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SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

Commission file number 1-15062

AOL TIME WARNER INC.

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

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

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes    X     No          

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

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.
INDEX TO FORM 10-Q

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

INTRODUCTION

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

      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’s financial condition, changes in financial condition and results of operations. The MD&A is organized as follows:

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Executive summary. This section provides a brief summary of AOL Time Warner’s results of operations for the three and six months ended June 30, 2003 and the Company’s financial condition and liquidity as of and for the six months period ending June 30, 2003.

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Business developments. This section provides a description of business developments that the Company believes are important to understand the results of operations, as well as to anticipate future trends in those operations.

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Results of operations. This section provides an analysis of the Company’s results of operations for the three and six months ended June 30, 2003 compared to the same periods in 2002. This analysis is presented on both a consolidated and a segment basis. In addition, a brief description is provided of significant transactions and events that impact the comparability of the results being analyzed.

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Financial condition and liquidity. This section provides an analysis of the Company’s financial condition and cash flows as of and for the six months ended June 30, 2003.

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Risk factors and caution concerning forward-looking statements. This section provides a description of risk factors that could adversely affect the operations, business or financial results of the Company or its business segments and how certain forward-looking statements made by the Company in this report, including throughout MD&A and in the consolidated financial statements, are based on management’s current expectations about future events and are inherently susceptible to uncertainty and changes in circumstances.

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

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

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

      Both Operating Income (Loss) before Depreciation and Amortization and Free Cash Flow should be considered in addition to, not as a substitute for the Company’s Operating Income (Loss), Net Income (Loss) and various cash

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

flow measures (e.g., Cash provided by operations), respectively, as well as other measures of financial performance reported in accordance with accounting principles generally accepted in the United States.

EXECUTIVE SUMMARY

Results of Operations

      Revenues for the three months ended June 30, 2003 increased 6% over the same period in 2002 to $10.818 billion. Revenues for the six months ended June 30, 2003 increased 6% to $20.816 billion. Both the three and six month periods reflect revenue gains at all business segments other than AOL. Such revenue gains were evidenced through increased Subscription and Content revenues, which more than offset declines in Advertising revenues at the AOL and Cable segments and Other revenues at the AOL segment, both of which are expected to continue throughout the year.

      AOL Time Warner had net income of $1.064 billion (or diluted net income per share of $0.23) for the three months ended June 30, 2003 compared to $396 million (or diluted net income per share of $0.09) in 2002. For the six months ended June 30, 2003, net income was $1.460 billion (or diluted net income per share of $0.32) compared to net income before the cumulative effect of an accounting change of $387 million (or diluted net income per share of $0.09).

      The improvement in net income for both the three and six month periods ended June 30, 2003 over the comparable prior year periods reflects declines in Operating Income and increased interest expense which were more than offset by higher investment and other gains and lower investment impairments in 2003. In particular, the three month period ended June 30, 2003 reflects an approximate $760 million gain on a legal settlement with Microsoft and investment gains of approximately $542 million (approximately $651 million for the six months ended June 30, 2003) primarily consisting of the gain on the sale of the Company’s interest in Comedy Partners L.P. (“Comedy Central”). This compares to investment gains of approximately $90 million for the three and six months ended June 30, 2002. Additionally, both the three months and six months ended June 30, 2003 reflect lower investment impairment charges than in 2002, as the six month period in 2002 included approximately $945 million of investment impairment charges primarily associated with the writedown of the Company’s 44% ownership interest in Time Warner Telecom Inc. (“Time Warner Telecom”).

      The Company had Operating Income of $1.285 billion for the three months ended June 30, 2003 compared to $1.520 billion in 2002. For the six months ended June 30, 2003, Operating Income was $2.436 billion compared to Operating Income of $2.577 billion for the six months ended June 30, 2002. The decline for the three month period is a result of lower business segment Operating Income before Depreciation and Amortization and an increase in depreciation and amortization expense. The decline for the six month period is a result of higher business segment Operating Income before Depreciation and Amortization which was more than offset by an increase in depreciation and amortization expense.

      Operating Income before Depreciation and Amortization decreased $102 million for the three months ended June 30, 2003 and increased $144 million for the six months ended June 30, 2003 over the same periods in 2002. Included in these results were several items affecting comparability, including impairments of goodwill and intangible assets, a gain on disposition of certain assets and merger and restructuring costs, which are discussed below. Excluding these items, Operating Income before Depreciation and Amortization for the three months ended June 30, 2003 increased as a result of increases at the Cable, Filmed Entertainment, Networks, and Music segments offset in part by declines at the AOL, Publishing and Corporate segments. Similarly, excluding these items for the six months ended June 30, 2003, Operating Income before Depreciation and Amortization increased as a result of increases at the Cable, Filmed Entertainment, Networks, and Publishing segments offset in part by declines at the AOL, Music and Corporate segments.

      For the three month and six month periods ended June 30, 2003, depreciation expense increased principally due to increases at the Cable and AOL segments. As a result of the completion of the cable system upgrades in mid-2002 and an increase in the amount of capital spending on customer premise equipment in recent years, a larger proportion of the Cable segment’s property, plant and equipment consisted of assets with shorter useful lives in 2003 than in 2002. Depreciation expense relating to these shorter-lived assets, coupled with existing depreciation expense relating to the upgraded cable systems, has resulted in the increase in overall depreciation expense.

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

For the AOL segment, the higher expense was due to an increase in network assets acquired under capital leases.

      For both the three and six months ended June 30, 2003, amortization expense increased principally due to increases at the Music, Publishing and Filmed Entertainment segments. The increase at the Music segment is principally related to the reduction in the amortization period of recorded music catalog and music publishing copyrights from 20 to 15 years. For the Publishing segment, the increase related to the acquisition of Synapse, a subscription marketing company, for which the purchase price accounting was finalized in the fourth quarter of 2002. For the Filmed Entertainment segment, the increase relates to the step up in valuation on the film library assets due to the restructuring of Time Warner Entertainment Company, L.P. (“TWE Restructuring”), which closed on March 31, 2003.

Cash Flows and Debt Reduction Program

      For the first six months of 2003, the Company generated $3.8 billion in Cash Flow from Operations and $2.5 billion in Free Cash Flow. Cash Flow from Operations and Free Cash Flow benefited from the favorable timing of working capital requirements and approximately $359 million of net cash received through the settlements of certain litigation.

      As of June 30, 2003, the Company’s net debt (defined as total debt less cash and cash equivalents) totaled $24.243 billion, compared to $25.779 billion at December 31, 2002. The reduction in net debt reflected more than $2 billion of proceeds from the sale of certain non-core investments, including the sale of the Company’s investment in Hughes Electronics Corp. (“Hughes”) and its 50% ownership stake in Comedy Central, as well as the generation of $2.5 billion of Free Cash Flow including the aforementioned net benefit from certain litigation settlements. These sources of debt reduction were offset partially by the use of $813 million of cash during the second quarter for the repurchase of all non-voting preferred shares in AOL Europe and the incurrence of $2.1 billion of debt by Time Warner Cable Inc. (“TWC Inc.”) as part of the restructuring of Time Warner Entertainment Company, L.P. (“TWE”) described below.

      The Company’s debt reduction program is expected to be positively impacted in the future as a result of its agreement to sell the CD and DVD manufacturing and distribution business for approximately $1.05 billion in cash. This transaction is expected to close by the end of 2003, but is subject to the applicable regulatory reviews in the United States and other countries and other customary closing conditions. Additionally, the Company continues to explore the sale of other non-core assets.

BUSINESS DEVELOPMENTS

Sale of Music Manufacturing

      In July 2003, the Company announced a definitive agreement to sell Warner Music Group’s DVD and CD manufacturing, printing, packaging, physical distribution and merchandising businesses for $1.05 billion in cash to Cinram International Inc. (“Cinram”). This agreement includes the following businesses: WEA Manufacturing Inc., Warner Music Manufacturing Europe GmbH, Ivy Hill Corporation, Giant Merchandising and the physical distribution operations of Warner-Elektra-Atlantic Corporation (“WEA Corp.”). The sales and marketing operations of WEA Corp. will remain as part of Warner Music Group (“WMG”).

      In addition, the Company will enter into long-term agreements effective at the closing under which Cinram will provide manufacturing, printing, packaging and physical distribution for the Company’s DVDs and CDs in North America and Europe. Had the sale and other agreements described above occurred at the beginning of 2003, Operating Income before Depreciation and Amortization for the Company for the six months ended June 30, 2003, would have been reduced by approximately $130 million. Similarly, depreciation and amortization would have been reduced by approximately $30 million resulting in a reduction in Operating Income of approximately $100 million. This transaction is expected to close by the end of 2003, but is subject to the applicable regulatory reviews in the United States and other countries and other customary closing conditions. The music

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

manufacturing business has been classified as held for sale and accordingly, we have stopped depreciating and amortizing the manufacturing assets effective July 2003.

Microsoft Settlement

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

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

      In determining the gain recognized in connection with the Microsoft Settlement, the Company evaluated the fair value of all elements received in addition to the cash payment of $750 million. The Company has preliminarily estimated the value of the noncash elements received in connection with the Microsoft Settlement aggregated approximately $10 million. Accordingly, the total gain recognized by AOL Time Warner as a result of the Microsoft Settlement is approximately $760 million, which is included in Other income (expense), net, in the Company’s consolidated statement of operations for the three and six months ended June 30, 2003.

Update on SEC and DOJ Investigations

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

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

      In the 2002 Form 10-K, the Company disclosed that the staff of the SEC had recently informed the Company that, based on information provided to the SEC by the Company, it was the preliminary view of the SEC staff that the Company’s accounting for two related transactions between America Online and Bertelsmann, A.G. should be adjusted. For a description of those transactions, see Management’s Discussion and Analysis of Results of Operations and Financial Condition and Note 17 to the financial statements in the Company’s 2002 Form 10-K and Note 10 to the Notes to Financial Statements in Part I of this report. At that time, the Company further disclosed that it had provided the SEC a written explanation of the basis for the Company’s accounting for these transactions and the reasons why both the Company and its auditors continued to believe that these transactions had been accounted for correctly.

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

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

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

TWE Restructuring

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

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

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

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

      Comcast’s 21.0% economic interest in TWC Inc.’s cable business, is held through a 17.9% direct ownership interest in TWC Inc. (representing a 10.7% voting interest) and a limited partnership interest in TWE representing a 4.7% residual equity interest. AOL Time Warner’s 79% economic interest in TWC Inc.’s cable business is held through an 82.1% ownership interest in TWC Inc. (representing an 89.3% voting interest) and a partnership interest in TWE representing a 1% residual equity interest. AOL Time Warner also holds a $2.4 billion mandatorily redeemable preferred equity interest in TWE. The additional ownership interests acquired by AOL Time Warner in the TWE Restructuring have been accounted for as a step acquisition and are reflected in the accompanying balance sheet as of June 30, 2003. The purchase price allocation is preliminary as the Company is in the process of completing a valuation study to identify and value the net assets acquired (Note 4).

Debt Reduction Plan

      In January 2003, the Company announced its intention to reduce its overall level of indebtedness. Specifically, it is the Company’s intention to reduce net debt to within a range of 2.25 to 2.75 times annual Operating Income before Depreciation and Amortization, excluding the impairment of intangible assets and gains and losses on asset disposals, by the end of 2003. In addition, the Company announced that it intends to reduce total consolidated net debt (defined as total debt less cash and cash equivalents) to approximately $20 billion by the end of 2004. The Company anticipates that the reduction in net debt will be achieved through the use of Free Cash Flow and other de-leveraging initiatives, including the sale of non-core assets. As part of this initiative, the Company reduced its net debt from $25.8 billion as of December 31, 2002 to $24.2 billion as of June 30, 2003. This reduction in net debt reflected more than $2 billion in proceeds from the sale of certain non-core investments, including the sale of the Company’s investment in Hughes ($783 million) and its 50% interest in Comedy Central ($1.225 billion). Also contributing to the reduction in net debt is Free Cash Flow of approximately $2.5 billion during the period including net cash of $359 million received from litigation settlements. These items were partially offset by the incurrence of approximately $2.1 billion of incremental debt as part of the TWE Restructuring and $813 million of incremental net debt incurred to repurchase non-voting preferred shares of AOL Europe.

      Additionally, in July 2003, the Company agreed to sell its CD and DVD manufacturing and distribution business for approximately $1.05 billion in cash. This transaction is expected to close before the end of 2003, but is subject to the applicable regulatory reviews in the United States and other countries and other customary closing conditions. The Company continues to explore the sale of other non-core businesses.

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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

Discontinued Operations

      During 2002, TWE and the Advance/Newhouse Partnership (“Advance/Newhouse”) restructured the TWE-Advance/Newhouse Partnership (“TWE-A/N”), resulting in Advance/Newhouse assuming responsibility for the day-to-day operations of and an economic interest in certain TWE-A/N cable systems. As a result, AOL Time Warner deconsolidated the financial position and operating results of these systems, and has reflected the 2002 operating results of these systems as discontinued operations. Revenues and net income from the discontinued operations totaled $363 million and $2 million, respectively, for the three months ended June 30, 2002 and $715 million and $1 million, respectively, for the six months ended June 30, 2002.

Other Items Affecting Comparability

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

      For the six months ended June 30, 2003, the above amounts included (i) merger and restructuring costs of $36 million (Note 2); (ii) impairment losses of $277 million recorded to reduce the carrying value of goodwill and certain intangible assets at the Turner winter sports teams (the Atlanta Thrashers, an NHL team, and the Atlanta Hawks, an NBA team) and certain intangible assets of the AOL Time Warner Book Group which were recorded at the time of the America Online-Time Warner merger. These changes were taken in the second quarter due to additional fair value information obtained through the Company’s negotiations with third parties related to the possible sale of the businesses (Note 1); (iii) a $43 million gain on the sale of the Company’s interests in a UK theater chain; (iv) a gain of approximately $760 million related to the Microsoft Settlement (Note 10); (v) approximately $651 million in gains related to certain investments, including $513 million gain from the sale of the Company’s interest in Comedy Central and a $50 million gain from the sale of the Company’s interest in Hughes and (vi) non-cash charges of $174 million, which is comprised of $187 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, offset in part by $13 million of gains to reflect market fluctuations in equity derivative instruments (Note 3).

      For the six months ended June 30, 2002, these items included (i) merger and restructuring costs of $107 million, which occurred in the first quarter, (Note 2) (ii) $90 million in gains on the sale of certain investments and (iii) a

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

non-cash charge of $945 million, which is comprised of $953 million to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, offset in part by $8 million of gains to reflect market fluctuations in equity derivative instruments. Included in the $953 million charge relating to other-than-temporary declines in value is a $772 million non-cash charge to reduce the carrying value of AOL Time Warner’s investment in Time Warner Telecom, a 44% owned equity investment (Note 3).

Consolidated Results

      Revenues. Consolidated revenues increased 6% to $10.8 billion for the three months ended June 30, 2003. For the six months ended June 30, 2003 consolidated revenues increased 6% to $20.8 billion. As shown below, these increases were led by growth in both Subscription and Content revenues, offset in part by declines in Advertising and Other revenues:

      For the three and six months ended June 30, 2003, the increase in Subscription revenues was principally due to increases at the Cable and Networks segments primarily driven by higher rates and at the AOL segment primarily from the favorable impact of foreign currency exchange rates. For the three months ended June 30, 2003, the increase in Content revenues was principally due to improved results at the Filmed Entertainment segment, primarily related to the strength of The Matrix Reloaded and additional international television availabilities, and the Music segment, related to the strength of new releases in the current quarter and the favorable effects of foreign exchange rates. For the six months ended June 30, 2003, the 11% increase in Content revenues related primarily to the Filmed Entertainment segment and higher ancillary sales of HBO programming at the Networks segment.

      The slight decline in Advertising revenues for the three and six months ended June 30, 2003 was primarily related to the AOL segment, due principally to the decline in the current benefit from prior period contract sales, and the Cable segment, due to a decrease in program vendor advertising. The decline in the benefit from prior year contracts at the AOL segment and program vendor advertising at the Cable segment are both expected to continue throughout 2003. The Advertising revenue declines at the AOL and Cable segments were offset in part by growth at the Networks and Publishing segments.

      The decline in Other revenues for the three and six months ended June 30, 2003 was primarily due to the AOL segment’s decision to reduce the promotion of its merchandise business (i.e., reducing pop up advertisements) to improve the member experience. The declines are expected to continue throughout 2003.

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

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

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

      The following table reconciles Operating Income before Depreciation and Amortization to Operating Income and in addition provides the components from Operating Income to net income (loss) for purposes of the discussions that follow:

      Operating Income before Depreciation and Amortization. Operating Income before Depreciation and Amortization decreased 4% to $2.165 billion for the three months ended June 30, 2003 from $2.267 billion in 2002. For the six months ended June 30, 2003, Operating Income before Depreciation and Amortization increased 4% to $4.150 billion from $4.006 billion in 2002.

      Included in these results were several items affecting comparability, including impairments of goodwill and intangible assets, a gain on disposition of certain assets and merger and restructuring costs, which are discussed below. Excluding these items, Operating Income before Depreciation and Amortization for the three months ended June 30, 2003 increased as a result of improvements at the Cable, Filmed Entertainment, Networks and Music segments offset in part by declines at the AOL, Publishing and Corporate segments. Similarly, excluding these items for the six months ended June 30, 2003, Operating Income before Depreciation and Amortization increased as a result of increases at the Cable, Filmed Entertainment, Networks, and Publishing segments offset in part by declines at the AOL and Corporate segments. Excluding impairment charges and gains and losses on the disposition of assets, the year-over-year rate of growth in both Operating Income before Depreciation and Amortization and Operating Income is expected to slow in the second half of 2003 in comparison to the first half as the Company faces difficult prior year comparisons in its Filmed Entertainment and Networks segments as well as an increase in the VAT assessment at AOL Europe. The segment variations are discussed in detail under “Business Segment Results” below.

      Impairments of Goodwill and Intangible Assets. For the three and six months ended June 30, 2003, Operating Income before Depreciation and Amortization includes a $178 million impairment charge at the Networks segment related to the writedown of the intangible assets of the winter sports teams and a $99 million impairment charge related to the writedown of goodwill and intangible assets of the AOL Time Warner Book Group at the Publishing segment. These impairment charges resulted from additional fair value information obtained through negotiations with third parties about the potential disposition of these businesses.

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

      Gain on Disposition of Assets. For the three and six months ended June 30, 2003, Operating Income before Depreciation and Amortization included a $43 million gain related to the sale of a UK theater chain at the Filmed Entertainment segment.

      Merger and Restructuring Costs. For the three months ended June 30, 2003, Operating Income before Depreciation and Amortization included merger and restructuring costs of $12 million, including $6 million at the Music segment and $6 million at the Publishing segment. These costs related to various employee and contractual terminations (Note 2). There were no merger and restructuring costs for the three months ended June 30, 2002.

      For the six months ended June 30, Operating Income before Depreciation and Amortization included merger and restructuring costs of $36 million in 2003 and $107 million in 2002. The 2003 costs included $4 million at the AOL segment, $8 million at the Networks segment, $18 million at the Publishing segment and $6 million at the Music segment and related to various employee and contractual terminations. The 2002 costs included $75 million at the AOL segment, $5 million at the Music segment and $27 million at Corporate. The 2002 costs included $43 million related to work force reductions and $64 million for termination of the AOL segment’s lease obligations for network modems that are no longer being used because network providers have upgraded their networks to newer technology (Note 2).

      Corporate Operating Loss before Depreciation and Amortization. AOL Time Warner’s Corporate Operating Loss before Depreciation and Amortization increased to $112 million and $213 million for the three and six months ended June 30, 2003, respectively, from $80 million and $186 million in the comparable prior periods, respectively. This occurred primarily due to legal and other professional fees related to the SEC and DOJ investigations into the accounting and disclosure practices of the Company and the defense of various shareholder lawsuits ($20 million and $35 million were incurred in the three and six month periods ended June 30, 2003, respectively). It is not yet possible to predict the outcome of these investigations and costs are expected to continue to be incurred throughout the year. The six months ended June 30, 2002 also includes $27 million of restructuring charges.

      Depreciation Expense. For the three months ended June 30, depreciation expense increased to $669 million in 2003 from $572 million in 2002 and for the six months ended June 30, increased to $1.308 billion in the same period in 2003 from $1.090 billion in 2002 principally due to increases at the Cable and AOL segments. As a result of the completion of the cable system upgrades in mid-2002 and an increase in the amount of capital spending on customer premise equipment in recent years, a larger proportion of the Cable segment’s property, plant and equipment consisted of assets with shorter useful lives in 2003 than in 2002. Depreciation expense relating to these shorter-lived assets, coupled with existing depreciation expense relating to the upgraded cable systems, has resulted in the increase in overall depreciation expense.

      Amortization Expense. For the three months ended June 30, amortization expense increased to $211 million in 2003 from $175 million in 2002 and to $406 million for the six months ended June 30, 2003, from $339 million in the same period in 2002. These increases are principally due to increases at the Music, Publishing and Filmed Entertainment segments. The increase at the Music segment is principally related to the reduction in the amortization period of music publishing copyrights and recorded music catalog from 20 to 15 years. For the Publishing segment, the increase related to the acquisition of Synapse, a subscription marketing company, whose purchase price allocation was finalized in the fourth quarter of 2002. For Filmed Entertainment, the increase relates to the preliminary step up in value on the film library assets due to the TWE Restructuring.

      Operating Income. AOL Time Warner’s Operating Income declined 15% for the three months and 5% for the six months ended June 30, 2003 as compared to the same period in 2002. The decline related to the change in business segment Operating Income before Depreciation and Amortization noted above and due to an increase in depreciation and amortization expense as previously discussed.

      Interest Expense, Net. Interest expense, net, increased to $473 million for the three months ended June 30, 2003, from $441 million in 2002 and to $941 million for the six months ended June 30, 2003, from $817 million in 2002, as a result of a higher average level of debt outstanding and a change in the mix of debt from lower rate variable debt to higher rate fixed debt as well as lower interest income resulting from the sale of AOL’s investment in Hughes.

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

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

      For the three and six months ended June 30, 2003, investment related gains were $542 million and $651 million, respectively, as compared to $90 million for the three and six months ended June 30, 2002. For 2003, the $651 million included a $513 million gain on the sale of the Company’s interest in Comedy Central and a $50 million gain from the sale of the Company’s interest in Hughes in the first quarter. Other income (expense), net also includes $49 million ($14 million in the second quarter) related to gains on the sale of international theater chains. For the three and six months ended June 30, 2002, the Company recognized investment related gains of $90 million, including a $59 million gain from the sale of a portion of the Company’s interest in the Columbia House Company Partnerships and a $31 million gain on the redemption of approximately 1.6 million shares of preferred stock of TiVo Inc.

      For the three and six months ended June 30, 2003, the Company recorded non-cash charges of $151 million and $174 million, respectively, to reduce the carrying value of certain investments that experienced other-than-temporary declines in value and to reflect market fluctuations in equity derivative instruments. For the three and six months ended June 30, 2002, the Company recorded charges of $364 million and $945 million, respectively. Included in the 2003 charge was a writedown of $77 million for AOL Japan and a $71 million writedown for n-tv KG (“NTV-Germany”). Included in the $945 million charge for the six months ended June 30, 2002, was a $772 million ($201 million in the three month period) charge to reduce the carrying value of AOL Time Warner’s investment in Time Warner Telecom Inc., a 44% owned equity investment (Note 3), and a $101 million charge related to Gateway, Inc. Excluding equity method investees, as of June 30, 2003, the fair value and carrying value of the Company’s investment portfolio were $1.605 billion and $1.378 billion, respectively.

      In addition, the three and six months ended June 30, 2003 include a $760 million gain related to the Microsoft Settlement (Note 1). Excluding the impact of the items discussed above, Other income (expense), net, improved in 2003 as compared to the prior year primarily from a reduction of losses from equity method investees.

      Minority Interest. For the three and six months ended June 30, 2003, AOL Time Warner had $60 million and $116 million of minority interest expense, respectively, compared to $53 million and $84 million for the three and six months in 2002. The increase in minority interest expense was related to additional minority interest expense for Comcast’s interest in TWC, Inc., offset in part by the elimination of minority interest of AOL Europe due to the repurchase of the remaining preferred securities and accrued dividends in April 2003.

      Income Tax Provision. AOL Time Warner had income tax expense of $791 million for the three months ended June 30, 2003, compared to $301 million in 2002. The Company’s pretax income before discontinued operations and cumulative effect of accounting change in the three month period was $1.855 billion in 2003 compared to $695 million in 2002. Applying the 35% U.S. federal statutory rate to pretax income would result in income tax expense of $649 million in 2003 and $243 million in 2002. However, the Company’s actual income tax expense (benefit) differs from these amounts primarily as a result of several factors including state and local income taxes and foreign income taxed at different rates.

      The Company had income tax expense of $1.088 billion for the six months ended June 30, 2003, compared to $304 million in 2002. The Company’s pretax income before discontinued operations and cumulative effect of accounting change in the six month period was $2.548 billion in 2003 compared to $690 million in 2002. Applying the 35% U.S. federal statutory rate to pretax income would result in income tax expense of $892 million in 2003 and

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

$242 million in 2002. However, the Company’s actual income tax expense (benefit) differs from these amounts primarily as a result of several factors including state and local income taxes and foreign income taxed at different rates.