset in part by a reduction in EBITDA losses at AOL Europe ($32 million in 2002 versus $149 million in 2001). The increase in advertising revenue generated from intercompany sales of advertising to other business segments of AOL Time Warner was more than offset by costs associated with increased intercompany advertising purchased by AOL on properties of other AOL Time Warner business segments ($73 million in 2002 versus $41 million in 2001).

             Cable . Revenues increased 18% to $2.103 billion in 2002, compared to $1.782 billion on both a pro forma and historical basis in 2001. EBITDA increased 12% to $872 million in 2002 from $777 million on both a pro forma and historical basis in 2001.

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            Revenues increased due to a 15% increase in Subscription revenues (from $1.640 billion to $1.894 billion) and a 47% increase in Advertising and Commerce revenues (from $142 million to $209 million). The increase in Subscription revenues was due to higher basic cable rates, an increase in subscribers to high-speed data services, an increase in digital cable subscribers and, to a lesser degree, an increase in basic cable subscribers. Digital cable subscribers increased by 54% to 3.9 million and high-speed data subscribers increased by 75% to 2.5 million in 2002 over the prior year comparable period. The increase in Advertising and Commerce revenues was primarily related to advertising purchased by programming vendors to promote their channels, including new channel launches, ($49 million in 2002 versus $0 in 2001) and the intercompany sale of advertising to other business segments of AOL Time Warner ($35 million in 2002 versus $10 million in 2001). The Company expects advertising sales to programming vendors to sequentially decline, resulting in declines in such advertising in the second half of 2002 as compared to the prior year.

            EBITDA increased principally as a result of the revenue gains, offset in part by increases in programming and other operating costs. The increase in video programming costs of 22% relates to general programming rate increases across both basic and digital services, the addition of new programming services and higher basic and digital subscriber levels. Programming costs are expected to continue to increase as general programming rates increase and digital services continue to be rolled out. Other operating costs increased as a result of increased costs associated with the roll out of new services, higher property taxes associated with the upgrade of cable plants and higher development spending in the Interactive Personal Video division.

             Filmed Entertainment. Revenues increased 26% to $2.386 billion in 2002, compared to $1.893 billion on both a pro forma and historical basis in 2001. EBITDA increased 31% to $328 million in 2002, compared to $250 million on both a pro forma and historical basis in 2001.

            Revenues and EBITDA increased at both Warner Bros. and the filmed entertainment businesses of Turner Broadcasting System, Inc. (the “Turner filmed entertainment businesses”), which include New Line Cinema, Castle Rock and the former film and television libraries of Metro-Goldwyn-Mayer, Inc. and RKO pictures.

            For Warner Bros., the revenue increase was primarily related to the worldwide home video release of Harry Potter and the Sorcerer’s Stone, the domestic home video release of Ocean’s Eleven , as well as the continued international theatrical success of those films and the theatrical success of the second quarter release of Scooby Doo, offset in part by reduced commerce revenues related to the closure of its Studio Stores. For the Turner filmed entertainment businesses, revenues increased primarily due to New Line Cinema’s continued theatrical success of The Lord of the Rings: The Fellowship of the Ring and Blade II .

            For Warner Bros., EBITDA increased principally due to the strong revenue growth. For the Turner filmed entertainment businesses, EBITDA increased primarily due to the revenue increase as well as an absence of losses on certain theatrical releases in 2001 .

             Networks. Revenues increased 7% to $1.957 billion in 2002, compared to $1.828 billion on both a pro forma and historical basis in 2001. EBITDA declined 5% to $420 million in 2002 from $444 million on both a pro forma and historical basis in 2001.

            Revenues grew primarily due to a 7% increase in Subscription revenues with growth at both the cable networks of TBS (the “Turner cable networks”) and HBO, a 5% increase in Advertising and Commerce revenues

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(from $679 million to $710 million) with growth at both the Turner cable networks and The WB Network and a 21% increase in Content and Other revenues with growth at HBO, offset in part by declines at the Turner cable networks. EBITDA decreased due to lower results at the Turner cable networks, offset in part by improved results at HBO and, to a lesser degree, The WB Network.

            For the Turner cable networks, Subscription revenues benefited from higher domestic rates and an increase in the number of domestic subscribers, led by TNT, CNN, Turner Classic Movies, TBS and Cartoon Network cable networks. Advertising and Commerce revenues increased marginally (from $557 million to $569 million) due to a slight recovery in the cable television advertising market and a small increase in intercompany sales of advertising to other business segments of AOL Time Warner ($25 million in 2002 versus $23 million in 2001). For HBO, Subscription revenues benefited from an increase in the number of subscribers and higher rates. Content and Other revenues benefited from higher home video sales of HBO’s original programming and higher licensing and syndication revenue from the broadcast comedy series, Everybody Loves Raymond . For The WB Network, the increase in Advertising and Commerce revenues (from $122 million to $141 million) was driven by higher rates.

            For the Turner cable networks, the decrease in EBITDA was principally due to higher programming, marketing and newsgathering costs, partially offset by the increased revenues. In addition, EBITDA was negatively impacted by reserves established on receivables from Adelphia Communications, a major cable television operator (“Adelphia”). For HBO, the increase in EBITDA was principally due to the increase in revenues and reduced costs relating to the finalization of certain licensing agreements, offset in part by reserves established on receivables from Adelphia and the write–off of development costs. For The WB Network, the improvement in EBITDA was principally due to the increase in revenues, offset in part by higher programming costs.

             Music . Revenues increased 4% to $972 million in 2002, compared to $935 million on both a pro forma and historical basis in 2001. EBITDA increased 17% to $102 million in 2002 from $87 million on both a pro forma and historical basis in 2001.

            Revenues increased primarily due to increases in DVD manufacturing and merchandising sales, and the impact of the acquisition of Word Entertainment in January 2002, offset in part by the negative effect of changes in foreign currency exchange rates on international revenues and lower industry–wide domestic recorded music sales.

            The increase in EBITDA is due primarily to the higher revenues and the impact of various cost–saving and restructuring programs. As of June 30, 2002, the Music segment had increased its domestic album market share to 17.6%, compared to 17.1% at June 30, 2001.

             Publishing. Revenues increased 8% to $1.396 billion in 2002, compared to $1.291 billion on a pro forma basis in 2001 ($1.155 billion on a historical basis). EBITDA increased 14% to $337 million in 2002 from $296 million on a pro forma basis in 2001 ($271 million on a historical basis).

            The increase in revenues is due to a 12% increase in Subscription revenues, 6% increase in Advertising and Commerce revenues (from $805 million to $850 million) and a 14% increase in Content and Other revenues. The growth in Subscription revenues was primarily due to lower commission payments to subscription agents as well as the impact of Synapse Group Inc. (“Synapse”), which was acquired in December 2001. The growth in Advertising and Commerce revenues was primarily due to revenues recognized by Synapse. This was offset in part by lower commerce revenues from Time Life’s direct marketing business and a 1% decline in advertising revenue resulting

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from the weakness in the magazine advertising market. The increase in Content and Other revenues is due primarily to increased sales at the AOL Time Warner Book Group driven by new releases in the quarter.

            The growth in EBITDA is due primarily to the increase in revenue, overall cost savings, including cost savings in connection with the integration of IPC, and reduced costs relating to the final settlement of certain liabilities associated with the closure of American Family Enterprises (“AFE”), offset in part by additional reserves established on receivables from newsstand distributors.

Six Months Ended June 30, 2002 Compared to Six Months Ended June 30, 2001

Consolidated Results

            AOL Time Warner had revenues of $20.339 billion, income before the cumulative effect of an accounting change of $393 million and net loss of $53.846 billion in 2002, compared to revenues of $19.039 billion and net income of $571 million on a pro forma basis in 2001 (revenues of $18.393 billion and net loss of $2.103 billion on a historical basis). AOL Time Warner had basic and diluted income before the cumulative effect of an accounting change per common share of $0.09 in 20