UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

 

 

Form 10-K

 

 

 

 

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2006

 

Commission file number 001-15062

 

 

 

 

TIME WARNER INC.

(Exact name of Registrant as specified in its charter)

 

One Time Warner Center

New York, NY 10019-8016

(Address of Principal Executive Offices)(Zip Code)

 

(212) 484-8000

(Registrant’s Telephone Number, Including Area Code)

 

 

 

 

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

 

 

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

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes þ     No o

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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

 

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

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes o     No þ

 

As of the close of business on February 16, 2007, there were 3,815,571,860 shares of the registrant’s Common Stock and 18,784,759 shares of the registrant’s Series LMCN-V Common Stock outstanding. The aggregate market value of the registrant’s voting and non-voting common equity securities held by non-affiliates of the registrant (based upon the closing price of such shares on the New York Stock Exchange on June 30, 2006) was approximately $66.27 billion.

 

Documents Incorporated by Reference:

 

 

 

PART I

 

 

Time Warner Inc. (the “Company” or “Time Warner”), a Delaware corporation, is a leading media and entertainment company. The Company classifies its businesses into the following five reporting segments:

 

 

At January 1, 2007, the Company had a total of approximately 92,700 employees.

 

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

 

Recent Developments

 

Adelphia Acquisition and Related Transactions

 

As part of Time Warner Cable Inc.’s (“TWC”) strategy to expand its cable footprint and improve the clustering of its cable systems, on July 31, 2006 Time Warner NY Cable LLC (“TW NY”), a subsidiary of TWC, and Comcast Corporation (“Comcast”) completed their respective acquisitions of assets comprising, in the aggregate, substantially all of the cable systems of Adelphia Communications Corporation (“Adelphia”). TW NY paid for the Adelphia assets acquired by it with approximately $8.9 billion in cash (after certain purchase price adjustments) and shares of TWC’s Class A Common Stock representing approximately 16% of TWC’s outstanding common stock. Immediately prior to the Adelphia acquisition, TWC and its subsidiary, Time Warner Entertainment Company, L.P. (“TWE”), redeemed Comcast’s interests in TWC and TWE, with the result that Comcast no longer has an interest in either company. In addition, immediately after the acquisition of the Adelphia assets, TW NY exchanged certain cable systems with subsidiaries of Comcast. These transactions resulted in a net increase of 3.2 million basic video subscribers served by TWC’s cable systems.

 

On February 13, 2007, Adelphia’s Chapter 11 reorganization plan became effective and, under applicable securities law regulations and provisions of the U.S. bankruptcy code, TWC became a public company subject to the requirements of the Securities Exchange Act of 1934 on the same day. Under the terms of the reorganization plan, most of the shares of TWC Class A Common Stock that Adelphia received as part of the payment for the systems TWC acquired in July 2006 are being distributed to Adelphia’s creditors. It is expected that the TWC Class A Common Stock will begin to trade on the New York Stock Exchange (“NYSE”) on or about March 1, 2007.

 

AOL - Google Alliance

 

On April 13, 2006, AOL LLC (“AOL”), Google Inc. (“Google”) and Time Warner completed the issuance to Google of a 5% indirect equity interest in AOL in exchange for $1 billion in cash, having entered into agreements in March 2006 that expanded their strategic alliance. Under the alliance, Google will continue to provide search services to AOL’s network of Internet properties worldwide and will provide AOL with a greater share of revenues generated through searches conducted on the AOL network. Google agreed, among other things, to provide AOL the use of a modified version of its search technology to enable AOL to sell search advertising directly to advertisers on AOL-owned properties, to provide AOL with marketing credits for promotion of AOL’s properties on Google’s network and other promotional opportunities for AOL content, to collaborate in video search and promotion of

AOL’s video destination, and to enable Google and AIM instant messaging users to communicate with each other, provided certain conditions are met.

 

New Broadcast Television Network

 

At the beginning of the Fall 2006 broadcast season, Warner Bros. Entertainment Inc. (“WBE”), a subsidiary of the Company, and CBS Corp. (“CBS”) launched a new fifth broadcast network named The CW Network. The new broadcast network is a 50-50 joint venture between WBE and CBS and is being accounted for by the Company as an equity investee. The WB Network, 77.75% owned by a subsidiary of WBE which operated for 11 years, ceased operations in conjunction with the launch of the new network and The WB Network’s partnership with Tribune Broadcasting was dissolved.

 

Caution Concerning Forward-Looking Statements and Risk Factors

 

This Annual Report on Form 10-K includes certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These statements are based on management’s current expectations and are subject to uncertainty and changes in circumstances. Actual results may vary materially from the expectations contained herein due to changes in economic, business, competitive, technological and/or regulatory factors. For more detailed information about these factors, and risk factors with respect to the Company’s operations, see Item 1A, “Risk Factors” below and “Caution Concerning Forward-Looking Statements” in “Management’s Discussion and Analysis of Results of Operations and Financial Condition” in the financial section of this report. Time Warner is under no obligation to (and expressly disclaims any obligation to) update or alter its forward-looking statements, whether as a result of new information, subsequent events or otherwise.

 

Available Information and Website

 

The Company’s annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and any amendments to such reports filed with or furnished to the Securities and Exchange Commission (“SEC”) pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934 are available free of charge on the Company’s website at www.timewarner.com as soon as reasonably practicable after such reports are electronically filed with the SEC.

 

AOL

 

AOL is a leader in interactive services. In the U.S. and internationally, AOL and its subsidiaries operate a leading network of web brands, offer free client software and services to users who have their own Internet connection and also provide services to advertisers on the Internet. In addition, AOL operates one of the largest Internet access subscription services in the U.S.

 

On April 13, 2006, AOL, Google and Time Warner completed the issuance to Google of a 5% indirect equity interest in AOL in exchange for $1 billion in cash, having entered into agreements in March 2006 that expanded their strategic alliance. Under the alliance, Google will continue to provide search services to AOL’s network of Internet properties worldwide and provide AOL with a greater share of revenues generated through searches conducted on the AOL network. Google agreed, among other things, to provide AOL the use of a modified version of its search technology to enable AOL to sell search advertising directly to advertisers on AOL-owned properties, to provide AOL with marketing credits for promotion of AOL’s properties on Google’s network and other promotional opportunities for AOL content, to collaborate in video search and promotion of AOL’s video destination, and to enable Google and AIM instant messaging users to communicate with each other, provided certain conditions are met.

 

Access and Global Web Services

 

Historically, AOL’s primary product has been an online subscription service providing dial-up Internet access for a monthly fee. This subscription service continues to generate the substantial majority of AOL’s revenues. As of December 31, 2006, AOL had 13.2 million access subscribers in the U.S. The primary price plans offered by AOL

are $25.90 and $9.95 per month plans providing varying levels of dial-up access service, storage, tools and services. In addition, AOL subsidiaries offer the CompuServe and Netscape Internet services.

 

During 2006, AOL began a transition from a primarily subscription-based business to an advertising-supported global web services business. A significant component of this transition was to permit the use of most of AOL’s services, including the AOL client software and AOL e-mail, without charge. As a result, as long as an individual has a means to connect to the Internet, that person is able to access and use most of the AOL services for free.

 

AOL offers a variety of websites, portals such as AOL.com (including versions in other languages), and related applications and services, which, along with the AOL and low-cost ISP services, form an online network (the “AOL Network”). Specifically, the AOL Network includes AOL.com, AIM, MapQuest, Moviefone, ICQ, and Netscape as well as other websites that are owned or operated by third parties for which the Internet traffic has been assigned to AOL under agreements with the other party. Accordingly, AOL’s audience includes AOL members and Internet users who visit the AOL Network. AOL seeks to attract highly-engaged users to and retain those users on the AOL Network by offering compelling free content, features and tools.

 

AOL’s strategy is to maintain or expand the audience of unique visitors to the AOL Network and to increase their activity. This activity is a significant driver of AOL’s advertising revenues. AOL intends to distribute its free and paid products and services through a variety of methods, including relationships with third-party high-speed Internet access providers, retailers, computer manufacturers or other aggregators of Internet activity and through search engine marketing and search engine optimization.

 

AOL earns revenue by offering advertisers a range of online marketing and promotional opportunities both on the AOL Network and on third-party websites primarily through Advertising.com. Online advertising arrangements generally involve payments by advertisers on either a fixed-fee basis or on a pay-for-performance basis, where the advertiser pays based on the “click” or customer transaction resulting from the advertisement. AOL also earns revenue through its relationship with Google, which sells advertising that appears on AOL search sites and shares the resulting revenues with AOL. AOL offers advertisers fixed-fee display advertising and performance-based display advertising, as well as a variety of customized programs, including premier placement, video advertising, rich media advertising, sponsorship of content offerings for designated time periods, local and classified advertising, audience targeting opportunities, search engine management and lead generation services. Advertising.com connects advertisers with online advertising inventory by purchasing this inventory from publishers of third-party websites, and using its proprietary optimization technology to determine the optimal advertising to display on each inventory placement.

 

AOL also offers paid services to AOL members and to Internet users generally, including storage and online safety and security products. AOL intends to develop and offer a variety of other premium content, services and applications that appeal to high-speed and mobile users.

 

International

 

Internationally, AOL is also transitioning from primarily a subscription-based business to an advertising-supported web services business. During 2006, the Company entered into agreements to sell its AOL European access businesses. On October 31, 2006, AOL completed the sale of its French access business to Neuf Cegetel S.A. for approximately $360 million in cash, and on December 29, 2006, AOL sold its U.K. access business to The Carphone Warehouse Group PLC for approximately $712 million in cash, $476 million of which was paid at closing and the remainder of which will be payable over the 18-month period following the closing. In connection with these sales, AOL entered into separate agreements with the purchasers to provide ongoing web services and content to their existing and purchased subscribers. For further information regarding these sales, see “Management’s Discussion and Analysis of Results of Operations and Financial Condition” in the financial section of this report. In September 2006, AOL entered into an agreement to sell its German access business to Telecom Italia S.p.A. for approximately $870 million in cash, subject to certain closing adjustments, and will also provide ongoing web services to Telecom Italia S.p.A. following closing, which is expected to occur in the first quarter of 2007.

 

Technologies

 

AOL employs a multiple vendor strategy in designing, structuring and operating the network services utilized in its interactive online services. AOLnet, an Internet protocol (IP) network of third-party network service providers, is used for the AOL service, the Netscape service, certain versions of the CompuServe service in North America, and other subscriber services, in addition to being used by outside parties. AOL expects to continue to review its network services arrangements in order to align its network capacity with market conditions and manage data network costs.

 

AOL enters into multi-year data communications agreements to support AOLnet. In connection with those agreements, AOL may commit to purchase certain minimum levels of data communications services or to pay a fixed cost for network services.

 

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

 

Improving and maintaining AOLnet and the ATDN requires a substantial investment in telecommunications equipment and services. In addition to making cash purchases of telecommunications equipment, AOL also finances some of these purchases through leases.

 

Marketing

 

To support its goals of attracting and retaining members and users, growing the audience of the AOL Network, and developing and differentiating its family of brands, AOL markets its brands, products and services through a broad array of programs and media, including retail distribution, bundling agreements, web advertising and alternate media. Other marketing strategies include search engine marketing as well as online and offline cross-promotion and co-branding with a wide variety of partners. Additionally, through multi-year bundling agreements, AOL’s interactive online services and products are installed on several different brands of personal computers made by personal computer manufacturers.

 

Competition

 

AOL’s global web services business competes for online users’ time and attention and advertising, subscription and commerce revenues with a wide range of companies, including web-based portals and individual websites providing content, commerce, search, communications, community and similar features, as well as ISPs and traditional media companies such as Viacom Inc., CBS Corp., News Corporation, The Walt Disney Company, Tribune Company, The New York Times Company and NBC Universal. Major competitors include Yahoo! Inc., Microsoft Corporation, Google, IAC/ InterActiveCorp and eBay Inc. In addition, new properties such as YouTube, MySpace and Facebook that have been able to gain large numbers of visitors and generate significant amounts of activity compete with AOL.

 

Advertising.com, which generates almost a quarter of AOL’s advertising revenues, competes with other aggregators of third-party inventory and other companies that offer competing advertising products, technology and services, such as 24/7 Real Media, Inc. and ValueClick, Inc. Competition affects the prices paid by Advertising.com for inventory and prices charged to advertisers for Advertising.com’s products and services. In order for Advertising.com to remain competitive, it is important that it offer compelling advertising products and technologies to the advertisers who are its customers.

 

As part of its strategy, AOL has sold its Internet access operations in France and the U.K. and has agreed to do so in Germany, and in conjunction with these sales has established relationships with the purchasers to continue to provide its former subscribers with web services, including portals, e-mail and content. In Europe, following the sales of its access operations businesses, AOL Europe’s primary competitors are Google, Microsoft Corporation and

Yahoo! Inc. in its main markets, in addition to Web.de in Germany and Voilá in France. Internationally, AOL expects to compete against local Internet and other web services companies as well as current U.S. competitors who have an established portal presence in these locations already.

 

Although AOL has implemented a new long-term business strategy, AOL continues to operate in the Internet access business and competes for subscription revenues with companies providing dial-up Internet service, including EarthLink, and discount ISPs such as NetZero. AOL also competes with companies providing Internet access via broadband technologies, such as cable companies and telephone companies, and companies offering emerging broadband access technologies, including wireless, mobile wireless, fiber optic cable and power line.

 

AOL faces significant competition, primarily from the competitors identified above, in the distribution of its products and services in a cost effective manner. For example, AOL competes to secure placement on new computers and mobile devices, including cellular telephones and PDAs, to distribute and promote its products and services. AOL also competes with other providers of portals and other Internet products and services to distribute and promote its products and services through high-speed internet access networks at retail outlets, on new computers, as well as via other distribution channels.

 

CABLE

 

The Company’s cable business, Time Warner Cable Inc. and its subsidiaries (“TWC” or “Time Warner Cable”), is the second-largest cable operator in the U.S. and is an industry leader in developing and launching innovative video, data and voice services. As of December 31, 2006, TWC’s cable systems passed approximately 26 million U.S. homes in well-clustered locations and had approximately 13.4 million basic video subscribers (after giving effect to the distribution of the assets of Texas and Kansas City Cable Partners, L.P. (“TKCCP”) to its partners on January 1, 2007). Approximately 85% of these homes were located in one of five principal geographic areas: New York state, the Carolinas, Ohio, southern California and Texas. As of February 1, 2007, Time Warner Cable was the largest cable system operator in a number of large cities, including New York City and Los Angeles.

 

As part of TWC’s strategy to expand its cable footprint and improve the clustering of its cable systems, on July 31, 2006, Time Warner NY Cable LLC (“TW NY”), a subsidiary of TWC, and Comcast completed their respective acquisitions of assets comprising in the aggregate substantially all of the cable systems of Adelphia. TW NY paid for the Adelphia assets acquired by it with approximately $8.9 billion in cash (after certain purchase price adjustments) and shares of TWC’s Class A Common Stock representing approximately 16% of TWC’s outstanding common stock. Immediately prior to the Adelphia acquisition, TWC and Time Warner Entertainment Company, L.P. (“TWE”) redeemed Comcast’s interests in TWC and TWE, with the result that Comcast no longer has an interest in either company. In addition, immediately after the acquisition of the Adelphia assets, TW NY exchanged certain cable systems with subsidiaries of Comcast. These transactions (referred to generally herein as the “Adelphia/Comcast Transactions”) resulted in a net increase of 3.2 million basic video subscribers served by TWC’s cable systems, consisting of approximately 4.0 million subscribers in acquired systems and approximately 0.8 million subscribers in systems transferred to Comcast. Cable systems acquired by TWC from Adelphia or from Comcast in the Adelphia/Comcast Transactions are referred to herein as the “Acquired Systems,” and systems owned or operated by TWC since prior to the Adelphia/Comcast Transactions are referred to herein as the “Legacy Systems.”

 

On February 13, 2007, Adelphia’s Chapter 11 reorganization plan became effective and, under applicable securities law regulations and provisions of the U.S. bankruptcy code, TWC became a public company subject to the requirements of the Securities Exchange Act of 1934 on the same day. Under the terms of the reorganization plan, most of the shares of TWC Class A Common Stock that Adelphia received as part of the payment for the systems TWC acquired in July 2006 are being distributed to Adelphia’s creditors. It is expected that the TWC Class A Common Stock will begin to trade on the NYSE on or about March 1, 2007.

 

As the marketplace for basic video services has matured, the cable industry has responded by introducing new services, including enhanced video services like HDTV and video-on-demand (“VOD”), high-speed Internet access and Internet protocol (“IP”)-based telephony. As of December 31, 2006, approximately 7.3 million (or 54%) of TWC’s 13.4 million basic video customers subscribed to digital video services, 6.6 million (or 26%) of high-speed

data service-ready homes subscribed to a residential high-speed data service such as the Road Runner service and 1.9 million (or 11%) of voice service-ready homes subscribed to Digital Phone, TWC’s newest service. TWC launched Digital Phone broadly in its Legacy Systems during 2004 and it is available in some of the Acquired Systems on a limited basis. As of December 31, 2006, in the Legacy Systems, approximately 56% of TWC’s 9.5 million basic video customers subscribed to digital video services and over 30% of high-speed data service ready homes subscribed to a residential high-speed data service. The customer data contained herein includes subscribers in certain managed, but unconsolidated, systems in the TKCCP joint venture which were distributed to TWC effective on January 1, 2007. For additional information with respect to the distribution of the assets of TKCCP to its partners on January 1, 2007, see “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Recent Developments” in the financial pages herein.

 

Products and Services

 

Time Warner Cable offers a variety of services over its broadband cable systems, including video, high-speed data and voice services. Time Warner Cable markets its services both separately and as “bundled” packages of multiple services and features. Increasingly, its customers subscribe to more than one service for a single price reflected on a single consolidated monthly bill.

 

As of December 31, 2006, nearly all of the Legacy Systems had bandwidth capacity of 750MHz or greater and were technically capable of delivering all of TWC’s advanced digital video, high-speed data and Digital Phone services. As of such date, it is estimated that approximately 94% of the homes passed in the Acquired Systems were served by plant that had been upgraded to at least 750MHz. TWC is in the process of upgrading the plant in the Acquired Systems. As a result of the Adelphia/Comcast Transactions, TWC has made and anticipates continuing to make significant capital expenditures over the next 12 to 24 months related to the continued integration of the Acquired Systems, which will enable TWC to offer its advanced services and features in the Acquired Systems.

 

Video Services

 

Time Warner Cable offers a full range of analog and digital video service levels, as well as advanced services such as VOD, HDTV, and set-top boxes equipped with digital video recorders (“DVRs”).

 

Analog services.  Analog video service is available in all of TWC’s operating areas. Time Warner Cable typically offers two levels or “tiers” of service — Basic and Standard — which together offer, for a fixed monthly fee based on the level of service selected, on average approximately 70 channels for viewing on “cable-ready” television sets without the need for a separate set-top box. The Basic tier generally provides customers with broadcast television signals, satellite delivered broadcast networks and superstations, local origination channels, and public access, educational and government channels. The Standard tier generally includes national, regional and local cable news, entertainment and other specialty networks, such as CNN, A&E, ESPN and MTV. Subscribers may also purchase premium channels, such as HBO, Showtime and Starz!, for an additional monthly fee.

 

In certain areas, Time Warner Cable’s Basic and Standard tiers also include Time Warner Cable’s proprietary local programming devoted to the communities served by Time Warner Cable. For example, Time Warner Cable provides 24-hour local news channels in the following areas: NY1 News and NY1 Noticias in New York, NY; News 14 Carolina in Charlotte, Greensboro and Raleigh, NC; R News in Rochester, NY; Capital News 9 in Albany, NY; News 8 Austin in Austin, TX; and News 10 Now in Syracuse, NY.

 

Digital services.  Subscribers to Time Warner Cable’s digital video services receive up to 250 digital video and audio services for a fixed monthly fee. Digital video subscribers also have access to an interactive on-screen program guide, on-demand services, multiplex versions of premium channels such as HBO and Showtime, and specialized, thematically-linked programming tiers. Digital video subscribers may also purchase seasonal sports packages, generally for a single fee for the entire season. As of December 31, 2006, 54.2% of TWC’s basic video subscribers, or approximately 7.3 million, subscribed to its digital video services and, in the Legacy Systems, approximately 55.6% of TWC’s basic video subscribers, or approximately 5.3 million, subscribed to its digital video services.

 

On-Demand services.  On-Demand services enable digital video users to view what they want, when they want it. These services feature advanced functionality, such as the ability to pause, rewind and fast-forward on-demand programs using Time Warner Cable’s VOD system. These services include Movies-on-Demand, Subscription-Video-on-Demand (“SVOD”), which provides subscribers with On-Demand access to programming that is either associated with a particular premium content provider to which they already subscribe, such as HBO On-Demand, or is otherwise made available on a subscription basis; and Free Video-on-Demand, which provides selected movies, programs and program excerpts to all digital subscribers with On-Demand access with no incremental charges. TWC’s new Start Over service uses VOD technology to allow digital video customers to instantly restart selected programs then being aired by participating programming services. Users cannot fast forward through commercials while using Start Over, so traditional advertising economics are preserved. The Start Over service was rolled out in a number of divisions during 2006 and is expected to be introduced in additional service areas during 2007.

 

DVRs.  Set-top boxes equipped with digital video recorders are available for a fixed monthly fee. Among other things, these set-top boxes enable customers to pause and/or rewind “live” television programs, and easily and conveniently record programs onto a hard drive built into the set-top box.

 

High definition services.  Time Warner Cable generally offers approximately 15 channels of high definition television, or HDTV, in each of its systems, mainly consisting of broadcast signals and standard and premium cable networks, as well as HDTV Movies-on-Demand in most of the Legacy Systems. HDTV provides a significantly clearer picture and improved audio quality. Due to a number of factors, during the first quarter of 2007, TWC has experienced, and may continue to experience during the near term, difficulty in obtaining sufficient quantities of HDTV-capable set-top boxes to satisfy all consumer requests for them.

 

Interactive services.  TWC’s two-way digital cable infrastructure enables Time Warner Cable to introduce innovative interactive features and services. Such services, which were either offered by Time Warner Cable systems as of December 31, 2006 or are in the process of being tested or rolled out, include Quick Clips, which permits digital subscribers to view on their televisions a variety of news, weather and sports content developed for websites; Instant News & More, which allows customers to gain access to information about the weather, sports, stocks, traffic, and other relevant data on TV; interactive voting and polling, which allows subscribers to participate in live on-screen voting and polling; a sports news alert and eBay tracking and participation via remote control.

 

High-speed Data Services

 

Time Warner Cable offered high-speed data services to nearly 99% of its homes passed as of December 31, 2006. As of December 31, 2006, Time Warner Cable had approximately 6.6 million residential high-speed data subscribers and approximately 245,000 commercial accounts. Residential high-speed data subscribers represent over 30% of service-ready homes passed in the Legacy Systems. Penetration rates are lower in the Acquired Systems. Subscribers pay a monthly flat fee based on the level of service received. Due to their different characteristics, commercial and bulk subscribers are charged at different rates than residential subscribers. High-speed data customers connect their personal computers (PCs) or other broadband-ready devices using a cable modem.

 

Road Runner.  As of December 31, 2006, Time Warner Cable offered its Road Runner branded, high-speed data service to residential subscribers in virtually all Legacy Systems. Time Warner Cable expects to complete a transition to the Road Runner service in the Acquired Systems before the end of 2007.

 

Time Warner Cable Business Class.  Time Warner Cable offers commercial customers a variety of high-speed data services, including Internet access, website hosting and managed security. These services are offered to a broad range of businesses and are marketed under the “Time Warner Cable Business Class” brand. In addition to the residential subscribers and commercial accounts serviced through TWC’s cable systems, Time Warner Cable provides the Road Runner high-speed data service to third parties for a fee.

 

Voice Services

 

Digital Phone.  Digital Phone is the newest of TWC’s core services, having been launched broadly across the Legacy Systems in 2004. With the Digital Phone service, Time Warner Cable can offer customers a combined, easy-to-use package of video, high-speed data and voice services and compete effectively against similarly bundled products offered by competitors. Most customers receive a Digital Phone package that provides unlimited local, in-state and U.S., Canada and Puerto Rico long-distance calling and a number of calling features for a fixed monthly fee. During 2006, Time Warner Cable also introduced, among other things, a lower-priced unlimited in-state only calling plan, and additional calling plans are expected to be introduced in the future.

 

As of December 31, 2006, Digital Phone had been launched in all of Time Warner Cable’s Legacy Systems and was available to nearly 94% of homes passed in such systems. At that time, Time Warner Cable had approximately 1.9 million Digital Phone customers and penetration of voice service to serviceable homes was approximately 11%. TWC has begun and expects to continue rolling out Digital Phone across the Acquired Systems during 2007.

 

As an adjunct to its existing commercial high-speed data business, TWC intends to introduce a commercial voice service to small- and medium-sized businesses in most of its Legacy Systems during 2007.

 

Digital Phone is delivered over the same system facilities used by Time Warner Cable to provide video and high-speed data services. Time Warner Cable provides customers with a voice-enabled cable modem that digitizes voice signals and routes them as data packets, using IP technology, over TWC’s managed broadband cable systems. Calls to destinations outside of TWC’s cable systems are routed through the traditional public switched telephone network. Unlike Internet phone providers, such as Vonage and Lingo, which utilize the Internet to transport telephone calls, TWC’s Digital Phone service uses only TWC’s managed network and the public switched telephone network to route calls, which TWC believes allows it to better monitor and maintain call and service quality.

 

TWC has agreements with Verizon Communications, Inc. and Sprint Nextel Corporation (“Sprint”) under which these companies assist it in providing Digital Phone service, delivering enhanced 911 service and assisting in local number portability and long distance traffic carriage. In July 2006, TWC agreed to expand its multi-year relationship with Sprint as its primary provider of these services, including in the Acquired Systems.

 

Wireless Joint Ventures

 

In November 2005, TWC and several other cable companies, together with Sprint, announced the formation of a joint venture to develop integrated video entertainment, wireline and wireless data and communications products and services. In 2006, TWC began offering a service bundle that includes Sprint wireless voice service in limited operating areas and will continue to roll out this product during 2007. A separate joint venture formed by the same parties participated in the FCC’s Advanced Wireless Spectrum (“AWS”) auction during 2006 and was awarded licenses covering 20 MHz of spectrum in about 90% of the continental U.S. and Hawaii. Under the joint venture agreement, Sprint has the ability to exit the venture upon 60 days’ notice and to require that the venture purchase its interests for an amount equal to Sprint’s capital contributions to that point. In addition, under certain circumstances, the cable operators that are members of the venture have the ability to exit the venture and receive, subject to certain limitations and adjustments, AWS licenses covering their operating areas.

 

Advertising

 

TWC also generates revenue by selling advertising time to a variety of national, regional and local businesses. Cable operators generally receive an allocation of scheduled advertising time on cable programming services into which the operator can insert commercials, generally two minutes per hour. The clustering of TWC’s systems expands the number of viewers that TWC reaches within a local designated market area, which helps local advertising sales personnel to compete more effectively with broadcast and other media. As a result of the Adelphia/Comcast Transactions, TWC has a strong presence in the country’s two largest advertising markets, New York City and Los Angeles. In addition, in many locations contiguous cable system operators have formed advertising interconnects to deliver locally inserted commercials across wider geographic areas, replicating the reach of

broadcast stations as closely as possible. TWC is exploring various means by which it could utilize its advanced services, such as VOD and interactive TV, to increase advertising revenues.

 

Content and Equipment Suppliers

 

Video programming content.  Video programming rights represent a major cost component for TWC. TWC generally obtains the right to carry video programming services through the negotiation of affiliation agreements with programmers, including affiliates of Time Warner . Most programming services impose a monthly license fee per subscriber upon the cable operator which typically increases over time and sometimes includes a volume discount. However, payments to the providers of some premium channels may be based on a percentage of TWC’s gross subscription receipts for the channel. TWC’s programming costs continue to rise, especially for sports programming. (See “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Business Segment Results — Cable” in the financial section of this report.) TWC obtains rights to On-Demand programming from film studios and other distributors and typically pays the provider a portion of any separate fees paid by the customer for the selected On-Demand programming.

 

TWC obtains the right to carry local broadcast television stations either through the stations’ exercise of their so-called “must carry” rights, or through negotiated retransmission consent agreements. See “Regulatory Matters — Communications Act and FCC Regulation — Carriage of Broadcast Television Stations and Other Programming Regulation” below. TWC’s existing programming and retransmission consent agreements expire at various times.

 

TWC also carries the high-definition television signals and other digital signals broadcast by numerous local television stations, including all stations owned and operated by the major broadcast networks and nearly all public television stations, as well as various basic cable and premium networks and certain high-definition sports programming.

 

Pay-Per-View and On-Demand content.  TWC generally obtains rights to carry movies on an on-demand basis, as well as Pay-Per-View events, through iN Demand, a company in which TWC holds a minority interest. iN Demand negotiates with motion picture studios to obtain the relevant distribution rights. Movies-on-Demand content is generally provided to TWC under a revenue-sharing arrangement, although in some cases there are required minimum guaranteed payments. SVOD and other “free on-demand” content is obtained directly from the relevant content providers.

 

Set-top boxes.  TWC currently purchases set-top boxes and CableCARDs^tm (which enable some digital televisions and other devices to receive certain non-interactive digital services without a set-top box) from a limited number of suppliers. TWC leases these set-top boxes and CableCARDs^tm to subscribers at monthly rates. Video equipment fees are regulated by the FCC on a basis tied to capital cost plus a set rate of return. Certain FCC regulations relating to set-top box equipment, which are to come into effect in July 2007, are expected to increase TWC’s set-top box costs. See “Regulatory Matters,” below, for additional information regarding these regulations.

 

Competition

 

TWC faces intense competition from a variety of alternative information and entertainment delivery sources, principally from direct-to-home satellite video providers and certain regional telephone companies, each of which offers or will shortly be able to offer a broad range of services through increasingly varied technologies. In addition, technological advances will likely increase the number of alternatives available to TWC’s customers from other providers and intensify the competitive environment. See “Risk Factors — Risks Related to Cable Competition.”

 

Principal Competitors

 

Direct broadcast satellite.  TWC’s video services face competition from direct broadcast satellite services, such as the Dish Network and DirecTV. DirecTV and Dish Network offer satellite-delivered pre-packaged programming services that can be received by relatively small and inexpensive receiving dishes. The video services provided by these satellite providers are comparable, in many respects, to TWC’s analog and digital video

services, and direct broadcast satellite subscribers can obtain satellite receivers with integrated digital video recorders from those providers as well. Both major direct broadcast satellite providers have entered into co-marketing arrangements with regional telephone companies that allow the telephone companies to offer customers a bundle of video, telephone and DSL services, which competes with TWC’s “Triple Play” of video, high-speed data and Digital Phone services.

 

Incumbent local telephone companies.  TWC’s high-speed data and Digital Phone services face competition from the DSL and traditional phone offerings of incumbent local telephone companies in most TWC operating areas. In some cases, DSL providers have partnered with ISPs such as AOL, which may enhance DSL’s competitive position. In addition, some incumbent local telephone companies, such as AT&T and Verizon, which have grown through consolidation in recent years, have undertaken fiber-optic upgrades of their networks. The technologies they are using, such as fiber-to-the-node (“FTTN”) and fiber-to-the-home (“FTTH”), are capable of carrying two-way video, high-speed data with substantial bandwidth and IP-based telephony services, each of which is similar to the comparable services offered by TWC. These upgraded networks allow for the marketing of service bundles of video, data and voice services plus wireless services provided by the telephone companies’ own or affiliated companies.

 

Cable overbuilds.  TWC operates its cable systems under non-exclusive franchises granted by state or local authorities. The existence of more than one cable system operating in the same territory is referred to as an “overbuild.” In some of TWC’s operating areas, other operators have overbuilt TWC systems and/or offer video, data and voice services in competition with TWC.

 

Satellite Master Antenna Television (“SMATV”).  Additional competition comes from private cable television systems servicing condominiums, apartment complexes and certain other multiple dwelling units, often on an exclusive basis, with local broadcast signals and many of the same satellite-delivered program services offered by franchised cable systems. Some SMATV operators now offer voice and high-speed data services as well.

 

Wireless Cable/Multi-channel Microwave Distribution Services (“MMDS”).  TWC faces competition from wireless cable operators, including digital wireless operators, who use terrestrial microwave technology to distribute video programming and some of which now offer voice and high-speed data services.

 

Other Competition and Competitive Factors

 

In addition to competing with the video, data and voice services offered by direct broadcast satellite providers, local incumbent telephone companies, cable overbuilders and some SMATVs and MMDSs, each of TWC’s services also faces competition from other companies that provide services on a stand-alone basis.

 

Video competition.  TWC’s video services face competition on a stand-alone basis from a number of different sources, including local television broadcast stations that provide free over-the-air programming which can be received using an antenna and a television set; local television broadcasters, which in selected markets sell digital subscription services; and video programming delivered over broadband Internet connections. TWC’s VOD services compete with online movie services, which are delivered over broadband Internet connections, and also video stores and mail-in companies, and home video products.

 

“Online” competition.  TWC’s high-speed data services face or may face competition from a variety of companies that offer other forms of online services, such as low cost dial-up services over ordinary telephone lines, and developing technologies, such as Internet service via power lines, satellite and various wireless services (e.g., Wi-Fi), including those of local municipalities.

 

Digital Phone competition.  TWC’s Digital Phone service also competes with wireless phone providers and national providers of Internet-based phone products such as Vonage. The increase in the number of different technologies capable of carrying voice services has intensified the competitive environment in which TWC’s Digital Phone service operates.

 

FILMED ENTERTAINMENT

 

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

 

Feature Films

 

Warner Bros.

 

Warner Bros. produces feature films both wholly on its own and under co-financing arrangements with others, and also distributes its films and completed films produced by others. The terms of Warner Bros.’ agreements with independent producers and other entities are separately negotiated and vary depending upon the production, the amount and type of financing by Warner Bros., the media and territories covered, the distribution term and other factors. Warner Bros.’ feature films are produced under both the Warner Bros. Pictures and Castle Rock banners, and also by Warner Independent Pictures (“WIP”).

 

Warner Bros.’ strategy focuses on offering a diverse slate of films with a mix of genres, talent and budgets that includes several “event” movies per year. In response to the high cost of producing theatrical films, Warner Bros. has entered into certain film co-financing arrangements with other companies, decreasing its financial risk while in most cases retaining substantially all worldwide distribution rights. During 2006, Warner Bros. released a total of 28 original motion pictures for theatrical exhibition (including WIP releases), including Happy Feet, The Departed and Superman Returns. Of the total 2006 releases, four were wholly financed by Warner Bros. and 24 were financed with or by others.

 

Warner Bros. has co-financing arrangements with Village Roadshow Pictures, Legendary Pictures, LLC and Virtual Studios, LLC. Additionally, Warner Bros. has an exclusive distribution arrangement with Alcon Entertainment for distribution of all of Alcon’s motion pictures in domestic and certain international territories. During 2006, Warner Bros. entered into an exclusive multi-year distribution agreement with Dark Castle Holdings, LLC, under which Warner Bros. will distribute Dark Castle’s next 15 feature films in the U.S. and, generally, in all international territories. Each of these feature films will be 100% financed by Dark Castle.

 

WIP produces or acquires smaller budget and alternative films for domestic and/or worldwide release. WIP released eight films during 2006, including The Painted Veil and A Scanner Darkly.

 

Warner Bros. distributes feature films to more than 125 international territories. In 2006, Warner Bros. released internationally 20 English-language motion pictures and 32 local-language films that it either produced or acquired.

 

New Line Cinema

 

Theatrical films are also produced and distributed by New Line, a leading independent producer and distributor of theatrical motion pictures. Included in its 11 films released during 2006 were Little Children; Texas Chainsaw Massacre, The Beginning and Final Destination 3. During 2005, New Line and Home Box Office formed Picturehouse, a jointly-owned theatrical distribution company, to produce and distribute independent films. This venture released six films in 2006, including the critically acclaimed Pan’s Labyrinth and A Prairie Home Companion. Like Warner Bros., New Line releases a diversified slate of films with an emphasis on building and leveraging franchises. As part of its strategy for reducing financial risk and dealing with the rising cost of film production, New Line typically pre-sells the international rights to its releases on a territory-by-territory basis, while still retaining a share of each film’s potential profitability in those foreign territories. New Line also has entered into a co-financing transaction arranged by The Royal Bank of Scotland which covers approximately two years of its films, beginning in February, 2007.

 

Home Video

 

Warner Home Video, a division of Warner Bros. Home Entertainment Inc. (“WHV”), distributes for home video use DVDs containing filmed entertainment product produced or otherwise acquired by the Company’s various content-producing subsidiaries and divisions, including Warner Bros. Pictures, Warner Bros. Television, Castle Rock, New Line, Home Box Office and Turner Broadcasting System. In addition to the creation of DVDs from new content generated by the Company, WHV produces and distributes DVDs from the Company’s extensive filmed entertainment library of thousands of feature films, television titles and animated titles. WHV also distributes other companies’ product, including DVDs for BBC, National Geographic and national sports leagues in the U.S., and has similar distribution relationships with producers outside the U.S.

 

WHV sells and/or licenses its product in the U.S. and in major international territories to retailers and/or wholesalers through its own sales force, with warehousing and fulfillment handled by third parties. In some countries, WHV’s product is distributed through licensees. WHV distributes packaged media product in the standard-definition DVD format and in the HD DVD and Blu-ray high-definition formats. DVD product is replicated by third parties, with replication for the U.S., Canada, Europe and Mexico provided for under a long-term contract. Significant WHV releases during 2006 include Superman Returns, Harry Potter and the Goblet of Fire and Wedding Crashers.

 

Television

 

Warner Bros. is one of the world’s leading suppliers of television programming, distributing programming in more than 200 foreign territories and in more than 45 languages. Warner Bros. both develops and produces new television series, made-for-television movies, mini-series, reality-based entertainment shows and animation programs and also licenses programming from the Warner Bros. library for exhibition on media all over the world.

 

Warner Bros.’ television programming is primarily produced by Warner Bros. Television, a division of WB Studio Enterprises Inc. (“WBTV”), which produces primetime dramatic and comedy programming for the major networks and for cable; Warner Horizon Television Inc. (“Warner Horizon”), which specializes in unscripted programming for network television as well as scripted and unscripted programming for cable television; and Telepictures Productions Inc. (“Telepictures”), which specializes in reality-based and talk/variety series for the syndication and daytime markets. For the 2006-07 season, WBTV is producing, among others, Gilmore Girls, Smallville and Supernatural for The CW Network and ER, Two and a Half Men, Without a Trace, Cold Case, Studio 60 on the Sunset Strip and The New Adventures of Old Christine for third-party networks. Warner Horizon produces the primetime reality series The Bachelor. Telepictures produces first-run syndication staples such as Extra and the talk shows The Ellen DeGeneres Show and Tyra.

 

Warner Bros. Animation Inc. (“WBAI”) is responsible for the creation, development and production of contemporary animated television programming, original made-for-DVD releases, including the popular Scooby Doo and Tom and Jerry series. WBAI also oversees the creative use of, and production of animated programming based on, classic animated characters from Warner Bros., including Looney Tunes, and from the Hanna-Barbera and DC Comics libraries.

 

Digital Media

 

For online audiences, Telepictures launched TMZ.com, a joint venture with AOL, in December 2005 to create a new ad-supported celebrity and entertainment news destination on the Internet. TMZ.com has become the number-one entertainment news site, according to comScore Media Metrix. Warner Bros. licenses television content to AOL for In2TV.com, a pioneer broadband network launched in March 2006 that streams episodes from classic television series such as Lois and Clark: The New Adventures of Superman and Welcome Back, Kotter in an ad-supported environment on the Internet. The Warner Bros. Television Group (“WBTVG”) recently established a digital production venture, named Studio 2.0, that works with creative talent and advertisers to create original live-action and animated short-form programming for broadband and wireless devices. For the 2006-07 broadcast season, WBTVG entered into digital distribution agreements with the ABC, CBS, NBC and The CW television networks, giving each network the right to offer via video-on-demand or subscription video-on-demand episodes of

certain currently airing television series for a limited time following the initial network broadcast. The agreements grant Warner Bros. permanent download rights once an episode has aired on the network.

 

Warner Bros. Digital Distribution is developing other new business opportunities for the digital delivery of movies and television programming to consumers via online and wireless services, including licensing arrangements with Apple’s iTunes, Wal-Mart, Amazon, Best Buy, Microsoft for Xbox 360, BitTorrent, Inc., AOL, Netflix and arvato mobile in Germany.

 

Other Entertainment Assets

 

Warner Bros. Interactive Entertainment, a division of Warner Bros. Home Entertainment Inc., licenses and produces interactive games for a variety of platforms based on Warner Bros.’ and DC Comics’ properties, as well as original game properties.

 

Warner Bros. Consumer Products Inc. licenses rights in both domestic and international markets to the names, likenesses, images, logos and other representations of characters and copyrighted material from the films and television series produced or distributed by Warner Bros., including the superhero characters of DC Comics, Hanna-Barbera characters, classic films and Looney Tunes.

 

Warner Bros. and CBS each have a 50% interest in The CW Network, a new broadcast network launched at the beginning of the Fall 2006 broadcast season. For additional information, see “Networks,” below.

 

Warner Bros. International Cinemas Inc. holds interests, either wholly owned or through joint ventures, in 84 multi-screen cinema complexes with over 64 screens in Japan, Italy and the U.S.

 

DC Comics, wholly owned by the Company, publishes more than 50 regularly issued comics magazines and graphic novels featuring such popular characters as Superman, Batman, Wonder Woman and The Sandman. DC Comics also derives revenues from motion pictures, television, product licensing and books. The Company also owns E.C. Publications, Inc., the publisher of MAD magazine.

 

Competition

 

The production and distribution of theatrical motion pictures, television and animation product and DVDs are highly competitive businesses, as each vies with the other, as well as with other forms of entertainment and leisure time activities, including video games, the Internet and other computer-related activities for consumers’ attention. Furthermore, there is increased competition in the television industry evidenced by the increasing number and variety of broadcast networks and basic cable and pay television services now available. Despite this increasing variety of networks and services, access to primetime and syndicated television slots has actually tightened as networks and owned and operated stations increasingly source programming from content producers aligned with or owned by their parent companies. There is active competition among all production companies in these industries for the services of producers, directors, writers, actors and others and for the acquisition of literary properties. With respect to the distribution of television product, there is significant competition from independent distributors as well as major studios. Revenues for filmed entertainment product depend in part upon general economic conditions, but the competitive position of a producer or distributor is still greatly affected by the quality of, and public response to, the entertainment product it makes available to the marketplace.

 

Warner Bros. also competes in its character merchandising and other licensing activities with other licensors of character, brand and celebrity names.

 

NETWORKS

 

The Company’s Networks business consists principally of domestic and international basic cable networks and pay television programming services. The basic cable networks (collectively, the “Turner Networks”) owned by Turner Broadcasting System, Inc. (“Turner”) constitute the Company’s basic cable networks. Pay television programming consists of the multichannel HBO and Cinemax pay television programming services (collectively, the “Home Box Office Services”) operated by Home Box Office, Inc.

 

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

 

The Turner Networks generate their revenue principally from the sale of advertising (other than Turner Classic Movies, which sells advertising only in certain European markets) and from receipt of monthly subscriber fees paid by cable system operators, satellite distribution services, hotels and other customers (known as affiliates) that have contracted to receive and distribute such networks. Because it does not carry advertising, Turner Classic Movies generates most of its revenue from the monthly fees paid by affiliates, which are generally charged on a per subscriber basis. The Home Box Office Services generate revenue principally from fees paid by affiliates for the delivery of the Home Box Office Services to subscribers, who are generally free to cancel their subscriptions at any time. Home Box Office’s agreements with its affiliates are typically long-term arrangements that provide for annual service fee increases and retail promotion activities and have fee arrangements that are generally related to the number of subscribers served by the affiliate. The Home Box Office Services and their affiliates engage in ongoing marketing and promotional activities to retain existing subscribers and acquire new subscribers. Home Box Office also derives revenues from its original films and series through the sale of DVDs, as well as, in recent years, from its licensing of original programming in syndication and to basic cable channels.

 

Although the Cable Networks believe prospects of continued carriage and marketing of their respective networks by the larger affiliates are good, the loss of one or more of them as distributors of any individual network or service could have a material adverse effect on their respective businesses. In addition, further consolidation of multiple-system cable operators could adversely impact the Cable Networks’ prospects for securing future carriage agreements on commercially reasonable terms, or at all.

 

Advertising revenues consist of consumer advertising, which is sold primarily on a national basis in the U.S. and on a local-language feed basis outside the U.S. Advertising contracts generally have terms of one year or less. Advertising revenue is generated from a wide variety of categories, including food and beverage, financial and business services, entertainment, pharmaceuticals and medical and automotive. Advertising revenue is a function of the size and demographics of the audience delivered, the “CPM,” which is the cost per thousand viewers delivered, and the number of units of time sold. Units sold and CPMs are influenced by the quantitative and qualitative characteristics of the audience of each network as well as overall advertiser demand in the marketplace.

 

Turner Networks

 

Domestic Networks

 

Turner’s entertainment networks include two general entertainment networks, TBS, with approximately 91.5 million U.S. households as of December 31, 2006, as reported by Nielsen Media Research (“households”); and TNT, with approximately 92.0 million households in the U.S. as of December 31, 2006; as well as Cartoon Network (including Adult Swim, its overnight block of contemporary animation aimed at adults), with approximately 90.9 million households in the U.S. as of December 31, 2006; Turner Classic Movies, a commercial-free network presenting classic films, which had approximately 76.1 million households in the U.S. as of December 31, 2006, and Boomerang, an animation network featuring classic cartoons. Programming for these entertainment networks is derived, in part, from the Company’s film, made-for-television and animation libraries to which Turner or other divisions of the Company own the copyrights, plus licensed programming, including sports, and original films and series. Turner South, a Southeast regional entertainment network, was sold in May 2006.

 

For its sports programming, Turner has licensed programming rights from the National Basketball Association to televise a certain number of regular season and playoff games on TNT through the 2007-08 season and has also secured rights to televise certain NASCAR Nextel Cup races from 2007 through 2014. TBS televises Atlanta Braves baseball games, for which rights fee payments are made to Major League Baseball’s central fund for distribution to all Major League Baseball clubs. Turner has also licensed programming rights from Major League Baseball to televise a certain number of regular season and playoff games on TBS beginning with the 2007 playoffs and continuing through the 2013 season. Through a wholly owned subsidiary, Turner owns the Atlanta Braves of Major League Baseball, but has signed a non-binding letter of intent to sell the team to Liberty Media Corporation and has submitted documents relating to the proposed transfer of the Atlanta Braves franchise to Major League Baseball.

Any sale of a major league baseball team requires the prior approval of the league. For further information regarding the proposed transaction, see “Management’s Discussion and Analysis of Results of Operations and Financial Condition.”

 

Turner’s CNN and Headline News networks, 24-hour per day cable television news services, reached approximately 92.0 million households and 91.3 million households in the U.S., respectively, as of December 31, 2006. Together with CNN International (“CNNI”), CNN reached more than 200 countries and territories as of December 31, 2006. CNN operates 36 news bureaus, of which 10 are located in the U.S. and 26 are located around the world.

 

During 2006, the Company acquired from Liberty Media the remaining 50% interest in Court TV that it did not already own and, as a result, Court TV is now wholly owned by the Company and managed by Turner. Court TV, with approximately 87.5 million households in the U.S. as of December 31, 2006, is an advertiser-supported basic cable television service broadcasting live trial coverage by day and original programs such as Forensic Files and Psychic Detectives and off-network series in the evening.

 

International Networks

 

Entertainment and news networks are distributed via a network of 20 regional satellites to multiple distribution platforms such as cable and IPTV systems, satellite platforms, mobile operators and broadcasters for delivery to hotels and other viewers around the world.

 

The entertainment networks distribute approximately 47 region-specific versions and local-language feeds of Cartoon Network, Boomerang, Turner Classic Movies and TNT in over 167 countries around the world. In the U.K. and Ireland, Turner distributes Toonami, an all-action animation network. In addition, Turner distributes Pogo (an entertainment network for children) in India and certain other South Asian territories.

 

CNN Headline News is distributed in the Asia Pacific region and Latin America; CNN en Español is a separate Spanish language all-news network distributed primarily in Latin America; and CNNj is an all-news network in Japan.

 

In a number of regions, Turner has launched local-language versions of its channels through joint ventures with local partners. These include CNN+, a Spanish language 24-hour news network distributed in Spain and Andorra; CNN Turk, a Turkish language 24-hour news network available in Turkey and the Netherlands; Cartoon Network Japan and Cartoon Network Korea (launched in November 2006), both local-language 24-hour channels for kids; and BOING, an Italian language 24-hour kids animation network. CNN is distributed through CNN-IBN, a co-branded, 24-hour, English-language general news and current affairs channel in India. Turner also has interests in services in China (CETV).

 

Internet Sites

 

In addition to its cable networks, Turner manages various Internet sites that generate revenue from commercial advertising and consumer subscription fees. CNN has multiple sites, including CNN.com and several localized editions that operate in Turner’s international markets. CNN also operates Pipeline, a broadband news service available via subscription in 44 countries. CNN also operates CNNMoney.com in collaboration with Time Inc.’s Money Magazine. Turner also operates the NASCAR website, NASCAR.com, pursuant to an agreement with NASCAR through 2008, with options to extend through 2012, and the PGA’s and PGA Tour’s websites, PGA.com and PGATour.com, respectively, pursuant to agreements with the PGA and the PGA Tour through 2011. Turner operates CartoonNetwork.com, a popular advertiser-supported site in the U.S., as well as 36 international sites affiliated with the regional children’s services feeds. Turner has introduced GameTap, a direct-to-consumer broadband subscription-based gaming service offering access to over 700 classic and contemporary video games. In 2006, Turner launched VeryFunnyAds.com featuring comic TV commercials from around the world, and also ACC Select, a broadband subscription service providing Atlantic Coast Conference basketball games and other college sports.

 

Home Box Office

 

HBO, operated by Home Box Office, Inc., is the nation’s most widely distributed pay television service. Including HBO’s sister service, Cinemax, the Home Box Office Services had approximately 40.5 million subscriptions as of December 31, 2006. Both HBO and Cinemax are made available on a number of multiplex channels and in high definition. Home Box Office also offers subscription video-on-demand products which enable digital cable subscribers who subscribe to the Home Box Office Services to view programs at a time of their choice.

 

A major portion of the programming on HBO and Cinemax consists of recently released, uncut and uncensored theatrical motion pictures. Home Box Office’s practice has been to negotiate licensing agreements of varying duration with major motion picture studios and independent producers and distributors in order to ensure continued access to such films. These agreements typically grant pay television exhibition rights to recently released and certain older films owned by the particular studio, producer or distributor in exchange for negotiated fees, which may be a function of, among other things, the box office performances of the films.

 

HBO is also defined by its award-winning original dramatic and comedy series, movies and mini-series such as The Sopranos, Entourage, Rome, Curb Your Enthusiasm and Elizabeth I, and boxing matches and sports news programs, as well as comedy specials, family programming and documentaries. In 2006, among other awards, HBO won 26 Primetime Emmys^® — the most of any network — as well as seven Sports Emmys^®.

 

HBO also generates revenue from the exploitation of its original programming through multiple distribution outlets. HBO Video markets a variety of HBO’s original programming on DVD. HBO licenses its original series, such as The Sopranos and Sex and the City, to basic cable channels and has licensed Sex and the City in syndication. The Home Box Office-produced show Everybody Loves Raymond, which aired for nine seasons on broadcast television, is currently in syndication as well. Home Box Office has entered into agreements with Cingular Wireless and Vodafone for the distribution of HBO content on their respective domestic and international mobile services. In addition, through various joint ventures, HBO-branded services are distributed in more than 50 countries in Latin America, Asia and Central Europe.

 

The CW Network

 

At the beginning of the Fall 2006 broadcast season, Warner Bros. and CBS launched a new fifth broadcast network, The CW Network. The new broadcast network is a 50-50 joint venture between Warner Bros. and CBS and is being accounted for by the Company as an equity investee. The WB Network, 77.75% owned by a Warner Bros. subsidiary which operated for the past 11 years, ceased operations in conjunction with the launch of the new network and The WB Network’s partnership with Tribune Broadcasting was dissolved.

 

The CW’s scheduling model includes, among other things, a six night-13 hour primetime lineup with programming such as America’s Next Top Model, Gilmore Girls, Everybody Hates Chris, Smallville and 7th Heaven, as well as a five-hour animated programming block of children’s programming on Saturday mornings. The CW is carried nationally by affiliated television stations covering approximately 94% of U.S. television households. Among the affiliates of The CW are 14 stations owned by Tribune and 11 CBS-owned stations.

 

Competition

 

Each of the Networks competes with other television programming services for marketing and distribution by cable and other distribution systems. Each of the Networks also compete for viewers’ attention and audience share with all other forms of programming provided to viewers, including broadcast networks, local over-the-air television stations, other pay and basic cable television services, home video, pay-per-view and video-on-demand services, online activities and other forms of news, information and entertainment. In addition, the Networks face competition for programming from those same commercial television networks, independent stations, and pay and basic cable television services, some of which have exclusive contracts with motion picture studios and independent motion picture distributors. Each of the Turner Networks, The CW Network and Turner’s Internet sites compete for advertising with numerous direct competitors and other media.

 

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

 

PUBLISHING

 

The Company’s magazine publishing business is conducted primarily by Time Inc., a wholly owned subsidiary of the Company, either directly or through its subsidiaries. In addition, Time Inc. operates certain direct-marketing and direct-selling businesses.

 

Magazines

 

As of December 31, 2006, Time Inc. published over 145 magazines worldwide, with over 40 in the U.S. and over 100 in other countries. These magazines generally appeal to the broad consumer market and include People, Sports Illustrated, In Style, Southern Living, Real Simple, Entertainment Weekly, Time, Cooking Light, Fortune and What’s On TV. In addition, Time Inc. websites, such as CNNMoney.com, SI.com and People.com, reached approximately 18 million unique users on average each month in the second half of 2006, according to comScore Media Metrix. Time Inc. reached agreement in January 2007 with a subsidiary of Bonnier AB, a Swedish media company, for the sale of its Time4 Media and Parenting magazine groups, consisting of 18 of Time Inc.’s smaller niche magazines. The sale is expected to close in the first quarter of 2007.

 

Time Inc. expands its magazine businesses generally through the development of product extensions, new magazines and licensed international editions. Product extensions are generally managed by the individual magazines and involve, among other things, new magazines launches, specialized editions aimed at particular audiences, and the development of new editorial content for different media, such as the Internet, books and television. Many of Time Inc.’s magazine brands have developed websites to publish content new to Internet audiences as well as content from the magazines.

 

Description of Magazines

 

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

 

Time Inc.’s major magazines and websites are described below:

 

People is a weekly magazine that reports on celebrities and other newsworthy individuals. People generated approximately 15% of Time Inc.’s revenues in 2006. People has expanded its franchise to include People en Español, a monthly Spanish-language magazine aimed primarily at U.S. Hispanic readers. Who Weekly is an Australian version of People managed by IPC Media, Time Inc.’s consumer magazine publisher in the U.K. People.com is a leading website for celebrity news, photos and entertainment coverage.

 

Sports Illustrated is a weekly magazine that covers sports. Sports Illustrated for Kids is a monthly sports magazine intended primarily for pre-teenagers. Golf, a leading monthly golf title, is managed by the Sports Illustrated group. SI.com is a news website that provides up-to-the-minute scores and sports news 24/7, as well as statistics and analysis of domestic and international professional sports, and also college and high school sports.

 

In Style is a monthly magazine and InStyle.com is a website focusing on celebrity, lifestyle, beauty and fashion. Time Inc. also publishes In Style in Australia, the U.K. and Mexico through wholly owned subsidiaries.

 

Real Simple is a monthly magazine that focuses on life, home, body and soul and provides practical solutions for simplifying various aspects of busy lives. In addition, Real Simple launched a weekly television series on PBS in 2006.

 

Entertainment Weekly is a weekly magazine, and its related EW.com is a daily news website, that feature reviews and reports on movies, DVDs, video, television, music and books.

 

Time is a weekly newsmagazine that summarizes the news and interprets the week’s events, both national and international. Time also has four weekly English-language editions that circulate outside the United States. Time for Kids is a weekly current events newsmagazine for children, ages 5 to 13. TIME.com provides breaking news and analysis, giving its readers access to its 24-hour global news gathering operation and its vast archive.

 

Fortune is a bi-weekly magazine that reports on worldwide economic and business developments and compiles the annual Fortune 500 list of the largest U.S. corporations. Other business and financial magazines include Money, a monthly magazine that reports primarily on personal finance, FSB: Fortune Small Business, a monthly magazine that covers small business and is published under an agreement with American Express Publishing Corporation, and Business 2.0, a monthly magazine that reports on innovation in the worlds of business and technology. All of these magazines combine their resources on the CNNMoney.com website, a joint venture with CNN.

 

IPC Media, the U.K.’s leading consumer magazine publisher, publishes over 80 magazines as well as numerous special issues and guides in the U.K. and Australia. These publications are largely focused in the television listings, women’s lifestyle, celebrity, home and garden, leisure, music and men’s lifestyle sectors. IPC’s magazines include What’s On TV and TV Times in the television listings sector, Chat, Woman and Woman’s Own in the women’s lifestyle sector, Now in the celebrity sector, Woman & Home and Ideal Home in the home and garden sector, Country Life and Horse & Hound in the leisure sector, NME in the music sector and Nuts and Loaded in the men’s lifestyle sector. In addition, IPC publishes four magazines through three unconsolidated joint ventures with Groupe Marie Claire.

 

Southern Progress Corporation publishes seven monthly magazines, including the regional lifestyle magazines Southern Living and Sunset, the epicurean magazine Cooking Light and the women’s fitness magazine Health.

 

This Old House publishes This Old House magazine and produces two television series, This Old House and Ask This Old House.

 

Essence Communications Inc. publishes Essence magazine and produces the annual Essence Music Festival.

 

Grupo Editorial Expansión (“GEE”) publishes 14 consumer and business magazines in Mexico including Expansión, a business magazine; Quién, a celebrity and personality magazine; Obras, an architecture, construction and engineering magazine; Life and Style, a men’s lifestyle magazine; and Balance, a fitness, health and nutrition magazine for women. In addition, GEE publishes two magazines through an unconsolidated joint venture with Hachette Filipacchi Presse S.A.

 

In addition, Time Inc. licenses over 20 editions of its magazines for publication outside the U.S. to publishers in over 10 countries.

 

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

 

Advertising

 

Advertising carried in Time Inc.’s U.S. magazines is predominantly consumer advertising, including toiletries and cosmetics, food, domestic and foreign automobiles, pharmaceuticals, retail and department stores, media and movies, direct response, financial services, apparel and computers and technology. In 2006, Time Inc. magazines accounted for 22.6% (compared to 23.4% in 2005) of the total U.S. advertising revenue in consumer magazines, excluding Life and other newspaper supplements, as measured by the Publishers Information Bureau (PIB). People, Time and Sports Illustrated were ranked 1, 3 and 4, respectively, by PIB revenue in 2006, and Time Inc. had 7 of the 25 leading magazines in terms of advertising dollars.

 

Circulation

 

Through the sale of magazines to consumers, circulation generates significant revenues for Time Inc. In addition, circulation is an important component in determining Time Inc.’s print advertising revenues because advertising page rates are based on circulation and readership. Most of Time Inc.’s U.S. magazines are sold primarily by subscription and delivered to subscribers through the mail. Subscriptions are sold primarily through

direct mail and online solicitation, subscription sales agents, marketing agreements with other companies and insert cards in Time Inc. magazines and other publications. Most of Time Inc.’s international magazines are sold primarily at newsstand.

 

Time Inc. owns 100% of Synapse Group, Inc. (“Synapse”), a leading seller of magazine subscriptions to Time Inc. magazines and magazines of other publishers in the U.S., having acquired in April 2006 the remaining 8% of Synapse that it did not already own. Synapse sells magazine subscriptions principally through marketing relationships with credit card issuers, consumer catalog companies, commercial airlines with frequent flier programs, retailers and Internet businesses.

 

Newsstand sales of magazines, which are reported as a component of Subscription revenues, are sold through traditional newsstands as well as other retail outlets such as Wal-Mart, supermarkets and convenience and drug stores, and may or may not result in repeat purchases. Time/Warner Retail Sales & Marketing Inc. distributes and markets copies of Time Inc. magazines and books and certain other publishers’ magazines and books through third-party wholesalers primarily in the U.S. and Canada. Wholesalers, in turn, sell Time Inc. magazines to retailers. Marketforce (UK) Ltd distributes and markets copies of all IPC magazines, some international Time Inc. editions and certain other publishers’ magazines outside of the U.S. and Canada through third-party wholesalers to retail outlets.

 

Paper and Printing

 

Paper constitutes a significant component of physical costs in the production of magazines. During 2006, Time Inc. purchased over half a million tons of paper principally from four independent manufacturers.

 

Printing and binding for Time Inc. magazines are performed primarily by major domestic and international independent printing concerns in multiple locations in the U.S. and in nine other countries. Magazine printing contracts are typically fixed-term at fixed prices with, in some cases, adjustments based on inflation.

 

Books, Direct Marketing and Selling

 

Through subsidiaries, Time Inc. conducts direct-marketing and direct-selling businesses as well as certain niche book publishing. In addition to selling magazine subscriptions, Synapse is a direct marketer of consumer products, including jewelry and other merchandise.

 

The Company’s book publishing business consists of Oxmoor House, Leisure Arts and Sunset Books, which are operated by Southern Progress Corporation and publish how-to, lifestyle and special commemorative books. During 2006, the Company completed the sale of the trade book publishing operations conducted by the Time Warner Book Group Inc. to Hachette for $524 million.

 

Southern Living At Home, the direct selling division of Southern Progress Corporation, specializes in home décor products that are sold in the U.S. through more than 35,000 independent consultants at parties hosted in people’s homes.

 

Book-of-the-Month Club, Inc. (“BOMC”) has a 50-50 joint venture with Bertelsmann’s Doubleday Direct, Inc. to operate the U.S. book clubs of BOMC and Doubleday jointly. The joint venture, named Bookspan, acquires the rights to manufacture and sell books to consumers through clubs. Bookspan operates its own fulfillment and warehousing operations in Pennsylvania. Under the relevant agreements, commencing in January of each year either Bertelsmann or the Company may elect to terminate the venture by giving notice during specified termination periods. If such an election is made by either party, a confidential bid process will take place pursuant to which the highest bidder will purchase the other party’s entire venture interest.

 

Postal Rates

 

Postal costs represent a significant operating expense for the Company’s magazine publishing and direct-marketing activities. In 2006, the Company spent over $350 million for services provided by the U.S. Postal Service. The U.S. Postal Service implemented a postal rate increase of 5.4% effective January 8, 2006 and has

proposed an additional increase of approximately 10% effective May 6, 2007, which is currently being challenged before the Postal Rate Commission. These increased costs are not directly passed on to magazine subscribers. Time Inc. strives to minimize postal expense through the use of certain cost-saving activities with respect to address quality, mail preparation and delivery of products to postal facilities.

 

Competition

 

Time Inc. faces significant competition from several direct competitors and other media, including the Internet. Time Inc.’s magazine operations compete for circulation and audience with numerous other magazine publishers and other media. Time Inc.’s magazine operations also compete with other magazine publishers and other media for advertising directed at the general public and at more focused demographic groups. The magazine publishing business presents few barriers to entry and many new magazines are launched annually. In recent years, competitors launched and/or repositioned many magazines, primarily in the celebrity and women’s service sectors, that compete directly with People, In Style, Real Simple and other Time Inc. magazines, particularly at newsstand checkouts in mass-market retailers. Time Inc. anticipates that it will face continuing competition from these new competitors and additional competitors may enter the magazine business and further intensify competition.

 

Time Inc.’s direct-marketing operations compete with other direct marketers through all media, including the Internet, for the consumer’s attention.

 

INTELLECTUAL PROPERTY

 

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

 

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

 

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

Company therefore engages in efforts to strengthen and update intellectual property protection around the world, including efforts to ensure effective and appropriately tailored remedies for infringement.

 

REGULATORY MATTERS

 

The Company’s cable system, cable and broadcast television network, original programming and Internet businesses are subject, in part, to regulation by the Federal Communications Commission (“FCC”), and the cable system business is also subject to regulation by most local and some state governments where the Company has cable systems. In addition, the Company’s cable business is subject to compliance with the terms of the Memorandum Opinion and Order issued by the FCC in July 2006 in connection with the regulatory clearance of the Adelphia/Comcast Transactions (the “Adelphia/Comcast Transactions Order”). The Company’s magazine and other direct marketing activities are also subject to regulation.

 

The following is a summary of the terms of these orders as well as current significant federal, state and local laws and regulations affecting the growth and operation of these businesses. In addition, various legislative and regulatory proposals under consideration from time to time by Congress and various federal agencies have in the past materially affected, and may in the future materially affect, the Company.

 

Cable System Regulation

 

Adelphia/Comcast Transactions Order

 

In the Adelphia/Comcast Transactions Order, the FCC imposed conditions on TWC related to regional sports networks (“RSNs”), as defined in the Adelphia/Comcast Transactions Order, and the resolution of disputes pursuant to the FCC’s leased access regulations. In particular, the Adelphia/Comcast Transactions Order provides that (i) neither TWC nor its affiliates may offer an affiliated RSN on an exclusive basis to any multichannel video programming distributor (“MVPD”); (ii) TWC may not unduly or improperly influence the decision of any affiliated RSN to sell programming to an unaffiliated MVPD; or the prices, terms and conditions of sale of programming by an affiliated RSN to an unaffiliated MVPD; (iii) if an MVPD and an affiliated RSN cannot reach an agreement on the terms and conditions of carriage, the MVPD may elect commercial arbitration to resolve the dispute; (iv) if an unaffiliated RSN is denied carriage by TWC, it may elect commercial arbitration to resolve the dispute in accordance with federal and FCC rules; and (v) with respect to leased access, if an unaffiliated programmer is unable to reach an agreement with TWC, that programmer may elect commercial arbitration to resolve the dispute, with the arbitrator being required to resolve the dispute using the FCC’s existing rate formula relating to pricing terms.

 

The application and scope of these conditions, which will expire in July 2012, have not yet been tested. TWC has the right to obtain FCC and judicial review of any arbitration awards made pursuant to these conditions.

 

Communications Act and FCC Regulation

 

The Communications Act and the regulations and policies of the FCC affect significant aspects of TWC’s cable system operations, including video subscriber rates; carriage of broadcast television stations, as well as the way TWC sells its program packages to subscribers; the use of cable systems by franchising authorities and other third parties; cable system ownership; offering of voice and high-speed data services; and the use of utility poles and conduits.

 

“Net Neutrality” Legislative and Regulatory Proposals.  In the 109th Congress (2005-2006), several net neutrality provisions were introduced as part of broader Communications Act reform legislation. These provisions would have limited to a greater or lesser extent the ability of broadband providers to adopt pricing models and network management policies that would differentiate based on different uses of the Internet. None of these provisions have been adopted. Similar legislation has been introduced in the 110th Congress (2007 — 2008).

 

In September 2005, the FCC issued a non-binding policy statement regarding “net neutrality” setting forth the FCC’s view that consumers are entitled to access and use the lawful Internet content and applications of their

choice, to connect lawful devices of their choosing that do not harm the broadband provider’s network and are entitled to competition among network, application, service and content providers. Although the FCC has made these principles binding as to certain telecommunications companies in orders adopted in connection with mergers undertaken by those companies, to date, the FCC has declined to adopt any such regulations that would be applicable to TWC.

 

Several parties are seeking to persuade the FCC to adopt “net neutrality” in a number of proceedings that are currently pending before the agency. These include pending FCC rulemakings regarding IP-enabled services and broadband Internet access services.

 

Subscriber Rates.  The Communications Act and the FCC’s rules regulate rates for basic cable service and equipment in communities that are not subject to “effective competition,” as defined by federal law. Where there is no effective competition, federal law authorizes franchising authorities to regulate the monthly rates charged by the operator for the minimum level of video programming service, referred to as basic service, which generally includes local broadcast channels and public access or educational and government channels required by the franchise. This kind of regulation also applies to the installation, sale and lease of equipment used by subscribers to receive basic service, such as set-top boxes and remote control units. In many localities, TWC is no longer subject to this rate regulation, either because the local franchising authority has not become certified by the FCC to regulate these rates or because the FCC has found that there is effective competition.

 

Carriage of Broadcast Television Stations and Other Programming Regulation.  The Communications Act and the FCC’s regulations contain broadcast signal carriage requirements that allow local commercial television broadcast stations to elect once every three years to require a cable system to carry their stations, subject to some exceptions, or to negotiate with cable systems the terms by which the cable systems may carry their stations, commonly called “retransmission consent.” The most recent election by broadcasters became effective on January 1, 2006.

 

The Communications Act and the FCC’s regulations require a cable operator to devote up to one-third of its activated channel capacity for the mandatory carriage of local commercial television stations. The Communications Act and the FCC’s regulations give local non-commercial television stations mandatory carriage rights, but non-commercial stations do not have the option to negotiate retransmission consent for the carriage of their signals by cable systems. Additionally, cable systems must obtain retransmission consent for all “distant” commercial television stations (i.e., those television stations outside the designated market area to which a community is assigned) except for commercial satellite-delivered independent “superstations” and some low-power television stations.

 

FCC regulations require TWC to carry the signals of both commercial and non-commercial local digital-only broadcast stations and the digital signals of local broadcast stations that return their analog spectrum to the government and convert to a digital broadcast format. The FCC’s rules give digital-only broadcast stations discretion to elect whether the operator will carry the station’s primary signal in a digital or converted analog format, and the rules also permit broadcasters with both analog and digital signals to tie the carriage of their digital signals to the carriage of their analog signals as a retransmission consent condition.

 

The Communications Act also permits franchising authorities to negotiate with cable operators for channels for public, educational and governmental access programming. It also requires a cable system with 36 or more activated channels to designate a significant portion of its channel capacity for commercial leased access by third parties to provide programming that may compete with services offered by the cable operator. The FCC regulates various aspects of such third-party commercial use of channel capacity on TWC’s cable systems, including the rates and some terms and conditions of the commercial use.

 

In connection with certain changes in TWC’s programming line-up, the Communications Act and FCC regulations also require TWC to give various kinds of advance notice. Direct broadcast satellite operators and other non-cable programming distributors are not subject to analogous duties.

 

High-Speed Internet Access.  From time to time, industry groups, telephone companies and ISPs have sought local, state and federal regulations that would require cable operators to sell capacity on their systems to ISPs under a common carrier regulatory scheme. Cable operators have successfully challenged regulations requiring this

“forced access,” although courts that have considered these cases have employed varying legal rationales in rejecting these regulations.

 

In 2002, the FCC released an order in which it determined that cable-modem service constitutes an “information service” rather than a “cable service” or a “telecommunications service,” as those terms are used in the Communications Act, and that determination was sustained by the U.S. Supreme Court. According to the FCC, an “information service” classification may permit but does not require it to impose “multiple ISP” requirements. In 2002, the FCC initiated a rulemaking proceeding to consider whether it may and should do so and whether local franchising authorities should be permitted to do so. As of February 1, 2007, this rulemaking proceeding was still pending. In 2005, the FCC adopted a Policy Statement intended to offer guidance on its approach to the Internet and broadband access. Among other things, the Policy Statement stated that consumers are entitled to competition among network, service and content providers, and to access the lawful content and services of their choice, subject to the needs of law enforcement. The FCC may in the future adopt specific regulations to implement the Policy Statement.

 

Ownership Limitations.  There are various rules prohibiting joint ownership of cable systems and other kinds of communications facilities. Local telephone companies generally may not acquire more than a small equity interest in an existing cable system in the telephone company’s service area, and cable operators generally may not acquire more than a small equity interest in a local telephone company providing service within the cable operator’s franchise area. In addition, cable operators may not have more than a small interest in MMDS facilities or SMATV systems in their service areas. Finally, the FCC has been exploring whether it should prohibit cable operators from holding ownership interests in satellite operators.

 

The Communications Act also required the FCC to adopt “reasonable limits” on the number of subscribers a cable operator may reach through systems in which it holds an ownership interest. In September 1993, the FCC adopted a rule that was later amended to prohibit any cable operator from serving more than 30% of all cable, satellite and other multi-channel subscribers nationwide. The Communications Act also required the FCC to adopt “reasonable limits” on the number of channels that cable operators may fill with programming services in which they hold an ownership interest. In September 1993, the FCC imposed a limit of 40% of a cable operator’s first 75 activated channels. In March 2001, a federal appeals court struck down both limits and remanded the issue to the FCC for further review. The FCC initiated a rulemaking in 2001 to consider adopting a new horizontal ownership limit and announced a follow-on proceeding to consider the issue anew. As of February 1, 2007, the FCC was continuing to explore whether it should re-impose any limits. The Company believes that it is unlikely that the FCC will adopt limits more stringent than those struck down.

 

Pole Attachment Regulation.  The Communications Act requires that utilities provide cable systems and telecommunications carriers with nondiscriminatory access to any pole, conduit or right-of-way controlled by investor-owned utilities. The Communications Act also requires the FCC to regulate the rates, terms and conditions imposed by these utilities for cable systems’ use of utility pole and conduit space unless state authorities demonstrate to the FCC that they adequately regulate pole attachment rates, as is the case in some states in which TWC operates. In the absence of state regulation, the FCC administers pole attachment rates on a formula basis. The FCC’s original rate formula governs the maximum rate utilities may charge for attachments to their poles and conduit by cable operators providing cable services. The FCC also adopted a second rate formula that became effective in February 2001 and governs the maximum rate investor-owned utilities may charge for attachments to their poles and conduit by companies providing telecommunications services. The U.S. Supreme Court has upheld the FCC’s jurisdiction to regulate the rates, terms and conditions of cable operators’ pole attachments that are being used to provide both cable service and high-speed data service.

 

Set-Top Box Regulation.  Certain regulatory requirements are also applicable to set-top boxes. Currently, many cable subscribers rent from their cable operator a set-top box that performs both signal-reception functions and conditional-access security functions. The lease rates cable operators charge for this equipment are subject to rate regulation to the same extent as basic cable service. In 1996, Congress enacted a statute seeking to allow subscribers to use set-top boxes obtained from third-party retailers. The most important of the FCC’s implementing regulations requires cable operators to offer separate equipment providing only the security function (so that subscribers can purchase set-top boxes or other navigational devices from other sources) and to cease placing into

service new set-top boxes that have integrated security. The regulations requiring cable operators to cease distributing new set-top boxes with integrated security are currently scheduled to go into effect on July 1, 2007. TWC expects to incur approximately $50 million in incremental set-top box costs during 2007 as a result of these regulations. In addition, the FCC ordered the cable industry to investigate and report on the possibility of implementing a downloadable security system that would be accessible to all set-top devices. If the implementation of such a system proves technologically feasible, this may eliminate the need for consumers to lease separate conditional-access security devices. On August 16, 2006, the National Cable and Telecommunications Association (“NCTA”) filed with the FCC a request that these rules be waived for all cable operators, including Time Warner Cable, until a downloadable security solution is available or December 31, 2009, whichever is earlier. As of February 1, 2007, this request was still pending. No assurance can be given that the FCC will grant this or any other waiver request.

 

In December 2002, cable operators and consumer-electronics companies entered into a standard-setting agreement relating to reception equipment which uses a conditional-access security card — a Cable-CARD^tm — provided by the cable operator to receive one-way cable services. To implement the agreement, the FCC adopted regulations that (i) establish a voluntary labeling system for such one way devices, (ii) require most cable systems to support these devices, and (iii) adopt various content-encoding rules, including a ban on the use of “selectable output controls.” The FCC has issued a notice of proposed rulemaking to consider additional changes. Cable operators, consumer-electronics companies and other market participants are holding discussions that may lead to a similar set of interoperability agreements covering digital devices capable of carrying cable operators’ two-way and interactive products.

 

Other Regulatory Requirements of the Communications Act and the FCC.  The Communications Act also includes provisions regulating customer service, inside wiring in residences and other buildings, subscriber privacy, marketing practices, equal employment opportunity, technical standards and equipment compatibility, antenna structure notification, marking, lighting, emergency alert system requirements and the collection from cable operators of annual regulatory fees, which are calculated based on the number of subscribers served and the types of FCC licenses held.

 

Compulsory Copyright Licenses for Carriage of Broadcast Stations and Music Performance Licenses.  TWC’s cable systems provide subscribers with, among other things, local and distant television broadcast stations. TWC generally does not obtain a license to use the copyrighted performances contained in these stations’ programming directly from program owners. Instead, it obtains this license pursuant to a compulsory license provided by federal law which requires TWC to make payments to a copyright pool. The elimination or substantial modification of the cable compulsory license could adversely affect TWC’s ability to obtain suitable programming and could substantially increase the cost of programming that is available for distribution to TWC subscribers.

 

State and Local Regulation

 

Cable operators operate their systems under non-exclusive franchises. Franchises are awarded, and cable operators are regulated, by state franchising authorities, local franchising authorities, or both. TWC believes it generally has good relations with state and local cable regulators.

 

Franchise agreements typically require payment of franchise fees and contain regulatory provisions addressing, among other things, upgrades, service quality, cable service to schools and other public institutions, insurance and indemnity bonds. The terms and conditions of cable franchises vary from jurisdiction to jurisdiction. The Communications Act provides protections against many unreasonable terms. In particular, the Communications Act imposes a ceiling on franchise fees of five percent of revenues derived from cable service. TWC generally passes the franchise fee on to its subscribers, listing it as a separate item on the bill.

 

Franchise agreements usually have a term of ten to 15 years from the date of grant, although some renewals may be for shorter terms. Franchises usually are terminable only if the cable operator fails to comply with material provisions. TWC has not had a franchise terminated due to breach. After a franchise agreement expires, a local franchising authority may seek to impose new and more onerous requirements, including requirements to upgrade facilities, to increase channel capacity and to provide various new services. Federal law, however, provides significant substantive and procedural protections for cable operators seeking renewal of their franchises. In

addition, although TWC occasionally reaches the expiration date of a franchise agreement without having a written renewal or extension, it generally has the right to continue to operate, either by agreement with the local franchising authority or by law, while continuing to negotiate a renewal. In the past, substantially all of the material franchises relating to TWC’s systems have been renewed by the relevant local franchising authority, though sometimes only after significant time and effort. During 2006, in adopting new regulations intended to limit the ability of local franchising authorities to delay or refuse the grant of competitive franchises (by, for example, imposing deadlines on franchise negotiations), the FCC announced the adoption of a Further Notice of Proposed Rulemaking that concluded tentatively that these new regulations should also apply to existing franchises, including cable operators, at the time of their next franchise renewal. The FCC indicated it would issue an order in the Further Notice of Proposed Rulemaking within six months from release of the final order adopting the new regulations applicable to new entrants. Despite TWC’s efforts and the protections of federal law, it is possible that some of TWC’s franchises may not be renewed, and TWC may be required to make significant additional investments in its cable systems in response to requirements imposed in the course of the franchise renewal process.

 

Regulation of Telephony

 

As of February 1, 2007 it was unclear whether and to what extent regulators will subject services like TWC’s Digital Phone service (“Non-traditional Voice Services”) to the regulations that apply to traditional circuit switched telephone service provided by incumbent telephone companies. In February 2004, the FCC opened a broad-based rulemaking proceeding to consider these and other issues. That rulemaking remains pending. In November 2004, the FCC issued an order preempting state certification and tariffing requirements for certain kinds of Non-traditional Voice Services. The validity of this order has been appealed to a federal appellate court where, as of February 20, 2007, a decision was still pending. The FCC has, however, issued a series of orders resolving discrete issues. For example, in May 2005, the FCC adopted rules requiring Non-traditional Voice Service providers to supply E911 capabilities as a standard feature to their subscribers and to obtain affirmative acknowledgement from all subscribers that they have been advised of the circumstances under which E911 service may not be available. In August 2005, the FCC adopted an order requiring certain types of Non-traditional Voice Services, as well as facilities-based broadband Internet access service providers, to assist law enforcement investigations through compliance with the Communications Assistance For Law Enforcement Act. In June 2006, the FCC adopted an order making clear that Non-traditional Voice Service providers must make contributions to the federal universal service fund. Certain other issues remain unclear, however, including whether the state and federal rules that apply to traditional circuit switched telephone service also apply to Non-traditional Voice Service providers and whether utility pole owners may charge cable operators offering Non-traditional Voice Services higher rates for pole rental than for traditional cable service and cable-modem service. One state public utility commission, for example, has determined that TWC’s Digital Phone service is subject to traditional state circuit switched telephone regulations.

 

Expiration of Turner Consent Decree

 

In connection with the FTC’s approval of the 1996 acquisition of Turner by the former Time Warner Inc., the Company has been subject to the terms of a consent decree (the “Turner Consent Decree”) which, among other things, imposed certain carriage commitments on TWC and certain restrictions which prohibited the Company from conditioning the offering of certain Turner Networks or the HBO service to competing distributors on certain anti-competitive terms. The Turner Consent Decree expired on February 10, 2007.

 

Network Regulation

 

Under the Communications Act and its implementing regulations, vertically integrated cable programmers like the Turner Networks and the Home Box Office Services are generally prohibited from offering different prices, terms, or conditions to competing unaffiliated multichannel video programming distributors unless the differential is justified by certain permissible factors set forth in the FCC’s program access regulations. The rules also place restrictions on the ability of vertically integrated programmers to enter into exclusive distribution arrangements with cable operators. On January 18, 2007, online video provider VDC Corporation (“VDC”) filed a program access complaint with the FCC against Turner, also naming TWC and Time Warner in the proceeding. VDC seeks both a

licensing agreement for the carriage of various Turner networks, as well as damages not to exceed $25 million. This complaint raises issues of first impression at the FCC, including whether online providers such as VDC are entitled to take advantage of the program access rules. Turner believes VDC’s arguments are without merit, and has requested dismissal of the complaint. As of February 20, 2007, this matter was still pending before the FCC.

 

Certain other federal laws also contain provisions relating to violent and sexually explicit programming, including provisions relating to the voluntary promulgation of ratings by the industry and requiring manufacturers to build television sets with the capability of blocking certain coded programming (the so-called “V-chip”). Cable networks with programming produced and broadcast primarily for an audience of children 12 and younger must also comply with commercial time limits during such programming.

 

Marketing Regulation

 

Time Inc.’s magazine and book marketing activities, as well as marketing and billing activities by AOL and other divisions of the Company, are subject to regulation by the FTC and each of the state Attorneys General under general consumer protection statutes prohibiting unfair or deceptive acts or practices. Certain areas of marketing activity are also subject to specific federal statutes and rules, such as the Telephone Consumer Protection Act, the Children’s Online Privacy Protection Act, the Gramm-Leach-Bliley Act (relating to financial privacy), the FTC Mail or Telephone Order Merchandise Rule and the FTC Telemarketing Sales Rule. There are also certain other statutes and rules that regulate conduct in areas such as privacy, data security and telemarketing. In addition, Time Inc. regularly receives and resolves routine inquiries from state Attorneys General and is subject to agreements with state Attorneys General addressing some of Time Inc.’s marketing activities. Also, Time Inc. has pending with the FTC a response to a Civil Investigative Demand relating to Time Inc.’s retail subscription sales partnership with Best Buy.

 

AOL is subject to certain consent orders and assurances of voluntary compliance or discontinuance reached with federal and state regulators. In 1998, AOL entered into an FTC Consent Decree regarding service access, billing authorization and disclosures. In 2004, AOL entered into a Consent Decree with the FTC related to the company’s retention and rebate practices. AOL has also entered into a series of settlements with State Attorneys General. In 2007, AOL entered into an Assurance of Voluntary Compliance (“AVC”) with the State of Florida under which it undertook an obligation to maintain various safeguards that it had previously implemented (and to develop and implement several new disclosure, confirmation and call recordation processes) around certain registration, marketing and retention processes. In 2005, AOL entered into an Assurance of Discontinuance with the State of New York under which it agreed to implement two safeguards around its retention process (third-party verification, which AOL had been testing prior to the investigation, and a change to retention compensation practices). In 1998, AOL entered into a multi-state AVC regarding free trial offers, changes to its Terms of Services, immaterial marketing, cancellation policies and procedures, and premium services. In 1996 and 1997, AOL entered into multi-state AVCs regarding changes in its service offering from metered to unlimited access. AOL from time to time also is subject to investigations by various state regulators regarding consumer protection issues related to marketing and billing matters.

 

DESCRIPTION OF CERTAIN PROVISIONS OF AGREEMENTS
RELATED TO TIME WARNER CABLE INC.

 

Background

 

Time Warner Cable Inc. (“TWC”) was created in connection with the March 31, 2003 restructuring (the “TWE Restructuring”) of Time Warner Entertainment Company, L.P. (“TWE”), a limited partnership which formerly held a substantial portion of Time Warner’s filmed entertainment, networks and cable system assets.

 

Among other things, as a result of the TWE Restructuring, all of Time Warner’s cable system assets, including those that were wholly owned by Time Warner and those that were held through TWE, became controlled by TWC. As part of the TWE Restructuring, Time Warner received a 79% economic interest in the cable systems of TWC and TWE, the non-cable system assets of TWE were distributed to Time Warner, and TWE, which continued to own cable systems, became a subsidiary of TWC. Comcast, which prior to the TWE Restructuring had a 27.64% stake in

TWE, following the TWE Restructuring held 17.9% of TWC’s common stock and a 4.7% limited partnership interest in TWE.

 

In connection with the closing on July 31, 2006 of the Adelphia acquisition (the “Adelphia Acquisition”), TW NY paid for the Adelphia assets acquired by it with both cash and shares of TWC’s Class A Common Stock representing approximately 16% of TWC’s outstanding common stock. Immediately prior to the Adelphia Acquisition, through a series of other transactions TWC and TWE redeemed Comcast’s interests in TWC and TWE and, as a result of these events, Comcast no longer has an interest in either TWC or TWE. Adelphia has begun distributing the shares it acquired in the Adelphia Acquisition to its creditors pursuant to a Chapter 11 bankruptcy plan, which became effective on February 13, 2007. On the same day that the Chapter 11 plan became effective, under applicable securities law regulations and provisions of the U.S. bankruptcy code, TWC became a public company subject to the requirements of the Securities Exchange Act of 1934. It is expected that the TWC Class A Common Stock will begin to trade on the NYSE on or about March 1, 2007.

 

Time Warner owns approximately 84% of TWC’s common stock (including approximately 83% of the outstanding TWC Class A Common Stock and all outstanding shares of TWC Class B Common Stock), and also owns an indirect 12.4% non-voting interest in TW NY.

 

Management and Operation of TWC

 

The following description summarizes certain provisions of agreements related to, and constituent documents of, TWC that affect and govern the ongoing operations of TWC. Such description does not purport to be complete and is qualified in its entirety by reference to the provisions of such agreements and constituent documents.

 

Stockholders of TWC.  A subsidiary of Time Warner owns 746,000,000 shares of TWC Class A Common Stock, which generally has one vote per share, and 75,000,000 shares of TWC Class B Common Stock, which generally has ten votes per share, which together represent 90.6% of the voting power of TWC stock and approximately 84% of the equity of TWC. The TWC Class B Common Stock is not convertible into TWC Class A Common Stock. The TWC Class A Common Stock and the TWC Class B Common Stock vote together as a single class on all matters, except with respect to the election of directors and certain matters described below.

 

Board of Directors of TWC.  The TWC Class A Common Stock votes as a separate class with respect to the election of the Class A directors of TWC (the “Class A Directors”), and the TWC Class B Common Stock votes as a separate class with respect to the election of the Class B directors of TWC (the “Class B Directors”). Pursuant to the amended and restated certificate of incorporation of TWC (the “TWC Certificate of Incorporation”), which was adopted upon the closing of the Adelphia Acquisition, the Class A Directors must represent not less than one-sixth and not more than one-fifth of the directors of TWC, and the Class B Directors must represent not less than four-fifths of the directors of TWC. As a result of its holdings, Time Warner has the ability to cause the election of all Class A Directors and Class B Directors, subject to certain restrictions on the identity of these directors discussed below.

 

The TWC Certificate of Incorporation requires that there be at least two independent directors on the board of directors of TWC. Pursuant to a shareholder agreement between TWC and Time Warner (the “Shareholder Agreement”), so long as Time Warner has the power to elect a majority of TWC’s board of directors, TWC must obtain Time Warner’s consent before entering into any agreement that binds or purports to bind Time Warner or its affiliates or that would subject TWC or its subsidiaries to significant penalties or restrictions as a result of any action or omission of Time Warner or its affiliates; or adopting a stockholder rights plan, becoming subject to section 203 of the Delaware General Corporation Law, adopting a “fair price” provision in its certificate of incorporation or taking any similar action.

 

Furthermore, pursuant to the Shareholder Agreement, Time Warner may purchase debt securities issued by TWE under the TWE Indenture only after giving notice to TWC of the approximate amount of debt securities it intends to purchase and the general time period for the purchase, which period may not be greater than 90 days, subject to TWC’s right to give notice to Time Warner that it intends to purchase such amount of TWE debt securities itself.

 

Under the terms of the TWC Certificate of Incorporation, for three years following July 31, 2006, the date upon which shares of TWC common stock were issued in connection with the Adelphia Acquisition, at least 50% of the board of directors of TWC must be independent directors.

 

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

 

 

Matters Affecting the Relationship between Time Warner and TWC

 

Indebtedness Approval Right.  Under the Shareholder Agreement, until such time as the indebtedness of TWC is no longer attributable to Time Warner, in Time Warner’s reasonable judgment, TWC, its subsidiaries and entities that it manages may not, without the consent of Time Warner, create, incur or guarantee any indebtedness (except for the issuance of commercial paper or borrowings under TWC’s current revolving credit facility up to the limit of that credit facility, to which Time Warner has consented), including preferred equity, or rental obligations if its ratio of indebtedness plus six times its annual rental expense to EBITDA (as EBITDA is defined in the Shareholder Agreement) plus rental expense, or “EBITDAR,” then exceeds or would exceed 3:1.

 

Other Time Warner Rights.  Under the Shareholder Agreement, TWC must obtain Time Warner’s consent before it enters into any agreement that binds or purports to bind Time Warner or its affiliates or that would subject TWC to significant penalties or restrictions as a result of any action or omission of Time Warner; or adopts a stockholder rights plan, becomes subject to Section 203 of the Delaware General Corporation Law, adopts a “fair price” provision or takes any similar action.

 

Time Warner Standstill.  Under the Shareholder Agreement, Time Warner has agreed that for a period of three years following the closing of the Adelphia Acquisition, Time Warner will not make or announce a tender offer or exchange offer for TWC Class A Common Stock without the approval of a majority of the independent directors of TWC; and for a period of 10 years following the closing of the Adelphia Acquisition, Time Warner will not enter into any business combination with TWC, including a short-form merger, without the approval of a majority of the independent directors of TWC. Under the Adelphia Acquisition agreement, TWC has agreed that for a period of two years following the closing of the Adelphia Acquisition it will not enter into any short-form merger and that for a period of 18 months following the closing of the Adelphia Acquisition it will not issue equity securities to any person (other than, subject to satisfying certain requirements, Time Warner and its affiliates) that have a higher vote per share than the TWC Class A Common Stock.

 

Transactions between Time Warner and TWC.  The TWC By-Laws provide that Time Warner may only enter into transactions with TWC and its subsidiaries, including TWE, that are on terms that, at the time of entering into such transaction, are substantially as favorable to TWC or its subsidiaries as they would be able to receive in a

comparable arm’s-length transaction with a third party. Any such transaction involving reasonably anticipated payments or other consideration of $50 million or greater also requires the prior approval of a majority of the independent directors of TWC. The TWC By-Laws also prohibit TWC from entering into any transaction having the intended effect of benefiting Time Warner and any of its affiliates (other than TWC and its subsidiaries) at the expense of TWC or any of its subsidiaries in a manner that would deprive TWC or any of its subsidiaries of the benefit it would have otherwise obtained if the transaction were to have been effected on arm’s-length terms.

 

Time Warner Registration Rights Agreement between TWC and Time Warner.  At the closing of the TWE Restructuring, Time Warner and TWC entered into a registration rights agreement (the “Registration Rights Agreement”) relating to Time Warner’s shares of TWC common stock. Subject to several exceptions, including TWC’s right to defer a demand registration under some circumstances, Time Warner may, under that agreement, require that TWC take commercially reasonable steps to register for public resale under the Securities Act all shares of common stock that Time Warner requests to be registered. Time Warner may demand an unlimited number of registrations. In addition, Time Warner has been granted “piggyback” registration rights subject to customary restrictions and TWC is permitted to piggyback on Time Warner’s registrations. TWC has also agreed that, in connection with a registration and sale by Time Warner under the Registration Rights Agreement, it will indemnify Time Warner and bear all fees, costs and expenses, except underwriting discounts and selling commissions.

 

FOREIGN CURRENCY EXCHANGE RATES

 

Time Warner’s foreign operations are subject to various risks, including the risk of fluctuation in currency exchange rates and to exchange controls. Time Warner cannot predict the extent to which such controls and fluctuations in currency exchange rates may affect its operations in the future or its ability to remit dollars from abroad. See “Management’s Discussion and Analysis of Results of Operations and Financial Condition — Market Risk Analysis,” Note 15, “Derivative Instruments” to the consolidated financial statements set forth in the financial section of this report, and “Risk Factors” below, for additional information.

 

FINANCIAL INFORMATION ABOUT SEGMENTS, GEOGRAPHIC AREAS AND BACKLOG

 

Financial and other information by segment and revenues by geographic area for each year in the three-year period ended December 31, 2006 is set forth in Note 16, “Segment Information,” to the Company’s consolidated financial statements in the financial section of this report. Information with respect to the Company’s backlog, representing future revenue not yet recorded from cash contracts for the licensing of theatrical and television programming, at December 31, 2006 and December 31, 2005, is set forth in Note 17, “Commitments and Contingencies — Programming Licensing Backlog,” to the Company’s consolidated financial statements in the financial section of this report.

 

 

RISKS RELATING TO TIME WARNER GENERALLY

 

Pending securities litigation or the failure to fulfill the obligations under the Consent Order with the Securities and Exchange Commission could adversely affect Time Warner’s operations.  In connection with the Company’s settlement with the SEC, the Company consented to the entry of a Consent Order requiring it to comply with federal securities laws and regulations and the terms of an earlier order. If the Company is found to be in violation of the Consent Order, it may be subject to increased penalties and consequences as a result of the prior actions. During 2002 and 2003, many putative class action and shareholder derivative lawsuits alleging violations of federal and state securities laws and ERISA, as well as purported breaches of fiduciary duties, were filed against Time Warner, certain of its current and former executives, past and present members of its Board of Directors and, in

certain instances, AOL. In addition, several actions alleging various securities law violations were filed by individual shareholders in state and federal court. During 2005 and 2006, the Company reached agreements to settle the primary consolidated securities class action lawsuits, the shareholder derivative lawsuits and the consolidated action alleging ERISA violations, as well as many of the lawsuits brought by individual shareholders. However, some members of the class elected to “opt out” of the settlement of the primary securities class action to pursue their claims separately. In addition, some of the individual shareholder actions remain pending in federal and state courts. In 2005, the Company established a reserve aggregating $3 billion, with $2.4 billion for the settlement of the primary consolidated securities class actions and $600 million in connection with the remaining shareholder derivative, ERISA and securities matters (including suits brought by individual shareholders who decided to “opt out” of the settlement in the primary securities class action). The $3 billion reserve had been substantially utilized to settle certain of these claims, and in the fourth quarter of 2006 the Company established an additional reserve of $600 million related to its remaining securities litigation matters. During February 2007 the Company reached agreements in principle to pay approximately $405 million to settle certain of the remaining “opt out” claims. Plaintiffs have claimed approximately $3 billion in aggregated damages with interest in the remaining cases. The Company has engaged in, and may in the future engage in, mediation in an attempt to resolve the remaining cases, but if they cannot be resolved by adjudication on summary judgment or by settlement, trials will ensue in these matters. Although the Company intends to defend against these lawsuits vigorously, the ultimate amount that may be paid to resolve all unsettled litigation in these matters could be materially greater than the remaining reserve of approximately $215 million. The Company also is incurring expenses as a result of the pending “opt out” cases and individual securities actions, and costs associated with judgments in or additional settlements of these matters could adversely affect its financial condition and results of operations. See Item 3, “Legal Proceedings — Securities Matters.”

 

Several of the Company’s businesses are characterized by rapid technological change, and if Time Warner does not respond appropriately to technological changes, its competitive position may be harmed.  Time Warner’s businesses operate in the highly competitive, consumer-driven and rapidly changing media, entertainment, interactive services and cable industries. Several of its businesses are dependent to a large extent on their ability to acquire, develop, adopt, and exploit new and existing technologies to distinguish their products and services from those of their competitors. Technological development, application and exploitation can take long periods of time and require significant capital investments. In addition, the Company may be required to anticipate far in advance which of the potential new technologies and equipment it should adopt for new products and services or for future enhancements of or upgrades to its existing products and services. If it chooses technologies or equipment that do not become the prevailing standard or that are less effective, cost-efficient or attractive to its customers than those chosen by its competitors, or if it offers products or services that fail to appeal to consumers, are not available at competitive prices or do not function as expected, the Company’s competitive position could deteriorate, and its operations, business or financial results could be adversely affected.

 

The Company’s competitive position also may be adversely affected by various timing factors, such as delays in its new product or service offerings or the ability of its competitors to acquire or develop and introduce new technologies, products and services more quickly than the Company. Furthermore, advances in technology or changes in competitors’ product and service offerings may require the Company in the future to make additional research and development expenditures or to offer at no additional charge or at a lower price certain products and services the Company currently offers to customers separately or at a premium. Also, if the costs of existing technologies decrease in the future, the Company may not be able to maintain current price levels for its products or services. In addition, the inability to obtain intellectual property rights from third parties at a reasonable price or at all could impair the ability of the Company to respond to technological advances in a timely or cost-effective manner.

 

The combination of increased competition, more technologically-advanced platforms, products and services, the increasing number of choices available to consumers and the overall rate of change in the media, entertainment, interactive services and cable industries requires companies such as Time Warner to become more responsive to consumer needs and to adapt more quickly to market conditions than had been necessary in the past. The Company

could have difficulty managing these changes while at the same time maintaining its rates of growth and profitability.

 

Piracy of the Company’s feature films, television programming and other content may decrease the revenues received from the exploitation of the Company’s entertainment content and adversely affect its business and profitability.  Piracy of motion pictures, television programming, video content and DVDs poses significant challenges to several of the Company’s businesses. Technological advances allowing the unauthorized dissemination of motion pictures, television programming and other content in unprotected digital formats, including via the Internet, increase the threat of piracy. Such technological advances make it easier to create, transmit and distribute high quality unauthorized copies of such content. The proliferation of unauthorized copies and piracy of the Company’s products or the products it licenses from third parties can have an adverse effect on its businesses and profitability because these products reduce the revenue that Time Warner potentially could receive from the legitimate sale and distribution of its content. In addition, if piracy continues to increase, it could have an adverse effect on the Company’s business and profitability. Although piracy adversely affects the Company’s U.S. revenues, the impact on revenues from outside the United States is more significant, particularly in countries where laws protective of intellectual property rights are not strictly enforced. Time Warner has taken, and will continue to take, a variety of actions to combat piracy, both individually and together with cross-industry groups, trade associations and strategic partners, including the launch of new services for consumers at competitive price points, aggressive online and customs enforcement, compressed release windows and educational campaigns. Policing the unauthorized use of the Company’s intellectual property is difficult, however, and the steps taken by the Company will not prevent the infringement by and/or piracy of unauthorized third parties in every case. There can be no assurance that the Company’s efforts to enforce its rights and protect its intellectual property will be successful in reducing content piracy.

 

The Company has been, and may be in the future, subject to intellectual property infringement claims, which could have an adverse impact on the Company’s business or operating results due to a disruption in its business operations, the incurrence of significant costs and other factors.  From time to time, the Company receives notices from others claiming that it infringes their intellectual property rights, and the number of these claims could increase in the future. Claims of intellectual property infringement could require Time Warner to enter into royalty or licensing agreements on unfavorable terms, incur substantial monetary liability or be enjoined preliminarily or permanently from further use of the intellectual property in question, which could require Time Warner to change its business practices and limit its ability to compete effectively. Even if Time Warner believes that the claims are without merit, the claims can be time-consuming and costly to defend and divert management’s attention and resources away from its businesses. In addition, agreements entered into by the Company may require it to indemnify the other party for certain third-party intellectual property infringement claims, which could require the Company to expend sums to defend against or settle such claims or, potentially, to pay damages. If Time Warner is required to take any of these actions, it could have an adverse impact on the Company’s business or operating results.

 

Time Warner’s businesses may suffer if it cannot continue to license or enforce the intellectual property rights on which its businesses depend.  The Company relies on patent, copyright, trademark and trade secret laws in the United States and similar laws in other countries, and licenses and other agreements with its employees, customers, suppliers and other parties, to establish and maintain its intellectual property rights in technology and products and services used in its various operations. However, the Company’s intellectual property rights could be challenged or invalidated, or such intellectual property rights may not be sufficient to permit it to take advantage of current industry trends or otherwise to provide competitive advantages, which could result in costly redesign efforts, discontinuance of certain product and service offerings or other competitive harm. Further, the laws of certain countries do not protect Time Warner’s proprietary rights, or such laws may not be strictly enforced. Therefore, in certain jurisdictions the Company may be unable to protect its intellectual property adequately against unauthorized copying or use, which could adversely affect its competitive position. Also, because of the rapid pace of technological change in the industries in which the Company operates, much of the business of its various segments relies on technologies developed or licensed by third parties, and Time Warner may not be able to obtain or to continue to obtain licenses from these third parties on reasonable terms, if at all. It is also possible that, in connection with a merger, sale or acquisition transaction, the Company may license its trademarks or service marks

and associated goodwill to third parties, or the business of various segments could be subject to certain restrictions in connection with such trademarks or service marks and associated goodwill that were not in place prior to such a transaction.

 

Time Warner’s international operations are subject to increased risks that could adversely affect its business and operating results.  Time Warner’s businesses operate and serve customers worldwide. There are certain risks inherent in doing business internationally, including:

 

 

One or more of these factors could harm the Company’s future international operations and consequently, could harm its business and operating results.

 

Weakening economic conditions or other factors could reduce the Company’s advertising or other revenues or hinder its ability to increase such revenues.  Expenditures by advertisers tend to be cyclical, reflecting general economic conditions, as well as budgeting and buying patterns. Because several of the Company’s segments derive a substantial portion of their revenues from the sale of advertising, a decline or delay in advertising expenditures could reduce the Company’s revenues or hinder its ability to increase these revenues. Disasters, acts of terrorism, political uncertainty or hostilities also could lead to a reduction in advertising expenditures as a result of uninterrupted news coverage and economic uncertainty. Advertising expenditures by companies in certain sectors of the economy, including the automotive, financial and pharmaceutical industries, represent a significant portion of the Company’s advertising revenues. Any political, economic, social or technological change resulting in a significant reduction in the advertising spending of these sectors could adversely affect the Company’s advertising revenues or its ability to increase such revenues. In addition, because many of the products and services offered by the Company are largely discretionary items, weakening economic conditions or outlook could reduce the consumption of such products and services and reduce the Company’s revenues.

 

The introduction and increased popularity of alternative technologies for the distribution of news, entertainment and other information and the resulting shift in consumer habits and/or advertising expenditures from traditional to online media could adversely affect the revenues of the Company’s Publishing, Networks and Filmed Entertainment segments.  The Company’s Publishing and Networks segments derive a substantial portion of their revenue from advertising in magazines and on television. Distribution of news, entertainment and other information via the Internet has become increasingly popular over the past several years, and viewing news, entertainment and other content on a personal computer, cellular phone or other electronic or portable electronic device has become increasingly popular as well. Accordingly, advertising dollars have started to shift from traditional media to online media. The shift in major advertisers’ expenditures from traditional to online media has had an adverse effect on the revenue growth of the Publishing and Networks segments, which may continue in the future. In addition, if consumers increasingly elect to obtain news and entertainment online instead of by purchasing the Publishing segment’s magazines, this trend could negatively impact the segment’s circulation revenue and also adversely affect its advertising revenue. The Publishing and Networks segments have taken various steps to diversify the means by which they distribute content and generate advertising revenue, including relaunching

certain websites and expanding their existing online content. However, the segments’ strategies for achieving sustained revenue growth may not be sufficient to offset revenue losses resulting from a continued shift in advertising dollars over the long term from traditional to online media. In addition, this trend also could have an indirect negative impact on the licensing revenue generated by the Filmed Entertainment segment and the revenue generated by Home Box Office from the licensing of its original programming in syndication and to basic cable channels.

 

The Company faces risks relating to competition for the leisure and entertainment time of audiences, which has intensified in part due to advances in technology.  In addition to the various competitive factors discussed in the following paragraphs, all of the Company’s businesses are subject to risks relating to increasing competition for the leisure and entertainment time of consumers. The Company’s businesses compete with each other and all other sources of news, information and entertainment, including broadcast television, movies, live events, radio broadcasts, home video products, console games, print media and the Internet. Technological advancements, such as video on demand, new video formats and Internet streaming and downloading, have increased the number of media and entertainment choices available to consumers and intensified the challenges posed by audience fragmentation. The increasing number of choices available to audiences could negatively impact not only consumer demand for the Company’s products and services, but also advertisers’ willingness to purchase advertising from the Company’s businesses. If the Company does not respond appropriately to further increases in the leisure and entertainment choices available to consumers, the Company’s competitive position could deteriorate, and its financial results could suffer.

 

Several of the Company’s businesses rely heavily on network and information systems or other technology, and a disruption or failure of such networks, systems or technology as a result of computer viruses, misappropriation of data or other malfeasance, as well as outages, natural disasters, accidental releases of information or similar events, may disrupt the Company’s businesses.  Because network and information systems and other technologies are critical to many of Time Warner’s operating activities, network or information system shutdowns caused by events such as computer hacking, dissemination of computer viruses, worms and other destructive or disruptive software, denial of service attacks and other malicious activity, as well as power outages, natural disasters, terrorist attacks and similar events, pose increasing risks. Such an event could have an adverse impact on the Company and its customers, including degradation of service, service disruption, excessive call volume to call centers and damage to equipment and data. Such an event also could result in large expenditures necessary to repair or replace such networks or information systems or to protect them from similar events in the future. Significant incidents could result in a disruption of the Company’s operations, customer dissatisfaction, or a loss of customers or revenues.

 

Furthermore, the operating activities of Time Warner’s various businesses could be subject to risks caused by misappropriation, misuse, leakage, falsification and accidental release or loss of information maintained in the Company’s information technology systems and networks, including customer, personnel and vendor data. The Company could be exposed to significant costs if such risks were to materialize, and such events could damage the reputation and credibility of Time Warner and its businesses and have a negative impact on its revenues. The Company also could be required to expend significant capital and other resources to remedy any such security breach. As a result of the increasing awareness concerning the importance of safeguarding personal information, the potential misuse of such information and legislation that has been adopted or is being considered regarding the protection, privacy and security of personal information, information-related risks are increasing, particularly for businesses like Time Warner’s that handle a large amount of personal customer data.

 

RISKS RELATING TO TIME WARNER’S AOL BUSINESS

 

If AOL’s business strategy does not succeed in sustaining current levels of activity generated on AOL’s interactive properties by current AOL subscribers and increasing the number of other Internet users and the level of activity they generate on AOL’s interactive properties, AOL’s business, results of operations and financial condition may be adversely impacted.  In the third quarter of 2006, AOL began implementing a new phase of its business strategy to shift from a primarily subscription-based business model to a primarily advertising-supported business model. In 2006, subscription revenues represented approximately 74% of AOL’s total revenues, and

advertising revenues represented approximately 24% of AOL’s total revenues. The success of AOL’s strategy depends on AOL’s ability to sustain current levels of activity generated on AOL’s interactive properties, whether accessed via the AOL client software or directly through the Internet, by current AOL access subscribers and its ability to increase the number of other Internet users and the level of activity they generate on AOL’s interactive properties.

 

As part of its business strategy, AOL is offering a “free” Internet service that was previously only available on a subscription basis; this “free” offer has contributed to declines in the number of access subscribers and related subscription revenues, and such declines are expected to continue.  Before the implementation of the new phase of its business strategy, AOL maintained greater distinctions between its subscription service (the AOL service) and its free interactive properties. A significant component of the new phase of its business strategy includes AOL providing content, features and tools, previously available only to access subscribers, to all Internet consumers at no charge, including the AOL client software, “AOL.com” e-mail addresses and certain safety and security tools. Certain components of the AOL service continue to be available only to subscribers, such as dial-up Internet access and live customer service. AOL is experiencing declines in the number of subscribers and related subscription revenues, and expects that subscribers and related subscription revenues will decline further as consumers continue to upgrade to broadband Internet access from dial-up Internet access. As subscription revenues decline, AOL will become more dependent on advertising revenues and continued cost reductions in order to improve its financial performance.

 

AOL currently depends on its access subscribers to generate a significant majority of its paid-search and display advertising revenues, and in the future it must be able to maintain the level of engagement of these subscribers and to attract new highly-engaged Internet users to its interactive properties to continue to increase its advertising revenues.  For its business strategy to be successful, AOL must continue to increase advertising revenues. A significant majority of AOL’s paid-search and display advertising revenues currently is generated from activity by AOL access subscribers who use AOL e-mail and the AOL client software. By permitting the general Internet population (including former subscribers) to use the AOL client software, “AOL.com” e-mail addresses and certain other AOL interactive offerings at no charge, AOL aims to maintain the generally high level of engagement of its current subscribers (regardless of whether they continue to pay AOL for Internet access) and to attract new highly-engaged Internet consumers to the AOL properties. Even though AOL has registered a significant number of new e-mail accounts and has migrated a significant number of paid subscribers to “free” accounts, these actions are not necessarily an indicator of high levels of future activity by the Internet users (including former subscribers) on the AOL Network, which activity is needed in order for AOL to continue to increase its advertising revenues.

 

Important components of AOL’s business strategy are maintaining the usage of the AOL client software by current subscribers, increasing the usage of the AOL client software by the general Internet population, including former subscribers, and increasing both traffic to AOL websites and consumption of other AOL interactive services. To increase the ease with which the general Internet population can obtain the AOL client software and access both AOL websites and other interactive services, AOL seeks to distribute its free and paid products and services (such as the AOL client software, AOL.com, AOL content and/or other AOL interactive services) through a variety of methods, including relationships with third-party high-speed Internet access providers, retailers, computer manufacturers or other aggregators of Internet activity, and through search engine optimization and search engine marketing. Although AOL had relationships with certain high-speed Internet access providers and computer manufacturers in place when it implemented the new phase of its business strategy, its ability to enter into new or additional distribution agreements may be limited by existing exclusive arrangements that distributors have with other Internet companies. Furthermore, distribution of interactive products and services is subject to significant competition. Although agreements with high-speed Internet access providers, computer manufacturers and retailers are not required for Internet users either to obtain the AOL client software or to access other free AOL interactive properties and services, if AOL is unable to enter into favorable arrangements with these parties, fewer Internet users may download the AOL client software and/or use other AOL interactive properties or services, which could hinder the growth of AOL’s advertising revenues.

 

In order for AOL to continue to improve its financial performance, AOL must increase its advertising revenues, as well as reduce its overall costs, in sufficient amounts and in a timely manner to coincide with or precede the continuing loss of subscribers to the AOL service and related subscription revenues.  Subscription revenues

declined substantially in 2006, and such declines are expected to continue. At the same time, advertising revenues increased during 2006, but not in an amount sufficient to offset the decline in subscription revenues. In 2007, advertising revenues must be increased substantially and AOL’s costs must be decreased substantially in order for AOL’s financial performance to improve. AOL made substantial cost reductions in 2006 related to marketing, network service, customer service and product development, and it intends to continue to identify and implement cost reductions. However, cost reductions may lead to employee distraction and morale problems, as well as difficulty in hiring or retaining necessary employees. Reducing costs may also lead to reduced operational capabilities, and if costs are reduced in a manner that is not consistent with operational requirements, AOL’s ability to provide satisfactory customer service may be adversely affected. Following the substantial cost reductions made prior to and during 2006, it may become increasingly difficult to identify and implement cost reductions in 2007 without adversely impacting AOL’s operational effectiveness. If advertising revenues do not increase and if cost reductions are not made in sufficient amounts and on a timeline that coincides with or precedes the continuing loss of subscribers and related decreases in subscription revenues, or if AOL is unable to make cost reductions in an operationally effective manner, AOL’s operating results and financial condition could be adversely affected.

 

The new phase of AOL’s business strategy has made AOL more susceptible to the risks of operating an advertising business.  With the implementation of the new phase of its business strategy, AOL has become more dependent on advertising revenues and thus more susceptible to the risks of operating an advertising-supported business. Purchases of advertising tend to be cyclical and are susceptible to changing economic and market conditions that are outside AOL’s control, as described above in the risk factor entitled “Weakening economic conditions or other factors could reduce the Company’s advertising or other revenues or hinder its ability to increase such revenues.” The size of the Internet advertising business, including the sponsored-links search business, has increased substantially during 2006. If the Internet advertising business does not continue to grow or shrinks in 2007, AOL’s ability to generate increased advertising revenues may be adversely impacted. Furthermore, the Internet advertising business is relatively new and has seen greater volatility than the general advertising market. It is possible that Internet advertising could be disproportionately affected by any advertising or economic slowdown. A significant amount of growth in AOL’s advertising revenues in 2006 was attributable to operational improvements and improved targeting. AOL must continue to identify and implement such operational and targeting improvements in order to support increased pricing and in order to continue to increase its advertising revenues. Also in 2006, almost a quarter of AOL’s growth in advertising revenues was attributable to the expansion of a relationship with a single customer. In the future, AOL will need to continue to maintain or expand this relationship or identify and enter into new or expanded relationships with other advertising customers in order to sustain or increase its growth in advertising revenues. Continued growth in AOL’s advertising business also depends on its ability to continue offering a competitive and distinctive range of advertising products and services for marketers and its ability to maintain or increase prices for its advertising products and services. If AOL cannot continue to improve its advertising products and services or if prices for its advertising products and services decrease, AOL’s advertising revenues could be adversely affected.

 

AOL faces intense competition in its global web services business, its Internet access business and in the distribution of its products and services, and must compete successfully in order to improve its financial performance.  AOL’s global web services business competes for online users’ time and attention and advertising, subscription and commerce revenues with a wide range of companies, including web-based portals and individual websites providing content, commerce, search, communications, community and similar features, as well as ISPs and traditional media companies such as Viacom Inc., CBS Corporation, News Corporation, The Walt Disney Company, Tribune Company, The New York Times Company and NBC Universal. Major competitors include Yahoo! Inc., Microsoft Corporation, Google, IAC/ InterActiveCorp and eBay Inc. In addition, new properties such as YouTube, MySpace and Facebook that are able to gain large numbers of visitors and generate significant amounts of activity also compete with AOL.

 

Advertising.com, which generates almost a quarter of AOL’s advertising revenues, competes with other aggregators of third-party inventory and other companies that offer competing advertising products, technology and services, such as 24/7 Real Media, Inc. and ValueClick, Inc. Competition affects the prices paid by Advertising.com for inventory and prices charged to advertisers for Advertising.com’s advertising products and services. In order for

Advertising.com to remain competitive, it is important that Advertising.com offer compelling advertising products and technologies to the advertisers who are its customers.

 

As part of its strategy, AOL has sold its Internet access operations in France and the U.K. and has agreed to do so in Germany, and, in conjunction with these sales, has maintained relationships with the purchasers to continue to provide its former subscribers with web services, including portals, e-mail and content. Accordingly, AOL Europe is reliant on the purchasers’ abilities to maintain relationships with these subscribers in order to generate web services activity and advertising revenues. In Europe, following the sales of its access operations businesses, AOL Europe’s competitors are Google, Microsoft Corporation and Yahoo! Inc. in its main markets, in addition to Web.de in Germany and Voila in France. Internationally, AOL expects to compete against local Internet and other web services companies as well as current U.S. competitors who have an established portal presence in these locations.

 

Although AOL has implemented a new phase of its business strategy to shift to a primarily advertising-supported business model, AOL continues to operate in the Internet access business, and competes for subscription revenues with companies providing dial-up Internet service, including EarthLink, and discount ISPs such as NetZero. AOL also competes with companies providing Internet access via broadband technologies, such as cable companies and telephone companies, and companies offering emerging broadband access technologies, including wireless, mobile wireless, fiber optic cable and power line.

 

AOL faces significant competition, primarily from the competitors identified above, in the distribution of its products and services in a cost effective manner. For example, AOL competes with other providers of portals and other Internet products and services to distribute and promote its products and services through high-speed Internet access networks, at retail outlets, on new computers, as well as via other distribution channels. AOL also competes to secure placement of its products and services on new computers and mobile devices, including cellular telephones and PDAs, to distribute and promote its products and services.

 

There can be no assurance that AOL will be able to compete successfully in the future with existing or potential competitors or that competition will not have an adverse effect on its business or results of operations.

 

If the Company’s AOL business is unable to acquire, develop or offer compelling applications, features, services, tools and content at reasonable costs, the size or value of its audience may not increase as anticipated, which could adversely affect its subscription and advertising revenue.  AOL believes that it must offer compelling and differentiated applications, features, services, tools and content to attract and retain subscribers and to attract Internet users to, and generate increased activity on, the AOL Network. Acquiring, developing and offering such applications, features, services, tools and content may require significant costs and effort to develop, while consumer tastes may be difficult to predict and are subject to rapid change. AOL also anticipates that subscribers and Internet users may demand an escalating quality of offerings. If AOL is unable to provide offerings that are compelling to subscribers and Internet users, the size and value of AOL’s audience may be adversely affected. With respect to search, a significant portion of AOL’s growth in advertising revenues has been attributable to its relationship with Google. AOL has agreed to use Google’s algorithmic search and sponsored links on an exclusive basis through December 19, 2010. Although AOL retains the ability to differentiate its search product from Google and other providers, competing search technologies may grow in popularity with consumers or businesses, and the exclusivity in certain circumstances may limit AOL’s flexibility to change providers of these products in the future. Furthermore, although AOL has access to certain content provided by the Company’s other businesses, it also may be required to make substantial payments to third parties from whom it licenses such content, and costs for such content may increase as a result of competition or for other reasons. Further, many of AOL’s content arrangements with third parties are non-exclusive, so competitors may be able to offer similar or identical content. AOL’s publication of user-created as well as third-party content may put AOL at increased risk of allegations of copyright infringement or other legal liability, and may cause AOL to incur significant monitoring or legal costs. These risks also could limit AOL’s ability to provide competitive content, features and tools. If AOL is unable to acquire or develop compelling content and do so at reasonable prices, or if other companies offer content that is similar to or the same as that provided by AOL, the size and value of AOL’s audience may be adversely affected. If the size and value of AOL’s audience do not increase significantly, AOL’s subscription and advertising revenue could be adversely affected.

 

More individuals are using non-PC devices to access the Internet, and AOL must be able to secure placement of its services, applications and features on such devices, must ensure that they are compatible with the devices and must ensure that the AOL Network is accessible by users of non-PC devices.  The number of individuals who access the Internet through devices other than a personal computer, such as personal digital assistants or mobile telephones, has increased significantly. AOL needs to secure arrangements with the device manufacturers as well as the access providers or wireless carriers, as the case may be, in order to ensure placement of its services, applications and features on the non-PC devices. In addition, due to differences in memory, functionality and resolution, AOL must ensure that its services, applications and features are technologically compatible in order for them to be placed on such non-PC devices. Also, the websites, applications and services included in the AOL Network must be designed so that they are technologically compatible with the non-PC devices in order that users of these devices can access the AOL Network and engage in activity. If AOL is unable to place its services, applications and features on non-PC devices, or if AOL is unable to attract and retain a substantial number of alternative device users to use the AOL Network, it could have an adverse impact on AOL’s advertising, subscription or other revenue.

 

Changes in international, federal, state and local tax laws and regulations, or interpretations of international, federal, state and local tax laws and regulations, could adversely affect AOL’s operating results.  International, federal, state and local tax laws and regulations affecting AOL’s business, or interpretations or application of these tax laws and regulations, could change. In addition, new international, federal, state and local tax laws and regulations affecting AOL’s business could be enacted. In December 2004, the U.S. federal government enacted the Internet Tax Nondiscrimination Act (or the ITNA), extending the moratorium on states and other local authorities imposing access or discriminatory taxes on the Internet through November 2007. If the ITNA is not extended or permanently enacted, state and local jurisdictions may seek to impose taxes on Internet access, other paid services or electronic commerce within their jurisdictions. These taxes could adversely affect AOL’s operating results.

 

In addition, under a directive adopted by the European Union in July 2003, certain services are subject to a Value Added Tax, or VAT, which is levied based on the country from which the service is provided rather than the place of consumption. If the EU votes in the future to change its approach from the current “place of supply” to a “place of consumption” approach, AOL’s operating results could be adversely affected. In December 2006, the French tax authorities assessed VAT against a subsidiary of AOL, largely under a “place of consumption” theory that does not exist under current law. To the extent that a court adopts this new theory, AOL’s operating results could be adversely affected.

 

New or changing federal, state or international privacy legislation or regulation could hinder the growth of AOL’s business.  A variety of federal, state and international laws govern the collection and use of customer data that AOL uses to operate its services and to help deliver advertisements to its customers. Not only are existing privacy-related laws in these jurisdictions evolving and subject to potentially disparate interpretation by governmental entities, new legislative proposals affecting privacy are now pending at both the federal and state level in the U.S. Changes to the interpretation of existing law or the adoption of new privacy-related requirements could hinder the growth of AOL’s business.

 

RISKS RELATING TO TIME WARNER’S CABLE BUSINESS

 

TWC faces certain challenges relating to the integration of the systems acquired in the Adelphia acquisition and related transactions with Comcast into its existing systems.  The successful integration of the Acquired Systems will depend primarily on TWC’s ability to manage the combined operations and integrate into its operations the Acquired Systems (including management information, marketing, purchasing, accounting and finance, sales, billing, customer support and product distribution infrastructure, personnel, payroll and benefits, regulatory compliance and technology systems). The integration of these systems, including the upgrade of certain portions of the Acquired Systems requires significant capital expenditures and may require TWC to use financial resources it would otherwise devote to other business initiatives, including marketing, customer care, the development of new products and services and the expansion of its existing cable systems. While TWC has planned for certain capital expenditures for, among other things, improvements to plant and technical performance and

upgrading system capacity of the Acquired Systems, TWC may be required to spend more than anticipated for those purposes. Furthermore, these integration efforts may require more attention from TWC’s management and impose greater strains on its technical resources than anticipated. If TWC fails to successfully integrate the Acquired Systems, it could have a material adverse effect on its business and financial results.

 

Additionally, to the extent TWC encounters significant difficulties in integrating systems or other operations, its customer care efforts may be hampered. For instance, TWC may experience higher-than-normal call volumes under such circumstances, which might interfere with its ability to take orders, assist customers not impacted by the integration difficulties and conduct other ordinary course activities. In addition, depending on the scope of the difficulties, TWC may be the subject of negative press reports or customer perception.

 

TWC has entered into transitional services arrangements with Comcast under which Comcast has agreed to assist TWC by providing certain services in the applicable Acquired Systems as TWC integrates those systems into its existing systems. Any failure by Comcast to perform under these agreements may cause the integration of the applicable Acquired Systems to be delayed and may increase the amount of time and money TWC needs to devote to the integration of such systems.

 

TWC may not realize the anticipated benefits of the Adelphia acquisition and/or related transactions with Comcast.  The Adelphia acquisition and related transactions with Comcast have combined cable systems that were previously owned and operated by three different companies. Time Warner expects that TWC will realize cost savings and other financial and operating benefits as a result of the transactions. However, due to the complexity of and risks relating to the integration of these systems, among other factors, Time Warner cannot predict with certainty when these cost savings and benefits will occur or the extent to which they actually will be achieved, if at all.

 

TWC faces risks inherent to its voice services business.  TWC may encounter unforeseen difficulties as it introduces its voice services in new operating areas, including the systems acquired from Adelphia and Comcast, and/or increases the scale of its voice service offerings in areas in which they have already been launched. First, TWC faces heightened customer expectations for the reliability of voice services as compared with its video and high-speed data services. TWC has undertaken significant training of customer service representatives and technicians, and it will continue to need a highly trained workforce. To ensure reliable service, TWC may need to increase its expenditures, including spending on technology, equipment and personnel. If the service is not sufficiently reliable or TWC otherwise fails to meet customer expectations, its voice services business could be adversely affected. Second, the competitive landscape for voice services is intense; TWC faces competition from providers of Internet phone services, as well as incumbent local telephone companies, cellular telephone service providers and others. See “— TWC faces a wide range of competition, which could affect its future results of operations.” Third, TWC’s voice services depend on interconnection and related services provided by certain third parties. As a result, its ability to implement changes as the services grow may be limited. Finally, TWC expects advances in communications technology, as well as changes in the marketplace and the regulatory and legislative environment. Consequently, the Company is unable to predict the effect that ongoing or future developments in these areas might have on TWC’s voice services business and operations.

 

In addition, TWC’s launch of voice services in the Acquired Systems may pose certain risks. TWC will be unable to provide its voice services in some of the Acquired Systems without first upgrading the facilities. Additionally, it may need to obtain certain services from third parties prior to deploying voice services in the Acquired Systems. If TWC encounters difficulties or significant delays in launching voice services in the Acquired Systems, its business and financial results may be adversely affected.

 

Increases in programming costs could adversely affect TWC’s operations, business or financial results.  Programming has been, and is expected to continue to be, one of TWC’s largest operating expense items for the foreseeable future. In recent years, TWC has experienced significant increases in the cost of programming, particularly sports programming. TWC’s programming cost increases are expected to continue due to a variety of factors, including inflationary and negotiated annual increases, additional programming being provided to subscribers, and increased costs to purchase new programming.

 

Programming cost increases that TWC is unable to pass on fully to its subscribers have had, and will continue to have, an adverse impact on cash flow and operating margins. In addition, such increases could have an adverse

impact on cash flow and operating margins from new video products and services. Current and future programming providers that provide content that is desirable to TWC subscribers may enter into exclusive affiliation agreements with TWC’s cable and non-cable competitors and may be unwilling to enter into affiliation agreements with TWC on acceptable terms, if at all.

 

In addition, increased demands by owners of some broadcast stations for carriage of other services or payments to those broadcasters for retransmission consent could further increase TWC’s programming costs. Federal law allows commercial television broadcast stations to make an election between “must-carry” rights and an alternative “retransmission-consent” regime. When a station opts for the latter, cable operators are not allowed to carry the station’s signal without the station’s permission. TWC currently has multi-year agreements with most, but not all, of the retransmission-consent stations that it carries. In some cases, TWC carries stations under short-term arrangements while it attempts to negotiate new long-term retransmission agreements. If negotiations with these programmers prove unsuccessful, they could require TWC to cease carrying their signals, possibly for an indefinite period. Any loss of stations could make TWC’s video service less attractive to subscribers, which could result in less subscription and advertising revenue. In retransmission-consent negotiations, broadcasters often condition consent with respect to one station on carriage of one or more other stations or programming services in which they or their affiliates have an interest. Carriage of these other services may increase TWC’s programming expenses and diminish the amount of capacity it has available to introduce new services, which could have an adverse effect on its business and financial results.

 

TWC faces a wide range of competition, which could affect its future results of operations.  TWC’s industry is and will continue to be highly competitive. Some of TWC’s principal competitors — in particular, direct broadcast satellite operators and incumbent local telephone companies — either offer or are making significant capital investments that will allow them to offer services that provide directly comparable features and functions to those TWC offers, and they are aggressively seeking to offer them in bundles similar to TWC’s.

 

Incumbent local telephone companies have recently increased their efforts to provide video services. The two major incumbent local telephone companies — AT&T Inc. (“AT&T”) and Verizon Communications, Inc. (“Verizon”) — have both announced that they intend to make fiber upgrades of their networks, although each is using a different architecture. AT&T is expected to utilize one of a number of fiber architectures, including the fiber-to-the-node (or FTTN) network, and Verizon utilizes a fiber architecture known as fiber-to-the-home (or FTTH). Some upgraded portions of these networks are or will be capable of carrying two-way video services that are technically comparable to TWC’s, high-speed data services that operate at speeds as high or higher than those TWC makes available to customers in these areas and digital voice services that are similar to TWC’s. In addition, these companies continue to offer their traditional phone services as well as bundles that include wireless voice services provided by affiliated companies. In areas where they have launched video services, these parties are aggressively marketing video, voice and data bundles at entry level prices similar to those TWC uses to market its bundles.

 

TWC’s video business faces intense competition from direct broadcast satellite providers. These providers compete with TWC based on aggressive promotional pricing and exclusive programming (e.g., “NFL Sunday Ticket,” which is not available to cable operators). Direct broadcast satellite programming is comparable in many respects to TWC’s analog and digital video services, including its DVR service. In addition, the two largest direct broadcast satellite providers offer some interactive programming features. These providers are working to increase the number of HDTV channels they offer in order to differentiate their service from services offered by cable operators.

 

In some areas, incumbent local telephone companies and direct broadcast satellite operators have entered into co-marketing arrangements that allow both parties to offer synthetic bundles (i.e., video services provided principally by the direct broadcast satellite operator, and digital subscriber line (“DSL”) and traditional phone service offered by the telephone companies). From a consumer standpoint, the synthetic bundles appear similar to TWC’s bundles and result in a single bill. AT&T is offering a service in some areas that utilizes direct broadcast satellite video but in an integrated package with AT&T’s DSL product, which enables an Internet-based return path that allows the user to order a VOD-like product and other services that TWC provides using its two-way network.

 

TWC operates its cable systems under non-exclusive franchises granted by state or local authorities. The existence of more than one cable system operating in the same territory is referred to as an “overbuild.” In some of TWC’s operating areas, other operators have overbuilt its systems and offer video, data and/or voice services in competition with TWC.

 

In addition to these competitors, TWC faces competition on individual services from a range of competitors. For instance, its video service faces competition from providers of paid television services (such as satellite master antenna services) and from video delivered over the Internet. TWC’s high-speed data service faces competition from, among others, incumbent local telephone companies utilizing their newly-upgraded fiber networks and/or DSL lines, Wi-Fi, Wi-Max and 3G wireless broadband services provided by mobile carriers such as Verizon Wireless, broadband over power line providers, and from providers of traditional dial-up Internet access. TWC’s voice service faces competition for voice customers from incumbent local telephone companies, cellular telephone service providers, Internet phone providers, such as Vonage, and others.

 

Any inability to compete effectively or an increase in competition with respect to video, voice or high-speed data services could have an adverse effect on TWC’s financial results and return on capital expenditures due to possible increases in the cost of gaining and retaining subscribers and lower per subscriber revenue, could slow or cause a decline in TWC’s growth rates, reduce its revenues, reduce the number of its subscribers or reduce its ability to increase penetration rates for services. As TWC expands and introduces new and enhanced products and services, it may be subject to competition from other providers of those products and services, such as telecommunications providers, Internet service providers and consumer electronics companies, among others. TWC cannot predict the extent to which this competition will affect its future financial results or return on capital expenditures.

 

Future advances in technology, as well as changes in the marketplace and in the regulatory and legislative environments, may result in changes to the competitive landscape.

 

The Internal Revenue Service and state and local tax authorities may challenge the tax characterizations of the Adelphia Acquisition, the Redemptions or the Exchange, or related valuations, and any successful challenge by the Internal Revenue Service or state or local tax authorities could materially adversely affect Time Warner’s tax profile, significantly increase its future cash tax payments and significantly reduce its future earnings and cash flow.  The Adelphia Acquisition was designed to be a fully taxable asset sale, the TWC Redemption was designed to qualify as a tax-free split-off under section 355 of the Internal Revenue Code of 1986, as amended (the “Tax Code”), the TWE Redemption was designed as a redemption of Comcast’s partnership interest in TWE, and the Exchange was designed as an exchange of designated cable systems. There can be no assurance, however, that the Internal Revenue Service (the “IRS”) or state or local tax authorities (together with the IRS, the “Tax Authorities”) will not challenge one or more of such characterizations or the related valuations. Such a successful challenge by the Tax Authorities could materially adversely affect Time Warner’s tax profile (including its ability to recognize the intended tax benefits from these transactions), significantly increase its future cash tax payments and significantly reduce its future earnings and cash flow. The tax consequences of the Adelphia Acquisition, the Redemptions and the Exchange are complex and, in many cases, subject to significant uncertainties, including, but not limited to, uncertainties regarding the application of federal, state and local income tax laws to various transactions and events contemplated therein and regarding matters relating to valuation.

 

TWC’s business is subject to extensive governmental regulation, which could adversely affect its business.  TWC’s video and voice services are subject to extensive regulation at the federal, state, and local levels. In addition, the federal government has been exploring possible regulation of high-speed data services. Additional regulation, including regulation relating to rates, equipment, programming, levels and types of services, taxes and other charges, could have an adverse impact on TWC’s services.

 

TWC expects that legislative enactments, court actions, and regulatory proceedings will continue to clarify and in some cases change the rights of cable companies and other entities providing video, data and voice services under the Communications Act of 1934, as amended (the “Communications Act”), and other laws, possibly in ways that it

has not foreseen. The results of these legislative, judicial, and administrative actions may materially affect TWC’s business operations in areas such as:

 

 

At the state level, several states, including California, New Jersey, North Carolina, South Carolina and Texas, have enacted statutes intended to streamline entry by additional video competitors. Some of these statutes provide more favorable treatment to new entrants than to existing providers. Similar bills are pending or may be enacted in additional states. To the extent federal or state laws or regulations facilitate additional competitive entry or create more favorable regulatory treatment for new entrants, TWC’s operations could be materially and adversely affected.

 

 

“Net neutrality” legislation or regulation could limit TWC’s ability to operate its high-speed data business profitably, to manage its broadband facilities efficiently and to make upgrades to those facilities sufficient to respond to growing bandwidth usage by its high-speed data customers.  Several disparate groups have adopted the term “net neutrality” in connection with their efforts to persuade Congress and regulators to adopt rules that could limit the ability of broadband providers to manage their networks efficiently and profitably. Although the positions taken by these groups are not well defined and are sometimes inconsistent with one another, most would directly or indirectly limit the ability of broadband providers to apply differential pricing or network management policies to different uses of the Internet. Proponents of such regulation also seek to prohibit broadband providers from recovering the costs of rising bandwidth usage from any parties other than retail customers. The average bandwidth usage of TWC’s high-speed data customers has been increasing significantly in recent years as the amount of high bandwidth content and the number of applications available on the Internet continues to grow. In order to continue to provide quality service at attractive prices, TWC needs the continued flexibility to develop and refine business models that respond to changing consumer uses and demands, to manage bandwidth usage efficiently and to make upgrades to its broadband facilities. As a result, depending on the form it might take, “net neutrality” legislation or regulation could impact TWC’s ability to operate its high-speed data network profitably and to undertake the upgrades that may be needed to continue to provide high quality high-speed data services. TWC is unable to predict the likelihood that such regulatory proposals will be adopted.

 

The FCC’s set-top box rules could impose significant additional costs on TWC.  Currently, many cable subscribers rent set-top boxes from TWC that perform both signal-reception functions and conditional-access security functions, as well as enable delivery of advanced services. In 1996, Congress enacted a statute seeking to allow cable subscribers to use set-top boxes obtained from certain third parties, including third-party retailers. The most important of the FCC’s implementing regulations requires cable operators to offer separate equipment that provides only the security functions and not the signal-reception functions (so that cable subscribers can purchase set-top boxes or other navigational devices from third parties) and to cease placing into service new set-top boxes that have integrated security and signal-reception functions. The regulations requiring cable operators to cease distributing new set-top boxes with integrated security and signal-reception functions are currently scheduled to go into effect on July 1, 2007. On August 16, 2006, the National Cable and Telecommunications Association filed with the FCC a request that these rules be waived for all cable operators, including TWC, until a downloadable security solution is available or December 31, 2009, whichever is earlier. No assurance can be given that the FCC will grant this or any other waiver request.

 

TWC’s vendors have not yet manufactured, on a commercial scale, set-top boxes that can support all the services that TWC offers while relying on separate security devices. It is possible that TWC’s vendors will be unable to deliver the necessary set-top boxes in time for TWC to comply with the FCC regulations. It is also possible that the FCC will determine that the set-top boxes that TWC eventually obtains are not compliant with applicable rules. In either case, the FCC may penalize TWC. In addition, design and manufacture of the new set-top boxes will come at a significant expense, which TWC’s vendors will seek to pass on to TWC, but which TWC in turn may not be able to pass on to its customers, thereby increasing its costs. The Company expects that TWC will incur approximately $50 million in incremental set-top box costs during 2007 as a result of these regulations. The FCC has indicated that direct broadcast satellite operators are not required to comply with the FCC’s set-top box rules, and one telephone company has asked for a waiver of the rules. If TWC has to comply with the rule prohibiting set-top boxes with integrated security while its competitors are not required to comply with that rule, TWC may be at a competitive disadvantage.

 

RISKS RELATING TO BOTH THE TIME WARNER
NETWORKS AND FILMED ENTERTAINMENT BUSINESSES

 

The Networks and Filmed Entertainment segments must respond to recent and future changes in technology, services and standards to remain competitive and continue to increase their revenue.  Technology in the video, telecommunications and data services used in the entertainment industry is changing rapidly, and advances in technology, such as video-on-demand, new video formats and distribution via the Internet, have led to alternative methods of product delivery and storage. Certain changes in consumer behavior driven by these methods of delivery and storage could have a negative effect on the revenue of the Networks and Filmed Entertainment segments. For example, devices that allow users to view television programs or motion pictures from a remote location may cause changes in consumer behavior that could negatively affect the subscription revenue of cable and DTH satellite operators and therefore have a corresponding negative effect on the subscription revenue generated by the Networks segment and the licensing revenue generated by the Networks and Filmed Entertainment segments. Devices that enable users to view television programs or motion pictures on a time-delayed basis or allow them to fast-forward or skip advertisements may cause changes in consumer behavior that could adversely affect the advertising revenue of the advertising-supported networks in the Networks segment and have an indirect negative impact on the licensing revenue generated by the Filmed Entertainment segment and the revenue generated by Home Box Office from the licensing of its original programming in syndication and to basic cable channels. In addition, further increased use of portable digital devices that allow users to view content of their own choice, at a time of their choice, while avoiding traditional commercial advertisements, could adversely affect such advertising and licensing revenue.

 

Technological developments also pose other challenges for the Networks and Filmed Entertainment segments that could adversely impact their revenue and competitive position. For example, the Networks and Filmed Entertainment segments may not have the right, and may not be able to secure the right, to distribute their licensed content across new delivery platforms that are developed. In addition, technological developments could enable third-party owners of programming to bypass traditional content aggregators, such as the Turner networks and Home Box Office, and deal directly with cable and DTH satellite operators or other businesses that develop to offer content to viewers. Such limitations on the ability of the segments to distribute their content could have an adverse impact on their revenue. Cable system and DTH satellite operators are developing new techniques that enable them to transmit more channels on their existing equipment to highly targeted audiences, reducing the cost of creating channels and potentially furthering the development of more specialized niche audiences. A greater number of options increases competition for viewers, and competitors targeting programming to narrowly defined audiences may improve their competitive position compared to the Networks and Filmed Entertainment segments for television advertising and for subscription and licensing revenue. In addition, traditional ratings measures are likely to change with emerging technologies that can measure viewing audiences with improved sensitivity. These changes could result in changes to measured audiences, especially in the local geographic regions measured by Nielsen Media Research. Any decrease in measured audiences could adversely affect the advertising revenue of the advertising-supported networks in the Networks segment and have a negative impact on the licensing revenue generated by the Filmed Entertainment segment and the revenue generated by Home Box Office from the licensing of its original programming in syndication and to basic cable channels. The ability to anticipate and adapt to changes in technology on a timely basis and exploit new sources of revenue from these changes will affect the ability of the Networks and Filmed Entertainment segments to continue to grow and increase their revenue.

 

The Networks and Filmed Entertainment segments operate in highly competitive industries.  The Company’s Networks and Filmed Entertainment businesses generate revenue through the production and distribution of feature films, television programming and home video products, licensing fees, the sale of advertising and subscriber fees paid by affiliates. Competition faced by the businesses within these segments is intense and comes from many different sources. For example:

 

 

 

The ability of the Company’s Networks and Filmed Entertainment segments to compete successfully depends on many factors, including their ability to provide high-quality and popular entertainment product and their ability to achieve high distribution levels. There has been consolidation in the media industry, and the Company’s Networks and Filmed Entertainment segments’ competitors include industry participants with interests in other multiple media businesses that are often vertically integrated. Vertical integration of other television networks and television and film production companies could adversely impact the Networks segment if it hinders the ability of the Networks segment to obtain programming for its networks. In addition, if purchasers of programming increasingly purchase their programming from production companies with which they are affiliated, such vertical integration could have a negative effect on the Filmed Entertainment segment’s licensing revenue. Furthermore, as described above, there is increased competition in the television industry evidenced by the increasing number and variety of broadcast networks and basic cable and pay television programming services now available. Although this increase could result in greater licensing revenue for the Filmed Entertainment segment, it also could result in higher licensing costs for the Networks segment. There can be no assurance that the Networks and Filmed Entertainment segments will be able to compete successfully in the future against existing or potential competitors, or that competition will not have an adverse effect on their businesses or results of operations.

 

The popularity of the Company’s television programs and films and other factors is difficult to predict and could lead to fluctuations in the revenue of the Networks and Filmed Entertainment segments.  Television program and film production and distribution are inherently risky businesses largely because the revenue derived from the production and distribution of a television program or motion picture, as well as the licensing of rights to the intellectual property associated with a program or film, depends primarily on its acceptance by the public, which is difficult to predict. The commercial success of a television program or feature film also depends on the quality and acceptance of other competing programs and films released at or near the same time, the availability of alternate forms of entertainment and leisure time activities, general economic conditions and other tangible and intangible factors, many of which are difficult to predict. In the case of the Turner networks, audience sizes are also factors that are weighed when determining their advertising rates. Poor ratings in targeted demographics can lead to a reduction in pricing and advertising spending. Further, the theatrical success of a motion picture may affect revenue from other distribution channels, such as home entertainment and pay television programming services, and sales of licensed consumer products. Therefore, low public acceptance of the television programs or feature films of the Networks and Filmed Entertainment segments may adversely affect their respective results of operations.

 

The Networks and Filmed Entertainment segments are subject to potential labor interruption.  The Networks and Filmed Entertainment segments and certain of their suppliers retain the services of writers, directors, actors, trade employees and others involved in the production of motion pictures and television programs who are covered by collective bargaining agreements. The segments’ collective bargaining agreement with the Writer’s Guild of America (East and West) expires on October 31, 2007. Additionally, there are a number of other production-related bargaining groups whose contracts expire throughout 2007. If expiring collective bargaining agreements are not renewed, it is possible that the affected unions and other groups could take action in the form of strikes, work slowdowns or work stoppages. Such actions could cause delays in the production or the release dates of the segments’ television programs or feature films as well as higher costs resulting either from such action or less favorable terms of these agreements on renewal.

 

Although piracy poses risks to several of Time Warner’s businesses, such risks are especially significant for the Networks and Filmed Entertainment segments due to the prevalence of piracy of feature films and television programming.  See “Risks Relating to Time Warner Generally — Piracy of the Company’s feature films, television programming and other content may decrease the revenues received from the exploitation of the Company’s entertainment content and adversely affect its business and profitability.”

 

RISKS RELATING TO TIME WARNER’S FILMED ENTERTAINMENT BUSINESS

 

DVD sales have been declining, which may adversely affect the Filmed Entertainment segment’s growth prospects and results of operations.  Several factors, including increasing competition for consumer discretionary spending, piracy, the maturation of the DVD format, increased competition for retailer shelf space and the fragmentation of consumer leisure time, may be contributing to an industry-wide decline in DVD sales both domestically and internationally. DVD sales also may be affected as consumers increasingly shift from consuming physical entertainment products to digital forms of entertainment. The filmed entertainment industry faces a challenge in managing the transition from physical to digital formats in a manner that continues to support the current DVD business and its relationships with large retail customers and yet meets the relatively small, but growing, consumer demand for delivery of filmed entertainment in a variety of digital formats. The high definition format war between the HD DVD and Blu-ray formats may slow consumer adoption of those technologies and may likewise result in increased competition for retailer shelf space. There can be no assurance that home video wholesale prices can be maintained at current levels, due to aggressive retail pricing, digital competition and other factors. A continuing decline in DVD sales could have an adverse impact on the segment’s results of operations and growth prospects.

 

The Filmed Entertainment segment’s strategy includes the release of a limited number of “event” films each year, and the underperformance of one or more of these films could have an adverse effect on the Filmed Entertainment segment’s results of operations and financial condition.  The Filmed Entertainment segment expects to theatrically release a limited number of feature films each year that are expected to be “event” or “tent-pole” films and that generally have higher production and marketing costs than the other films released during the year. The underperformance of one of these films can have an adverse impact on the segment’s results of operations in both the year of release and in the future. Historically, there has been a correlation between domestic box office success and international box office success, as well as a correlation between box office success and success in the subsequent distribution channels of home video and television. If the segment’s films fail to achieve box office success, the results of operations and financial condition of the Filmed Entertainment segment could be adversely affected. Further, there can be no assurance that these historical correlations will continue in the future.

 

The costs of producing and marketing feature films have increased and may increase in the future, which may make it more difficult for a film to generate a profit.  The production and marketing of feature films require substantial capital, and the costs of producing and marketing feature films have generally increased in recent years. These costs may continue to increase in the future, which may make it more difficult for the segment’s films to generate a profit. As production and marketing costs increase, it creates a greater need to generate revenue internationally or from other media, such as home video, television and new media.

 

Changes in estimates of future revenues from feature films could result in the write-off or the acceleration of the amortization of film production costs.  The Filmed Entertainment segment is required to amortize

capitalized film production costs over the expected revenue streams as it recognizes revenue from the associated films. The amount of film production costs that will be amortized each quarter depends on how much future revenue the segment expects to receive from each film. Unamortized film production costs are evaluated for impairment each reporting period on a film-by-film basis. If estimated remaining revenue is not sufficient to recover the unamortized film production costs plus expected but unincurred marketing costs, the unamortized film production costs will be written down to fair value. In any given quarter, if the segment lowers its forecast with respect to total anticipated revenue from any individual feature film, it would be required to accelerate amortization of related film costs. Such a write-down or accelerated amortization could adversely impact the operating results of the Filmed Entertainment segment.

 

A decrease in demand for television product could adversely affect Warner Bros.’ revenues.  Warner Bros. is a leading supplier of television programming. If there is a decrease in the demand for Warner Bros.’ television product, it could lead to the launch of fewer new television series and a reduction in the number of original programs ordered by the networks and the per-episode license fees generated by Warner Bros. in the near term. In addition, such a decrease in demand could lead to a reduction in syndication revenues in the future. Various factors may increase the risk of such a decrease in demand, including station group consolidation and vertical integration between station groups and broadcast networks, as well as the vertical integration between television production studios and broadcast networks, which can increase the networks’ reliance on their in-house or affiliated studios. In addition, the move of viewers and advertisers away from network television to other entertainment and information outlets could adversely affect the amount of original programming ordered by networks and the amount they are willing to pay for such programming. Local television stations may face loss of viewership and an accompanying loss of advertising revenue as viewers move to other entertainment outlets, which may negatively impact the segment’s ability to obtain the per-episode license fees in syndication that it has received in the past. Finally, the increasing popularity of local television content in international markets also could result in decreased demand, fewer available broadcast slots, and lower licensing and syndication revenue for U.S. television content.

RISKS RELATING TO TIME WARNER’S NETWORKS BUSINESS

 

The loss of affiliation agreements could cause the revenue of the Networks segment to decline in any given period, and further consolidation of multichannel video programming distributors could adversely affect the segment.  The Networks segment depends on affiliation agreements with cable system and DTH satellite operators for the distribution of its networks, and there can be no assurance that these affiliation agreements will be renewed in the future on terms that are acceptable to the Networks segment. The renewal of such agreements on less favorable terms may adversely affect the segment’s results of operations. In addition, the loss of any one of these arrangements representing a significant number of subscribers or the loss of carriage on the most widely penetrated programming tiers could reduce the distribution of the segment’s programming, which may adversely affect its advertising and subscription revenue. The loss of favorable packaging, positioning, pricing or other marketing opportunities with any distributor of the segment’s networks also could reduce subscription revenue. In addition, further consolidation among cable system and DTH satellite operators has provided greater negotiating power to such distributors, and increased vertical integration of such distributors could adversely affect the segment’s ability to maintain or obtain distribution and/or marketing for its networks on commercially reasonable terms, or at all.

 

The inability of the Networks segment to license rights to popular programming or create popular original programming could adversely affect the segment’s revenue.  The Networks segment obtains a significant portion of its popular programming from third parties. For example, some of Turner’s most widely viewed programming, including sports programming, is made available based on programming rights of varying durations that it has negotiated with third parties. Home Box Office also enters into commitments to acquire rights to feature films and other programming for its HBO and Cinemax pay television programming services from feature film producers and other suppliers for varying durations. Competition for popular programming licensed from third parties is intense, and the businesses in the segment may be outbid by their competitors for the rights to new popular programming or in connection with the renewal of popular programming they currently license. In addition, renewal costs could substantially exceed the existing contract costs. Alternatively, third parties from which the segment obtains programming, such as professional sports teams or leagues, could create their own networks.

 

The operating results of the Networks segment also fluctuate with the popularity of its programming with the public, which is difficult to predict. Revenue from the segment’s businesses is therefore partially dependent on the segment’s ability to develop strong brand awareness and to target key areas of the television viewing audience, including both newer demographics and preferences for particular genres, as well as its ability to continue to anticipate and adapt to changes in consumer tastes and behavior on a timely basis. Moreover, the Networks segment derives a portion of its revenue from the exploitation of the Company’s library of feature films, animated titles and television titles. If the content of the Company’s programming libraries ceases to be of interest to audiences or is not continuously replenished with popular original content, the revenue of the Networks segment could be adversely affected.

 

Increases in the costs of programming licenses and other significant costs may adversely affect the gross margins of the Networks segment.  As described above, the Networks segment licenses a significant amount of its programming, such as motion pictures, television series, and sports events, from movie studios, television production companies and sports organizations. For example, the Turner networks license the rights to broadcast significant sports events such as the NBA play-offs and a series of NASCAR races. In addition, Home Box Office relies on film studios for a significant portion of its content. If the level of demand for quality content exceeds the amount of quality content available, the networks may have to pay significantly higher licensing costs, which in turn will exert greater pressure on the segment to offset such increased costs with higher advertising and/or subscription revenue. There can be no assurance that the Networks segment will be able to renew existing or enter into additional license agreements for its programming and, if so, if it will be able to do so on terms that are similar to existing terms. There also can be no assurance that it will be able to obtain the rights to distribute the content it licenses over new distribution platforms on acceptable terms. If it is unable to obtain such extensions, renewals or agreements on acceptable terms, the gross margins of the Networks segment may be adversely affected.

 

The Networks segment also produces programming, and it incurs costs for new show concepts and all types of creative talent, including actors, writers and producers. The segment incurs additional significant costs, such as

newsgathering and marketing costs. Unless they are offset by increased revenue, increases in the costs of creative talent or in production, newsgathering or marketing costs may lead to decreased profits at the Networks segments.

 

The continued decline in the growth rate of U.S. basic cable and DTH satellite households, together with rising retail rates, distributors’ focus on selling alternative products and other factors, could adversely affect the future revenue growth of the Networks segment.  The U.S. video services business generally is a mature business, which may have a negative impact on the ability of the Networks segment to achieve incremental growth in its advertising and subscription revenues. In addition, programming distributors may increase their resistance to wholesale programming price increases, and programming distributors are increasingly focused on selling services other than video, such as high-speed data access and voice services. Also, consumers’ basic cable rates have continued to increase, which could cause consumers to cancel their cable or satellite service subscriptions. The inability of the Networks segment to implement measures to maintain future revenue growth may adversely affect its business.

 

Changes in U.S. or foreign communications laws or other regulations may have an adverse effect on the business of the Networks segment.  The multichannel video programming and distribution industries in the United States, as well as broadcast networks, are regulated by U.S. federal laws and regulations issued and administered by various federal agencies, including the FCC. The U.S. Congress and the FCC currently are considering, and may in the future adopt, new laws, regulations and policies regarding a wide variety of matters that could, directly or indirectly, affect the operations of the Networks segment. For example, the FCC has been examining whether cable operators should offer “à la carte” programming to subscribers on a network-by-network basis or provide “family-friendly” tiers. A number of cable operators, including TWC, have voluntarily agreed to offer family tiers in light of this interest. The unbundling or tiering of program services may reduce distribution of certain cable networks, thereby creating the risk of reduced viewership and increased marketing expenses, and may affect the segment’s ability to compete for or attract the same level of advertising dollars. Any decline in subscribers could lead to a decrease in the segment’s advertising and subscription revenues.

 

There also has been consideration of the extension of indecency rules applicable to over-the-air broadcasters to cable and satellite programming and stricter enforcement of existing laws and rules. If such an extension or attempt to increase enforcement occurred and were upheld, the content of the Networks segment could be subject to additional regulation, which could affect subscriber and viewership levels. Moreover, the determination of whether content is indecent is inherently subjective and, as such, it can be difficult to predict whether particular content would violate indecency standards. The difficulty in predicting whether individual programs, words or phrases may violate the FCC’s indecency rules adds uncertainty to the ability of the Networks segment to comply with the rules. Violation of the indecency rules could lead to sanctions that may adversely affect the businesses and results of operations of the Networks segment.

 

RISKS RELATING TO TIME WARNER’S PUBLISHING BUSINESS

 

The Publishing segment’s operating income could decrease as a result of rising paper costs and postal rates, and its business could be negatively impacted by a significant disruption in postal service.  The Publishing segment’s principal raw material is paper, and paper prices have fluctuated over the past several years. Accordingly, significant unanticipated increases in paper prices could adversely affect the segment’s operating income. Postage for magazine distribution and direct solicitation is another significant operating expense of the Publishing segment, which primarily uses the U.S. Postal Service to distribute its products. The U.S. Postal Service implemented a postal rate increase of 5.4% effective January 8, 2006 and has proposed an additional increase of approximately 10% effective May 6, 2007, which is currently being challenged before the Postal Rate Commission. If there are further or more frequent significant increases in paper costs or postal rates and the Publishing segment is not able to offset these increases, they could have a negative impact on the segment’s operating income. In addition, if factors such as increased fuel and wage costs lead to a significant reduction or disruption in the service provided by the U.S. Postal Service, this could adversely affect the Publishing segment’s business.

 

The Publishing segment faces risks relating to various regulatory and legislative matters, including changes in Audit Bureau of Circulations rules and possible changes in regulation of direct marketing.  The Publishing segment’s magazine subscription and direct marketing activities are subject to regulation by the FTC and the states

under general consumer protection statutes prohibiting unfair or deceptive acts or practices. Certain areas of marketing activity are also subject to specific federal statutes and rules, such as the Telephone Consumer Protection Act, the Children’s Online Privacy Protection Act, the Gramm-Leach-Bliley Act (relating to financial privacy), the FTC Mail or Telephone Order Merchandise Rule and the FTC Telemarketing Sales Rule. Other statutes and rules also regulate conduct in areas such as privacy, data security and telemarketing. New statutes and regulations are adopted frequently. In addition, the Publishing segment’s magazine subscription and direct marketing activities are subject to the rules of the Audit Bureau of Circulations. New rules, as well as new interpretations of existing rules, are periodically adopted by the Audit Bureau of Circulations and could lead to changes in the segment’s marketing methods that could have a negative effect on the segment’s ability to generate new magazine subscriptions, meet rate bases and support advertising sales.

 

The Publishing segment faces significant competition for advertising and circulation.  The Publishing segment faces significant competition from several direct competitors and other media, including the Internet. The Publishing segment’s magazine operations compete for circulation and audience with numerous other magazine publishers and other media. The Publishing segment’s magazine operations also compete with other magazine publishers and other media for advertising directed at the general public and at more focused demographic groups. Time Inc.’s direct marketing operations compete with other direct marketers through all media for the consumer’s attention.

 

Competition for advertising revenue is primarily based on advertising rates, the nature and amount of readership, reader response to advertisers’ products and services and the effectiveness of sales teams. Other competitive factors in magazine publishing include product positioning, editorial quality, circulation, price and customer service, which impact readership audience, circulation revenue and, ultimately, advertising revenue. The magazine publishing business presents few barriers to entry and many new magazines are launched annually across multiple sectors. In recent years competitors launched and/or repositioned many magazines, primarily in the celebrity and women’s service sectors, that compete directly with People, In Style, Real Simple and other Publishing segment magazines, particularly at newsstand checkouts in mass-market retailers. The Company anticipates that it will face continuing competition from these new competitors, and it is possible that additional competitors may enter this field and further intensify competition, which could have an adverse impact on the segment’s revenue.

 

The Publishing segment has in recent years made various changes in its circulation practices and consequently faces new challenges in identifying new subscribers and increasing circulation, which could have an adverse impact not only on its circulation revenue but also on its advertising revenue.

 

The Publishing segment could face increased costs and business disruption resulting from instability in the newsstand distribution channel.  The Publishing segment operates a national distribution business that relies on wholesalers to distribute magazines published by the Publishing segment and other publishers to newsstands and other retail outlets. Due to industry consolidation, four wholesalers represent more than 80% of the wholesale magazine distribution business. There is a possibility of further consolidation among these wholesalers and/or insolvency of one or more of these wholesalers. Should there be a disruption in this wholesale channel it could adversely affect the Publishing segment’s operating income and cash flow, including temporarily impeding the Publishing segment’s ability to distribute magazines to the retail marketplace.

 

Although the shift in consumer habits and/or advertising expenditures from traditional to online media poses risks to several of the Company’s businesses, such risks are particularly significant for the Company’s Publishing segment because a substantial portion of the segment’s revenue is derived from the sale of advertising.  See “Risks Relating to Time Warner Generally — The introduction and increased popularity of alternative technologies for the distribution of news, entertainment and other information and the resulting shift in consumer habits and/or advertising expenditures from traditional to online media could adversely affect the revenues of the Company’s Publishing, Networks and Filmed Entertainment segments.”

 

 

Not applicable.

 

 

The following table sets forth certain information as of December 31, 2006 with respect to the Company’s principal properties (over 250,000 square feet in area) that are occupied for corporate offices or used primarily by the Company’s divisions, all of which the Company considers adequate for its present needs, and all of which were substantially used by the Company or were leased to outside tenants:

 

 

 

 

 

Securities Matters

 

Consolidated Securities Class Action

 

During the Summer and Fall of 2002, 30 shareholder class action lawsuits were filed naming as defendants the Company, certain current and former executives of the Company and, in several instances, AOL. These lawsuits were filed in U.S. District Courts for the Southern District of New York, the Eastern District of Virginia and the Eastern District of Texas. The complaints purported to be made on behalf of certain shareholders of the Company and alleged that the Company made material misrepresentations and/or omissions of material fact in violation of Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated thereunder, and Section 20(a) of the Exchange Act. Plaintiffs claimed that the Company failed to disclose AOL’s declining advertising revenues and that the Company and AOL inappropriately inflated advertising revenues in a series of transactions. Certain of the lawsuits also alleged that certain of the individual defendants and other insiders at the Company improperly sold their personal holdings of Time Warner stock, that the Company failed to disclose that the January 2001 merger of America Online, Inc. (now AOL LLC) and Time Warner Inc., now known as Historic TW Inc. (“Historic TW”) (the “Merger” or the “AOL-Historic TW Merger”), was not generating the synergies anticipated at the time of the announcement of the merger and, further, that the Company inappropriately delayed writing down more than $50 billion of goodwill. The lawsuits sought an unspecified amount in compensatory damages. All of these lawsuits were centralized in the U.S. District Court for the Southern District of New York for coordinated or consolidated pretrial proceedings (along with the federal derivative lawsuits and certain lawsuits brought under ERISA described below) under the caption In re AOL Time Warner Inc. Securities and “ERISA” Litigation.

The Minnesota State Board of Investment (“MSBI”) was designated lead plaintiff for the consolidated securities actions and filed a consolidated amended complaint on April 15, 2003, adding additional defendants including additional officers and directors of the Company, Morgan Stanley & Co., Salomon Smith Barney Inc., Citigroup Inc., Banc of America Securities LLC and JP Morgan Chase & Co. Plaintiffs also added additional allegations, including that the Company made material misrepresentations in its registration statements and joint proxy statement-prospectus related to the AOL-Historic TW Merger and in its registration statements pursuant to which debt securities were issued in April 2001 and April 2002, allegedly in violation of Section 11 and Section 12 of the Securities Act of 1933. On July 14, 2003, the defendants filed a motion to dismiss the consolidated amended complaint. On May 5, 2004, the district court granted in part the defendants’ motion, dismissing all claims with respect to the registration statements pursuant to which debt securities were issued in April 2001 and April 2002 and certain other claims against other defendants, but otherwise allowing the remaining claims against the Company and certain other defendants to proceed. On August 11, 2004, the court granted MSBI’s motion to file a second amended complaint. On July 30, 2004, defendants filed a motion for summary judgment on the basis that plaintiffs could not establish loss causation for any of their claims, and thus plaintiffs did not have any recoverable damages. On April 8, 2005, MSBI moved for leave to file a third amended complaint to add certain new factual allegations and four additional individual defendants.

 

In July 2005, the Company reached an agreement in principle with MSBI for the settlement of the consolidated securities actions. The settlement is reflected in a written agreement between the lead plaintiff and the Company. On September 30, 2005, the court issued an order granting preliminary approval of the settlement and certified the settlement class. The court issued an order dated April 6, 2006 granting final approval of the settlement, and the time to appeal that decision has expired. In connection with reaching the agreement in principle on the securities class action, the Company established a reserve of $3 billion during the second quarter of 2005 reflecting the MSBI settlement and other pending related shareholder and ERISA litigation. Pursuant to the MSBI settlement, in October 2005, Time Warner paid $2.4 billion into a settlement fund (the “MSBI Settlement Fund”) for the members of the class represented in the action, and Ernst & Young LLP paid $100 million. In connection with the settlement, the $150 million previously paid by Time Warner into a fund in connection with the settlement of the investigation by the DOJ was transferred to the MSBI Settlement Fund. In addition, the $300 million the Company previously paid in connection with the settlement of its SEC investigation will be distributed to investors through the MSBI settlement process pursuant to an order issued by the U.S. District Court for the District of Columbia on July 11, 2006. On October 27, 2006, the court awarded to plaintiffs’ counsel fees in the amount of $147.5 million and reimbursement for expenses in the amount of $3.4 million, plus interest accrued on such amounts since October 7, 2005, the date the Company paid $2.4 billion into the MSBI Settlement Fund; these amounts are to be paid from the MSBI Settlement Fund. The administration of the MSBI settlement is ongoing. Settlements also have been reached in many of the additional related cases, including the ERISA and derivative actions, as described below.

 

Other Related Securities Litigation Matters

 

During the Fall of 2002 and Winter of 2003, three putative class action lawsuits were filed alleging violations of ERISA in the U.S. District Court for the Southern District of New York on behalf of current and former participants in the Time Warner Savings Plan, the Time Warner Thrift Plan and/or the TWC Savings Plan (the “Plans”). Collectively, these lawsuits named as defendants the Company, certain current and former directors and officers of the Company and members of the Administrative Committees of the Plans. The lawsuits alleged that the Company and other defendants breached certain fiduciary duties to plan participants by, inter alia, continuing to offer Time Warner stock as an investment under the Plans, and by failing to disclose, among other things, that the Company was experiencing declining advertising revenues and that the Company was inappropriately inflating advertising revenues through various transactions. The complaints sought unspecified damages and unspecified equitable relief. The ERISA actions were consolidated as part of the In re AOL Time Warner Inc. Securities and “ERISA” Litigation described above. On July 3, 2003, plaintiffs filed a consolidated amended complaint naming additional defendants, including TWE, certain current and former officers, directors and employees of the Company and Fidelity Management Trust Company. On September 12, 2003, the Company filed a motion to dismiss the consolidated ERISA complaint. On March 9, 2005, the court granted in part and denied in part the Company’s motion to dismiss. The court dismissed two individual defendants and TWE for all purposes, dismissed other individuals with respect to claims plaintiffs had asserted involving the TWC Savings Plan, and dismissed all

individuals who were named in a claim asserting that their stock sales had constituted a breach of fiduciary duty to the Plans. The parties reached an agreement to resolve this matter in 2006 and the court granted preliminary approval of the settlement in an opinion dated May 1, 2006. A final approval hearing was held on July 19, 2006, and the court granted final approval of the settlement in an opinion dated September 27, 2006. On October 25, 2006, one of the objectors to this settlement filed a notice of appeal of this decision; pursuant to a settlement agreement between the parties in a related securities matter, that objector subsequently withdrew his notice of appeal, and the time to appeal has expired. The court has yet to rule on plaintiffs’ petition for attorneys’ fees and expenses.

 

During the Summer and Fall of 2002, 11 shareholder derivative lawsuits were filed naming as defendants certain current and former directors and officers of the Company, as well as the Company as a nominal defendant. Three were filed in New York State Supreme Court for the County of New York, four were filed in the U.S. District Court for the Southern District of New York and four were filed in the Court of Chancery of the State of Delaware for New Castle County. The complaints alleged that defendants breached their fiduciary duties by causing the Company to issue corporate statements that did not accurately represent that AOL had declining advertising revenues and by failing to conduct adequate due diligence in connection with the AOL-Historic TW Merger, that the AOL-Historic TW Merger was not generating the synergies anticipated at the time of the announcement of the merger, and that the Company inappropriately delayed writing down more than $50 billion of goodwill, thereby exposing the Company to potential liability for alleged violations of federal securities laws. The lawsuits further alleged that certain of the defendants improperly sold their personal holdings of Time Warner securities. The lawsuits requested that (i) all proceeds from defendants’ sales of Time Warner common stock, (ii) all expenses incurred by the Company as a result of the defense of the shareholder class actions discussed above and (iii) any improper salaries or payments be returned to the Company. The four lawsuits filed in the Court of Chancery for the State of Delaware for New Castle County were consolidated under the caption, In re AOL Time Warner Inc. Derivative Litigation. A consolidated complaint was filed on March 7, 2003 in that action, and on June 9, 2003, the Company filed a notice of motion to dismiss the consolidated complaint. On May 2, 2003, the three lawsuits filed in New York State Supreme Court for the County of New York were dismissed on forum non conveniens grounds, and plaintiffs’ time to appeal has expired. The four lawsuits pending in the U.S. District Court for the Southern District of New York were centralized for coordinated or consolidated pre-trial proceedings with the securities and ERISA lawsuits described above under the caption In re AOL Time Warner Inc. Securities and “ERISA” Litigation. On October 6, 2004, plaintiffs filed an amended consolidated complaint in three of these four cases. On April 20, 2006, plaintiffs in the four lawsuits filed in the Court of Chancery of the State of Delaware for New Castle County filed a new complaint in the U.S. District Court for the Southern District of New York. The parties to all of these actions subsequently reached an agreement to resolve all remaining matters in 2006, and the federal district court in New York granted preliminary approval of the settlement in an opinion dated May 10, 2006. A final approval hearing was held on June 28, 2006, and the court granted final approval of the settlement in an opinion dated September 6, 2006. The time to appeal that decision has expired. The court has yet to rule on plaintiffs’ petition for attorneys’ fees and expenses.

 

During the Summer and Fall of 2002, several lawsuits brought by individual shareholders were filed in various federal jurisdictions, and in late 2005 and early 2006, numerous additional shareholders determined to “opt-out” of the settlement reached in the consolidated federal securities class action described above, and many have since filed federal lawsuits. The claims alleged in these actions are substantially identical to the claims alleged in the consolidated federal securities class action described above, and all of these cases have been transferred to the U.S. District Court for the Southern District of New York for coordinated or consolidated pre-trial proceedings. In May 2006, amended complaints were filed in thirty-five of these cases. In June 2006, the Company filed a motion to dismiss and a motion for partial summary judgment in these thirty-five cases, which seek to dismiss some or all of the complaints and/or to preclude recovery of alleged damages incurred prior to July 2002 based on loss causation principles. The Court has scheduled oral argument on these motions for February 28, 2007. In March 2006, the parties reached an agreement to settle the claims brought in the case Stichting Pensioenfonds ABP v. AOL Time Warner, et al. In December 2006, the parties reached an agreement to settle the claims brought in the case DEKA Investment GMBH et al. v. AOL Time Warner Inc. et al. Also in December 2006, the parties reached an agreement to settle the claims brought in the case Norges Bank v. AOL Time Warner Inc. et al. The aggregate amount for which the Company has settled these three lawsuits as well as related lawsuits is described below. The Company intends to defend against the remaining lawsuits vigorously.

 

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

 

On April 14, 2003, Regents of the University of California et al. v. Parsons et al., was filed in California Superior Court, County of Los Angeles, naming as defendants the Company, certain current and former officers, directors and employees of the Company, Ernst & Young LLP, Citigroup Inc., Salomon Smith Barney Inc. and Morgan Stanley & Co. Plaintiffs allege that the Company made material misrepresentations in its registration statements related to the AOL-Historic TW Merger and stock option plans in violation of Sections 11 and 12 of the Securities Act of 1933. The complaint also alleges common law fraud and breach of fiduciary duties under California state law. Plaintiffs seek disgorgement of alleged insider trading proceeds and restitution for their stock losses. Three related cases have been filed in California Supreme Court and have been coordinated in the County of Los Angeles. On January 26, 2004, certain individuals filed motions to dismiss for lack of personal jurisdiction. On September 10, 2004, the Company filed a motion to dismiss plaintiffs’ complaints and certain individual defendants (who had not previously moved to dismiss plaintiffs’ complaints for lack of personal jurisdiction) filed a motion to dismiss plaintiffs’ complaints. On April 22, 2005, the court granted certain motions to dismiss for lack of personal jurisdiction and denied certain motions to dismiss for lack of personal jurisdiction. The court issued a series of rulings on threshold issues presented by the motions to dismiss on May 12, July 22 and August 2, 2005. These rulings granted in part and denied in part the relief sought by defendants, subject to plaintiffs’ right to make a prima facie evidentiary showing to support certain dismissed claims. In January 2006, the Los Angeles County Employees Retirement Agency, which had filed one of the three related cases described above, voluntarily dismissed its lawsuit; an order of dismissal was entered on January 17, 2006. Also in January 2006, two additional individual actions were filed in California Superior Court against the Company and, in one instance, Ernst & Young LLP and certain former officers, directors and executives of the Company. Both of these additional individual actions assert claims substantially identical to those asserted in the four actions already coordinated in California Superior Court, and have been consolidated with the other coordinated proceedings. In December 2006, the Company reached an agreement to settle the claims brought by the California State Teachers’ Retirement System and the Franklin Funds. In February 2007, the Company reached an agreement in principle to settle the claims brought by the plaintiffs in the remaining related cases, including the Regents of the University of California and the California Public Employees’ Retirement System. The aggregate amount for which the Company has settled these as well as related lawsuits is described below.

 

On July 18, 2003, Ohio Public Employees Retirement System et al. v. Parsons et al. was filed in Ohio, Court of Common Pleas, Franklin County, naming as defendants the Company, certain current and former officers, directors and employees of the Company, Citigroup Inc., Salomon Smith Barney Inc., Morgan Stanley & Co. and Ernst & Young LLP. Plaintiffs allege that the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiffs also allege violations of Ohio law, breach of fiduciary duty and common law fraud. Plaintiffs seek disgorgement of alleged insider trading proceeds, restitution and unspecified compensatory damages. On October 29, 2003, the Company moved to stay the proceedings or, in the alternative, dismiss the complaint. Also on October 29, 2003, all named individual defendants moved to dismiss the complaint for lack of personal jurisdiction. On October 8, 2004, the court granted in part the Company’s motion to dismiss plaintiffs’ complaint; specifically, the court dismissed plaintiffs’ common law claims but otherwise allowed plaintiffs’ remaining statutory claims against the Company and certain other defendants to proceed. The Company answered the complaint on February 22, 2005. On November 17, 2005, the court granted the jurisdictional motions of twenty-five of the individual defendants, and dismissed them from the case. The court has informed the parties that it intends for this matter to be ready for trial by January 2008. The Company intends to defend against this lawsuit vigorously.

 

On July 18, 2003, West Virginia Investment Management Board v. Parsons et al. was filed in West Virginia, Circuit Court, Kanawha County, naming as defendants the Company, certain current and former officers, directors and employees of the Company, Citigroup Inc., Salomon Smith Barney Inc., Morgan Stanley & Co., and Ernst & Young LLP. Plaintiff alleges the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiff also alleges violations of West Virginia law, breach of fiduciary duty and common law fraud. Plaintiff seeks disgorgement of alleged insider trading proceeds, restitution and unspecified compensatory damages. On May 27, 2004, the Company filed a motion to dismiss the complaint. Also on May 27, 2004, all named individual defendants moved to dismiss the complaint for lack of personal jurisdiction. The Company intends to defend against this lawsuit vigorously.

 

On January 28, 2004, McClure et al. v. AOL Time Warner Inc. et al. was filed in the District Court of Cass County, Texas (purportedly on behalf of several purchasers of Company stock) naming as defendants the Company and certain current and former officers, directors and employees of the Company. Plaintiffs allege that the Company made material misrepresentations in its registration statements in violation of Sections 11 and 12 of the Securities Act of 1933. Plaintiffs also allege breach of fiduciary duty and common law fraud. Plaintiffs seek unspecified compensatory damages. On May 8, 2004, the Company filed a general denial and a motion to dismiss for improper venue. Also on May 8, 2004, all named individual defendants moved to dismiss the complaint for lack of personal jurisdiction. In February 2007, the parties reached an agreement in principle to settle this lawsuit. The aggregate amount for which the Company has settled this as well as related lawsuits is described below.

 

On April 1, 2004, Alaska State Department of Revenue et al. v. America Online, Inc. et al. was filed in Superior Court in Juneau County, Alaska, naming as defendants the Company, certain current and former officers, directors and employees of the Company, AOL, Historic TW, Morgan Stanley & Co., Inc., and Ernst & Young LLP. Plaintiffs alleged that the Company made material misrepresentations in its registration statements in violation of Alaska law and common law fraud. The plaintiffs sought unspecified compensatory and punitive damages. In December 2006, the parties reached an agreement to settle this lawsuit. The aggregate amount for which the Company has settled this as well as related lawsuits is described below.

 

On November 15, 2002, the California State Teachers’ Retirement System filed an amended consolidated complaint in the U.S. District Court for the Central District of California on behalf of a putative class of purchasers of stock in Homestore.com, Inc. (“Homestore”). Plaintiff alleged that Homestore engaged in a scheme to defraud its shareholders in violation of Section 10(b) of the Exchange Act. The Company and two former employees of its AOL division were named as defendants in the amended consolidated complaint because of their alleged participation in the scheme through certain advertising transactions entered into with Homestore. Motions to dismiss filed by the Company and the two former employees were granted on March 7, 2003, and a final judgment of dismissal was entered on March 8, 2004. On April 7, 2004, plaintiff filed a notice of appeal in the Ninth Circuit Court of Appeals. The Ninth Circuit heard oral argument on this appeal on February 6, 2006 and issued an opinion on June 30, 2006 affirming the lower court’s decision and remanding the case to the district court for further proceedings. On September 28, 2006, plaintiff filed a motion for leave to amend the complaint, and on December 18, 2006, the court held a hearing and denied plaintiff’s motion. In addition, on October 20, 2006, the Company joined its co-defendants in filing a petition for certiorari with the Supreme Court of the United States, seeking reconsideration of the Ninth Circuit’s decision. In December 2006, the Company reached an agreement with plaintiff to settle its claims against the Company and its former employees. The aggregate amount for which the Company has agreed to settle this as well as related lawsuits is described below. The settlement agreement will be subject to preliminary and final approval by the district court. There can be no assurance that the settlement will receive either preliminary or final court approval.

 

On April 30, 2004, a second amended complaint was filed in the U.S. District Court for the District of Nevada on behalf of a putative class of purchasers of stock in PurchasePro.com, Inc. (“PurchasePro”). Plaintiffs alleged that PurchasePro engaged in a scheme to defraud its shareholders in violation of Section 10(b) of the Exchange Act. The Company and four former officers and employees were added as defendants in the second amended complaint and were alleged to have participated in the scheme through certain advertising transactions entered into with PurchasePro. Three similar putative class actions had previously been filed against the Company, AOL and certain former officers and employees, and were consolidated with the Nevada action. On February 17, 2005, the judge in the consolidated action granted the Company’s motion to dismiss the second amended complaint with

prejudice. The parties have agreed to settle this matter. The court granted preliminary approval of the proposed settlement in an order dated July 18, 2006 and granted final approval of the settlement in an order dated October 10, 2006. The administration of the settlement is ongoing. The aggregate amount for which the Company has settled this as well as related lawsuits is described below.

 

During the fourth quarter of 2006, the Company established an additional reserve of $600 million related to the remaining securities litigation matters described above, bringing the total reserve for unresolved claims to approximately $620 million at December 31, 2006. The prior reserve aggregating $3.0 billion established in the second quarter of 2005 had been substantially utilized as a result of the settlements resolving many of the other shareholder lawsuits that had been pending against the Company, including settlements entered into during the fourth quarter of 2006. During February 2007, the Company reached agreements in principle to pay approximately $405 million to settle certain of the remaining claims — amounts consistent with the estimates contemplated in establishing the additional reserve, including approximately $400 million for which agreement in principle was reached on February 14, 2007. However, additional lawsuits remain pending, with plaintiffs in these remaining matters claiming approximately $3 billion in aggregated damages with interest. The Company has engaged in, and may in the future engage in, mediation in an attempt to resolve the remaining cases. If the remaining cases cannot be resolved by adjudication on summary judgment or by settlement, trials will ensue in these matters. As of February 22, 2007, the remaining reserve of approximately $215 million reflects the Company’s best estimate, based on the many related securities litigation matters that it has resolved to date, of its financial exposure in the remaining lawsuits. The Company intends to defend the remaining lawsuits vigorously, including through trial. It is possible, however, that the ultimate resolution of these matters could involve amounts materially greater or less than the remaining reserve, depending on various developments in these litigation matters.

 

Government Investigations

 

As previously disclosed by the Company, the SEC and the DOJ had conducted investigations into accounting and disclosure practices of the Company. Those investigations focused on advertising transactions, principally involving the Company’s AOL segment, the methods used by the AOL segment to report its subscriber numbers and the accounting related to the Company’s interest in AOL Europe prior to January 2002. During 2004, the Company established $510 million in legal reserves related to the government investigations, the components of which are discussed in more detail in the following paragraphs.

 

The Company and its subsidiary, AOL, entered into a settlement with the DOJ in December 2004 that provided for a deferred prosecution arrangement for a two-year period. In December 2006, as part of the deferred prosecution arrangement, the DOJ’s complaint against AOL was dismissed. As part of the settlement with the DOJ, in December 2004, the Company paid a penalty of $60 million and established a $150 million fund, which the Company could use to settle related securities litigation. During October 2005, the $150 million was transferred by the Company into the MSBI Settlement Fund for the members of the class covered by the MSBI consolidated securities class action described above.

 

In addition, on March 21, 2005, the Company announced that the SEC had approved the Company’s proposed settlement, which resolved the SEC’s investigation of the Company. Under the terms of the settlement with the SEC, the Company agreed, without admitting or denying the SEC’s allegations, to be enjoined from future violations of certain provisions of the securities laws and to comply with the cease-and-desist order issued by the SEC to AOL in May 2000. The settlement also required the Company to:

 

 

The Company paid the $300 million penalty in March 2005; however, it is unable to deduct the penalty for income tax purposes, be reimbursed or indemnified for such payment through insurance or any other source, or use such payment to setoff or reduce any award of compensatory damages to plaintiffs in related securities litigation pending against the Company. As described above, the district court judge presiding over the $300 million fund has approved the SEC’s plan to distribute the monies to investors through the settlement in the consolidated class action, as provided in its order. Historical accounting adjustments related to the SEC settlement were reflected in the restatement of the Company’s financial results for each of the years ended December 31, 2000 through December 31, 2003 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.

 

During the third quarter of 2006, the independent examiner completed his review and, in accordance with the terms of the SEC settlement, provided a report to the Company’s audit and finance committee of his conclusions. As a result of the conclusions, the Company’s consolidated financial results were restated for each of the years ended December 31, 2000 through December 31, 2005 and for the three months ended March 31, 2006 and the three and six months ended June 30, 2006 and are reflected in amendments filed with the SEC on September 13, 2006.

 

Other Matters

 

Warner Bros. (South) Inc. (“WBS”), a wholly owned subsidiary of the Company, is litigating numerous tax cases in Brazil. WBS currently is the theatrical distribution licensee for Warner Bros. Entertainment Nederlands (“Warner Bros.”) in Brazil and acts as a service provider to the Warner Bros. home video licensee. All of the ongoing tax litigation involves WBS’ distribution activities prior to January 2004, when WBS conducted both theatrical and home video distribution. Much of the tax litigation stems from WBS’ position that in distributing videos to rental retailers, it was conducting a distribution service, subject to a municipal service tax, and not the “industrialization” or sale of videos, subject to Brazilian federal and state VAT-like taxes. Both the federal tax authorities and the State of Sao Paulo, where WBS is based, have challenged this position. In some additional tax cases, WBS, often together with other film distributors, is challenging the imposition of taxes on royalties remitted outside of Brazil and the constitutionality of certain taxes. The Company intends to defend all of these various tax cases vigorously, but is unable to predict the outcome of these suits.

 

On October 8, 2004, certain heirs of Jerome Siegel, one of the creators of the “Superman” character, filed suit against the Company, DC Comics and Warner Bros. Entertainment Inc. in the U.S. District Court for the Central District of California. Plaintiffs’ complaint seeks an accounting and demands up to one-half of the profits made on Superman since the alleged April 16, 1999 termination by plaintiffs of Siegel’s grants of one-half of the rights to the Superman character to DC Comics’ predecessor-in-interest. Plaintiffs have also asserted various Lanham Act and unfair competition claims, alleging “wasting” of the Superman property by DC Comics and failure to accord credit to Siegel. The Company answered the complaint and filed counterclaims on November 11, 2004, to which plaintiffs replied on January 7, 2005. This case has been consolidated for discovery purposes with the “Superboy” litigation described immediately below. The Company intends to defend against this lawsuit vigorously, but is unable to predict its outcome.

 

On October 22, 2004, the same Siegel heirs filed a second lawsuit against the Company, DC Comics, Warner Bros. Entertainment Inc., Warner Communications Inc. and Warner Bros. Television Production Inc. in the U.S. District Court for the Central District of California. Plaintiffs claim that Jerome Siegel was the sole creator of the character Superboy and, as such, DC Comics has had no right to create new Superboy works since the alleged October 17, 2004 termination by plaintiffs of Siegel’s grants of rights to the Superboy character to DC Comics’ predecessor-in-interest. This lawsuit seeks a declaration regarding the validity of the alleged termination and an injunction against future use of the Superboy character. Plaintiffs have also asserted Lanham Act and unfair

competition claims alleging false statements by DC Comics regarding the creation of the Superboy character. The Company answered the complaint and filed counterclaims on December 21, 2004, to which plaintiffs replied on January 7, 2005. The case was consolidated for discovery purposes with the “Superman” action described immediately above. The parties filed cross-motions for summary judgment or partial summary judgment on February 15, 2006. In its ruling dated March 23, 2006, the court denied the Company’s motion for summary judgment, granted plaintiffs’ motion for partial summary judgment on termination and held that further proceedings are necessary to determine whether the Company’s Smallville television series may infringe on plaintiffs’ rights to the Superboy character. On January 12, 2007, the Company filed a motion for reconsideration of the court’s decision granting plaintiffs’ motion for partial summary judgment on termination. That motion is pending. The Company intends to defend against this lawsuit vigorously, but is unable to predict its outcome.

 

On May 24, 1999, two former AOL Community Leader volunteers filed Hallissey et al. v. America Online, Inc.  in the U.S. District Court for the Southern District of New York. This lawsuit was brought as a collective action under the Fair Labor Standards Act (“FLSA”) and as a class action under New York state law against AOL and AOL Community, Inc. The plaintiffs allege that, in serving as Community Leader volunteers, they were acting as employees rather than volunteers for purposes of the FLSA and New York state law and are entitled to minimum wages. On December 8, 2000, defendants filed a motion to dismiss on the ground that the plaintiffs were volunteers and not employees covered by the FLSA. On March 10, 2006, the court denied defendants’ motion to dismiss. On May 11, 2006, plaintiffs filed a motion under the Fair Labor Standards Act asking the court to notify former community leaders nationwide about the lawsuit and allow those community leaders the opportunity to join the lawsuit. A related case was filed by several of the Hallissey plaintiffs in the U.S. District Court for the Southern District of New York alleging violations of the retaliation provisions of the FLSA. This case was stayed pending the outcome of the Hallissey motion to dismiss and has not yet been activated. Three related class actions have been filed in state courts in New Jersey, California and Ohio, alleging violations of the FLSA and/or the respective state laws. The New Jersey and Ohio cases were removed to federal court and subsequently transferred to the U.S. District Court for the Southern District of New York for consolidated pretrial proceedings with Hallissey. The California action was remanded to California state court, and on January 6, 2004 the court denied plaintiffs’ motion for class certification. Plaintiffs appealed the trial court’s denial of their motion for class certification to the California Court of Appeals. On May 26, 2005, a three-justice panel of the California Court of Appeals unanimously affirmed the trial court’s order denying class certification. The plaintiffs’ petition for review in the California Supreme Court was denied. The Company has settled the remaining individual claims in the California action. The Company intends to defend against the remaining lawsuits vigorously, but is unable to predict the outcome of these suits.

 

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

 

On August 1, 2005, Thomas Dreiling filed a derivative suit in the U.S. District Court for the Western District of Washington against AOL and Infospace Inc. as nominal defendant. The complaint, brought in the name of Infospace by one if its shareholders, asserts violations of Section 16(b) of the Securities Exchange Act of 1934. Plaintiff alleges that certain AOL executives and the founder of Infospace, Naveen Jain, entered into an agreement to manipulate Infospace’s stock price through the exercise of warrants that AOL had received in connection with a commercial agreement with Infospace. Because of this alleged agreement, plaintiff asserts that AOL and Mr. Jain constituted a “group” that held more than 10% of Infospace’s stock and, as a result, AOL violated the short-swing trading prohibition of Section 16(b) in connection with sales of shares received from the exercise of those warrants. The complaint seeks disgorgement of profits, interest and attorneys fees. On September 26, 2005, AOL filed a motion to dismiss the complaint for failure to state a claim, which was denied by the Court on December 5, 2005. The case is scheduled for trial starting in October of 2007. The Company intends to defend against this lawsuit vigorously, but is unable to predict the outcome of this suit or reasonably estimate the range of possible loss.

 

On September 1, 2006, Ronald A. Katz Technology Licensing, L.P. filed a complaint in the U.S. District Court for the District of Delaware alleging that TWC and AOL, among other defendants, infringe a number of patents purportedly relating to customer call center operations, voicemail and/or video-on-demand services. The plaintiff is seeking unspecified monetary damages as well as injunctive relief. The Company intends to defend against the claim vigorously, but is unable to predict the outcome of the suit or reasonably estimate a range of possible loss.

 

On June 16, 1998, plaintiffs in Andrew Parker and Eric DeBrauwere, et al. v. Time Warner Entertainment Company, L.P. and Time Warner Cable filed a purported nation-wide class action in U.S. District Court for the Eastern District of New York claiming that TWE sold its subscribers’ personally identifiable information and failed to inform subscribers of their privacy rights in violation of the Cable Communications Policy Act of 1984 and common law. The plaintiffs seek damages and declaratory and injunctive relief. On August 6, 1998, TWE filed a motion to dismiss, which was denied on September 7, 1999. On December 8, 1999, TWE filed a motion to deny class certification, which was granted on January 9, 2001 with respect to monetary damages, but denied with respect to injunctive relief. On June 2, 2003, the U.S. Court of Appeals for the Second Circuit vacated the District Court’s decision denying class certification as a matter of law and remanded the case for further proceedings on class certification and other matters. On May 4, 2004, plaintiffs filed a motion for class certification, which the Company opposed. On October 25, 2005, the court granted preliminary approval of a class settlement arrangement on terms that were not material to the Company. A final settlement approval hearing was held on May 19, 2006, and on January 26, 2007, the court denied approval of the settlement. The Company intends to defend against this lawsuit vigorously, but is unable to predict the outcome of this suit or reasonably estimate a range of possible loss.

 

On October 20, 2005, a group of syndicate participants, including BNZ Investments Limited, filed three related actions in the High Court of New Zealand, Auckland Registry, against New Line Cinema Corporation, a wholly owned subsidiary of the Company, and its subsidiary, New Line Productions Inc. (collectively, “New Line”). The complaints allege breach of contract, breach of duties of good faith and fair dealing, and other common law and statutory claims under California and New Zealand law. Plaintiffs contend, among other things, they have not received proceeds from certain financing transactions they entered into with New Line relating to three motion pictures: The Lord of the Rings: The Fellowship of the Ring; The Lord of the Rings: The Two Towers; and The Lord of the Rings: The Return of the King. The parties to these actions have agreed that all claims will be heard before a single arbitrator, who has been selected, before the International Court for Arbitration, and the proceedings before the High Court of New Zealand have been dismissed without prejudice. The Company intends to defend against these proceedings vigorously, but is unable to predict the outcome of the proceedings.

 

As previously disclosed, in 2005, Time Inc. received a grand jury subpoena from the United States Attorney’s Office for the Eastern District of New York in connection with an investigation of certain magazine circulation-related practices. Time Inc. responded to the subpoena and is cooperating with the investigation.

 

On December 22, 2006, AOL Europe Services SARL (“AOL Luxembourg”), a wholly owned subsidiary of AOL organized under the laws of Luxembourg, received an assessment from the French tax authorities for €34 million (approximately $44 million) for value added tax (“VAT”) due in France, including interest, related to subscription revenues from French subscribers earned from July 1, 2003 through December 31, 2003. The French tax authorities claim that these revenues are subject to French VAT, instead of Luxembourg VAT, as originally reported and paid by AOL. The Company intends to defend against this assessment vigorously, but is unable to predict the outcome of the proceedings. AOL Luxembourg also could receive similar assessments from the French tax authorities in the future for subscription revenues earned in 2004 through 2006, which assessment could total up to €72 million (approximately $94 million), including interest.

 

In the normal course of business, the Company’s tax returns are subject to examination by various domestic and foreign taxing authorities. Such examinations may result in future tax and interest assessments on the Company. In instances where the Company believes that a loss is probable, it has accrued a liability.

 

From time to time, the Company receives notices from third parties claiming that it infringes their intellectual property rights. Claims of intellectual property infringement could require Time Warner to enter into royalty or licensing agreements on unfavorable terms, incur substantial monetary liability or be enjoined preliminarily or permanently from further use of the intellectual property in question. In addition, certain agreements entered into by the Company may require the Company to indemnify the other party for certain third-party intellectual property

infringement claims, which could increase the Company’s damages and its costs of defending against such claims. Even if the claims are without merit, defending against the claims can be time-consuming and costly.

 

The costs and other effects of pending or future litigation, governmental investigations, legal and administrative cases and proceedings (whether civil or criminal), settlements, judgments and investigations, claims and changes in those matters (including those matters described above), and developments or assertions by or against the Company relating to intellectual property rights and intellectual property licenses, could have a material adverse effect on the Company’s business, financial condition and operating results.

 

 

Not applicable.

EXECUTIVE OFFICERS OF THE COMPANY

 

Pursuant to General Instruction G(3) to Form 10-K, the information regarding the Company’s executive officers required by Item 401(b) of Regulation S-K is hereby included in Part I of this report.

 

The following table sets forth the name of each executive officer of the Company, the office held by such officer and the age of such officer as of February 16, 2007.

 

 

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

 

 

PART II

 

 

The Company is a corporation organized under the laws of Delaware, and was formed on February 4, 2000 in connection with the AOL-Historic TW Merger. The principal market for the Company’s Common Stock is the NYSE. For quarterly price information with respect to the Company’s Common Stock for the two years ended December 31, 2006, see “Quarterly Financial Information” at pages 240 through 241 herein, which information is incorporated herein by reference. The number of holders of record of the Company’s Common Stock as of February 20, 2007 was approximately 51,400.

 

On May 20, 2005, the Company announced that it would begin paying a regular quarterly cash dividend of $0.05 per share on its Common Stock beginning in the third quarter 2005. The Company paid a cash dividend of $0.05 per share in the third and fourth quarters of 2005 and the first and second quarters of 2006. On July 27, 2006, the Company announced an increase of its regular quarterly cash dividend to $0.055 per share on its Common Stock beginning in the third quarter of 2006. The Company paid a cash dividend of $0.055 per share in the third and fourth quarters of 2006.

 

The Company currently expects to continue to pay comparable cash dividends in the future; however, changes in the Company’s dividend program will depend on the Company’s earnings, capital requirements, financial condition, restrictions in any existing indebtedness and other factors considered relevant by the Company’s Board of Directors.

 

There is no established public trading market for the Company’s Series LMCN-V Common Stock, which as of February 20, 2007 was held of record by one holder.

 

Company Purchases of Equity Securities

 

The following table provides information about purchases by the Company during the quarter ended December 31, 2006 of equity securities registered by the Company pursuant to Section 12 of the Exchange Act.

 

Issuer Purchases of Equity Securities

 

 

 

 

 

The selected financial information of the Company for the five years ended December 31, 2006 is set forth at pages 238 through 239 herein and is incorporated herein by reference.

 

 

The information set forth under the caption “Management’s Discussion and Analysis” at pages 72 through 152 herein is incorporated herein by reference.

 

 

The information set forth under the caption “Market Risk Management” at pages 141 through 143 herein is incorporated herein by reference.

 

 

The consolidated financial statements and supplementary data of the Company and the report of independent auditors thereon set forth at pages 153 through 234, 242 through 249 and 236 herein are incorporated herein by reference.

 

Quarterly Financial Information set forth at pages 240 through 241 herein is incorporated herein by reference.

 

 

Not applicable.

 

 

Evaluation of Disclosure Controls and Procedures

 

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

 

Management’s Report on Internal Control Over Financial Reporting

 

Management’s report on internal control over financial reporting and the report of the independent auditors thereon set forth at pages 235 and 237 are incorporated herein by reference.

 

Changes in Internal Control Over Financial Reporting

 

On July 31, 2006, the Company’s Cable segment acquired certain cable systems from Adelphia and Comcast and, as a result, is integrating the processes, systems and controls relating to the acquired cable systems into the Cable segment’s existing system of internal control over financial reporting. The Cable segment has continued to integrate into its control structure many of the processes, systems and controls relating to the acquired cable systems in accordance with its integration plans. In addition, various transitional controls designed to supplement existing internal controls have been implemented with respect to the acquired systems. Except for the processes, systems and controls relating to the integration of the acquired cable systems at the Cable segment, there have not been any changes in the Company’s internal control over financial reporting during the quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.

 

 

Not applicable.

 

PART III

 

 

Information called for by Items 10, 11, 12, 13 and 14 of Part III is incorporated by reference from the Company’s definitive Proxy Statement to be filed in connection with its 2007 Annual Meeting of Stockholders pursuant to Regulation 14A, except that (i) the information regarding the Company’s executive officers called for by Item 401(b) of Regulation S-K has been included in Part I of this Annual Report; and (ii) the information regarding certain Company equity compensation plans called for by Item 201(d) of Regulation S-K is set forth below.

 

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

 

Equity Compensation Plan Information

 

The following table summarizes information as of December 31, 2006, about the Company’s outstanding stock options and shares of Common Stock reserved for future issuance under the Company’s equity compensation plans.

 

 

 

 

The Time Warner Inc. 2006 Stock Incentive Plan (the “2006 Stock Incentive Plan”) was approved by the stockholders of Time Warner in May 2006. Under the 2006 Stock Incentive Plan, stock options (non-qualified and incentive), stock appreciation rights, restricted stock, and other stock-based awards, including restricted stock units and performance stock units, can be granted to employees, directors and consultants of the Company and its consolidated subsidiaries. Awards of restricted stock and other stock-based awards can be performance-based awards and have terms designed to meet the requirements of Section 162(m) of the Code. No incentive stock options or stock appreciation rights have been awarded under the 2006 Stock Incentive Plan. The exercise price of a stock option under the 2006 Stock Incentive Plan cannot be less than the fair market value of the Common Stock on the date of grant, which is defined in the 2006 Stock Incentive Plan as the average of the high and low prices of the Common Stock on the NYSE for the applicable trading day. The stock options generally become exercisable, or vest, in installments of 25% over a four-year period, subject to acceleration upon the occurrence of certain events such as retirement, death or disability, and expire ten years from the grant date. Participants in the 2006 Stock Incentive Plan awarded stock options do not receive dividends or dividend equivalents or have any voting rights with respect to the shares of Common Stock underlying the stock options. Similarly, any participants who are awarded stock appreciation rights will not receive dividends or dividend equivalents or have any voting rights with respect to the shares of Common Stock covered by the stock appreciation rights. The number of shares available for award under the 2006 Stock Incentive Plan will be reduced by the total number of shares covered by awards under the 2006 Stock Incentive Plan, including awards of stock appreciation rights. Stock appreciation rights generally can have a term of no more than ten years. No more than 30% of the total 150 million shares of Common Stock that can be issued pursuant to the 2006 Stock Incentive Plan can be issued for awards of restricted stock and other stock-based awards paid through the issuance of shares of stock, such as restricted stock units and performance stock units. Awards of restricted stock and restricted stock units vest in amounts and at times designated at the time of

award, and generally vest over a four-year period. Awards of restricted stock and restricted stock units are subject to restrictions on transfer and forfeiture prior to vesting. Participants awarded restricted stock and restricted stock units are generally entitled to receive dividends or dividend equivalents, respectively, on such awards.

 

The Time Warner Inc. 2003 Stock Incentive Plan (the “2003 Stock Incentive Plan”) was approved by the stockholders of Time Warner in May 2003. Under the 2003 Stock Incentive Plan, stock options (non-qualified and incentive), stock appreciation rights, restricted stock, and other stock-based awards, including restricted stock units and performance stock units, can be granted to employees, directors and consultants of the Company and its consolidated subsidiaries. Awards of restricted stock and other stock-based awards can be performance-based awards and have terms designed to meet the requirements of Section 162(m) of the Code. No incentive stock options or stock appreciation rights have been awarded under the 2003 Stock Incentive Plan. The exercise price of a stock option under the 2003 Stock Incentive Plan cannot be less than the fair market value of the Common Stock on the date of grant, which is defined in the 2003 Stock Incentive Plan as the average of the high and low prices of the Common Stock on the NYSE for the applicable trading day. The stock options generally become exercisable, or vest, in installments of 25% over a four-year period, subject to acceleration upon the occurrence of certain events such as retirement, death or disability, and expire ten years from the grant date. Participants in the 2003 Stock Incentive Plan awarded stock options do not receive dividends or dividend equivalents or have any voting rights with respect to the shares of Common Stock underlying the stock options. No more than 20% of the total 200 million shares of Common Stock that can be issued pursuant to the 2003 Stock Incentive Plan can be issued for awards of restricted stock and other stock-based awards paid through the issuance of shares of stock, such as restricted stock units and performance stock units. Awards of restricted stock and restricted stock units vest in amounts and at times designated at the time of award, and generally have vested over a four-year period. Awards of restricted stock and restricted stock units are subject to restrictions on transfer and forfeiture prior to vesting. Participants awarded restricted stock and restricted stock units are generally entitled to receive dividends or dividend equivalents, respectively, on such awards. In March 2006, the Compensation Committee approved amendments to the 2003 Stock Incentive Plan to clarify that (i) the number of shares available for award under the 2003 Stock Incentive Plan will be reduced by the total number of shares covered by awards of stock appreciation rights, (ii) stock appreciation rights generally can have a term of no more than ten years, and (iii) any participants who are awarded stock appreciation rights will not receive dividends or dividend equivalents or have any voting rights with respect to the shares of Common Stock covered by the stock appreciation rights.

 

In January 2007, the Compensation and Human Development Committee adopted and approved the principal terms of performance stock units. The Company’s senior executive officers and certain senior executives at the Company’s subsidiaries may be granted performance stock units under either the 2006 Stock Incentive Plan or the 2003 Stock Incentive Plan. Recipients of performance stock units receive awards designated as a target number of units that may be paid out in a number of shares of Common Stock based on the Company’s total stockholder return, or TSR, relative to the TSR of other companies in the S&P 500 Index (subject to certain adjustments) over a three-year performance period. Depending on the Company’s TSR ranking relative to the TSR of the other companies in the S&P 500 Index, a holder will receive between 0% and 200% of his or her target award following the three-year performance period (with a 0% payout if the Company’s TSR ranking is below the 25th percentile and 200% if the Company’s TSR is at the 100th percentile). Holders of unvested performance stock units will not be entitled to receive or accrue dividends or dividend equivalents on the awards. Upon the termination of employment of a holder by the Company other than for cause, termination by the holder for good reason, retirement or disability, the holder will receive for his or her outstanding performance stock units a payment of Common Stock following the end of the applicable performance period based on the Company’s actual performance pro-rated based on the amount of time the holder was an employee during the performance period. Upon the death of a holder, the Company will pay a pro-rated amount of Common Stock based on the Company’s actual performance (or target performance, if less than one year) through the date of the holder’s death. Upon the occurrence of certain events involving a change of control of the Company or the applicable subsidiary, the holder’s outstanding performance stock units will be accelerated and paid out in an amount of shares of Common Stock based on (i) the Company’s actual performance from the beginning of the applicable performance cycle to the date of the change in control and (ii) a deemed performance at target from the date of the change in control to the end of the performance period.

 

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

 

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

 

The Time Warner Inc. 1988 Restricted Stock and Restricted Stock Unit Plan for Non-Employee Directors (the “Directors’ Restricted Stock Plan”) was approved most recently in May 1999 by the stockholders of Historic TW and was assumed by the Company in connection with the AOL-Historic TW Merger. The Directors’ Restricted Stock Plan will terminate on May 19, 2009. The Directors’ Restricted Stock Plan provides for the award each year on the date of the annual stockholders meeting of either restricted stock or restricted stock units, as determined by the Board of Directors, to non-employee directors of the Company with value established by the Board of Directors. The awards of restricted stock and restricted stock units vest in equal annual installments on the first four anniversaries of the first day of the month in which the restricted stock or restricted stock units were awarded and in full if the director ends his or her service as a director due to (a) mandatory retirement, (b) failure to be re-elected after being nominated, (c) death or disability, (d) the occurrence of certain transactions involving a change in control of the Company and (e) with the approval of the Board of Directors on a case-by-case basis, under certain other designated circumstances. Restricted stock units also vest in full if a director retires from the Board of Directors after serving as a director for five years. If a non-employee director leaves the Board for any other reason, his or her unvested restricted stock and restricted stock units are forfeited to the Company. Participants awarded restricted stock and restricted stock units are generally entitled to receive dividends or dividend equivalents, respectively, on such awards. Restricted stock units have been awarded since 2005 and will be awarded in 2007.

 

The Time Warner Inc. Employee Stock Purchase Plan (the “ESPP”) was approved most recently in October 1998 by the stockholders of AOL and was assumed by the Company in connection with the AOL-Historic TW Merger. Under the ESPP, employees of AOL and certain subsidiaries of AOL may purchase shares of the Company’s Common Stock at a 5% discount from the fair market value of the Common Stock on the last day of a six-month participation period. The purchases are made through payroll deductions during the participation period and are subject to annual limits.

 

PART IV

 

 

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

 

(i) The list of consolidated financial statements and schedules set forth in the accompanying Index to Consolidated Financial Statements and Other Financial Information at page 71 herein is incorporated herein by reference. Such consolidated financial statements and schedules are filed as part of this Annual Report.

 

(ii) All other financial statement schedules are omitted because the required information is not applicable, or because the information required is included in the consolidated financial statements and notes thereto.

 

(3) Exhibits:

 

The exhibits listed on the accompanying Exhibit Index are filed or incorporated by reference as part of this Annual Report and such Exhibit Index is incorporated herein by reference. Exhibits 10.1 through 10.44 listed on the accompanying Exhibit Index identify management contracts or compensatory plans or arrangements required to be filed as exhibits to this Annual Report, and such listing is incorporated herein by reference.

 

SIGNATURES

 

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

 

Time Warner Inc.

 

Name: Wayne H. Pace

 

Date: February 23, 2007

 

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

 

TIME WARNER INC.

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

AND OTHER FINANCIAL INFORMATION

 

 

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 notes to help provide an understanding of Time Warner Inc.’s (“Time Warner” or the “Company”) financial condition, changes in financial condition and results of operations. MD&A is organized as follows:

 

 

As discussed more fully in Note 1 to the accompanying consolidated financial statements, the 2005 and 2004 financial information was recast in the fourth quarter of 2006 so that the basis of presentation would be consistent with that of 2006. Specifically, the amounts were recast to reflect (i) the retrospective application of Financial Accounting Standards Board (“FASB”) Statement No. 123 (revised 2004), Share-Based Payment (“FAS 123R”), which was adopted by the Company in 2006, (ii) the retrospective application of a change in accounting principle made in 2006 for recognizing programming inventory costs at HBO and (iii) the retrospective presentation of certain businesses sold or transferred in 2006 as discontinued operations.

 

Use of Operating Income before Depreciation and Amortization

 

The Company utilizes Operating Income before Depreciation and Amortization, among other measures, to evaluate the performance of its businesses. Operating Income before Depreciation and Amortization is considered an important indicator of the operational strength of the Company’s businesses and it provides an indication of the Company’s ability to service debt and fund capital expenditures. Operating Income before Depreciation and Amortization eliminates the uneven effect across all business segments of considerable amounts of noncash

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

depreciation of tangible assets and amortization of certain intangible assets that were recognized in business combinations. A limitation of this measure, however, is that it does not reflect the periodic costs of certain capitalized tangible and intangible assets used in generating revenues in the Company’s businesses. Management evaluates the investments in such tangible and intangible assets through other financial measures, such as capital expenditure budgets, investment spending levels and return on capital.

 

Operating Income before Depreciation and Amortization should be considered in addition to, not as a substitute for, the Company’s Operating Income, Net Income and various cash flow measures (e.g., Cash provided by operations) as well as other measures of financial performance reported in accordance with U.S. generally accepted accounting principles (“GAAP”). A reconciliation of Operating Income before Depreciation and Amortization to Operating Income is presented under “Results of Operations.”

 

OVERVIEW

 

Time Warner is a leading media and entertainment company, whose major businesses encompass an array of the most respected and successful media brands. Among the Company’s brands are HBO, CNN, AOL, People, Sports Illustrated, Time and Time Warner Cable, which completed the Adelphia acquisition and related transactions on July 31, 2006. The Company produces and distributes films, including Happy Feet, Superman Returns and Wedding Crashers, as well as television programs, including ER, Two and a Half Men, Cold Case, Without a Trace and The New Adventures of Old Christine. During 2006, the Company generated revenues of $44.224 billion (up 4% from $42.401 billion in 2005), Operating Income before Depreciation and Amortization of $10.941 billion (up 54% from $7.112 billion in 2005), Operating Income of $7.362 billion (up 85% from $3.984 billion in 2005), Net Income of $6.552 billion (up 145% from $2.671 billion in 2005) and Cash Provided by Operations of $8.598 billion (up 76% from $4.877 billion in 2005). The results for 2006 and 2005 reflect the effects of pretax charges of $650 million and $3 billion, respectively, related to securities litigation as discussed further in “Recent Developments.”

 

Time Warner Businesses

 

Time Warner classifies its operations into five reportable segments: AOL, Cable, Filmed Entertainment, Networks and Publishing.

 

AOL.  AOL LLC (together with its subsidiaries, “AOL”) is a leader in interactive services. In the U.S. and internationally, AOL operates a leading network of web brands, offers free client software and services to users who have their own Internet connection and provides services to advertisers on the Internet. In addition, AOL operates one of the largest Internet access subscription services in the United States. At December 31, 2006, AOL had 13.2 million total AOL brand subscribers in the U.S., which does not include registrations for the free AOL service. In 2006, AOL reported total revenues of $7.866 billion (18% of the Company’s overall revenues), $2.570 billion in Operating Income before Depreciation and Amortization and $1.923 billion in Operating Income.

 

Historically, AOL’s primary product offering has been an online subscription service that includes dial-up Internet access, and this product currently generates the substantial majority of AOL’s revenues. AOL has experienced significant declines in 2006 in the number of its U.S. subscribers and related revenues, due primarily to AOL’s decisions to focus on its advertising business and offer most of its services (other than Internet access) for free, AOL’s proactive reduction of subscriber acquisition efforts, and the industry-wide decline of the premium dial-up ISP business and growth in the broadband Internet access business. The decline in subscribers has had an adverse impact on AOL’s Subscription revenues. However, dial-up network costs have also decreased and are anticipated to continue to decrease as subscribers decline. AOL’s Advertising revenues, in large part, are generated from the traffic to and usage of the AOL service by AOL’s subscribers. Therefore, the decline in subscribers also could have an adverse impact on AOL’s Advertising revenues to the extent that subscribers canceling their subscriptions do not maintain their relationship with and usage of the AOL Network.

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

 

Since its announcement on August 2, 2006, AOL has continued to implement the next phase of its strategy to transition from a business that has relied heavily on Subscription revenues from dial-up subscribers to one that attracts and engages more Internet users and takes advantage of the growth in online advertising. AOL is emphasizing growing its global web services business and managing costs in its access services business. A goal of AOL’s strategy is to maintain and expand relationships with current and former AOL subscribers, whether they continue to purchase the dial-up Internet access subscription service or not. Another component of the strategy is to permit access to most of the AOL services, including use of the AOL client software and AOL e-mail accounts, without charge. Therefore, as long as an individual has a means to connect to the Internet, that person can access and use most of the AOL services for free.

 

The components of this strategy primarily include the following:

 

 

 

 

As discussed in more detail in “Recent Developments,” consistent with its strategy, in October and December 2006, respectively, AOL Europe completed the sales of its French and U.K. access businesses and entered into separate agreements to provide ongoing web services, including content, e-mail and other online tools and services, to the respective purchasers of these businesses. In September 2006, AOL Europe also entered into an agreement to sell its German access business and will enter into a separate agreement to provide ongoing web services to the purchaser of this business upon the closing of the sale, which is expected to be completed in the first quarter of 2007.

 

AOL continues to serve customers with dial-up Internet access in the U.S., a business that AOL believes will continue to exist for the foreseeable future, by providing dial-up connectivity to the Internet and customer service for those subscribers for a monthly subscription fee. However, AOL has substantially reduced its marketing and customer service efforts previously aimed at attracting and retaining subscribers to the dial-up AOL service.

 

In connection with this strategic shift, AOL undertook certain restructuring and related activities in 2006, including involuntary employee terminations, contract terminations, asset write-offs and facility closures. Additional restructuring and related activities of this nature are anticipated in 2007.

 

Cable.  Time Warner’s cable business, Time Warner Cable Inc. and its subsidiaries (“TWC”), is the second-largest cable operator in the U.S. and is an industry leader in developing and launching innovative video, data and voice services. As part of the strategy to expand TWC’s cable footprint and improve the clustering of its cable systems, on July 31, 2006, a subsidiary of TWC, Time Warner NY Cable LLC (“TW NY”), and Comcast Corporation (together with its subsidiaries, “Comcast”) completed their respective acquisitions of assets comprising in the aggregate substantially all of the cable systems of Adelphia Communications Corporation (“Adelphia”). Immediately prior to the Adelphia acquisition, TWC and Time Warner Entertainment Company, L.P. (“TWE”) redeemed Comcast’s interests in TWC and TWE, respectively. In addition, TW NY exchanged

 

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OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

certain cable systems with subsidiaries of Comcast. In connection with these transactions, TWC acquired approximately 3.2 million net basic video subscribers, consisting of approximately 4.0 million acquired subscribers and approximately 0.8 million subscribers transferred to Comcast. The systems transferred to Comcast that TWC owned prior to the Adelphia acquisition have been reflected as discontinued operations for all periods presented. Refer to “Recent Developments” for further details.

 

At December 31, 2006, TWC had approximately 13.4 million basic video subscribers in technologically advanced, well-clustered systems located mainly in five geographic areas — New York state, the Carolinas, Ohio, southern California and Texas. This subscriber number includes approximately 788,000 managed subscribers located in the Kansas City, south and west Texas and New Mexico cable systems (the “Kansas City Pool”) that were consolidated on January 1, 2007, upon the distribution of the assets of Texas and Kansas City Cable Partners, L.P. (“TKCCP”), an equity method investee at December 31, 2006, to its partners, TWC and Comcast. Refer to “Recent Developments” for further details. As of December 31, 2006, TWC was the largest cable operator in a number of large cities, including New York City and Los Angeles. In 2006, TWC delivered revenues of $11.767 billion (26% of the Company’s overall revenues), $4.229 billion in Operating Income before Depreciation and Amortization and $2.179 billion in Operating Income.

 

TWC principally offers three products — video, high-speed data and voice, which have been primarily targeted to residential customers. Video is TWC’s largest product in terms of revenues generated. TWC expects to continue to increase video revenues through the offering of advanced digital video services such as video-on-demand (“VOD”), subscription-video-on-demand (“SVOD”), high definition television (“HDTV”) and set-top boxes equipped with digital video recorders (“DVRs”), as well as through price increases and subscriber growth. TWC’s digital video subscribers provide a broad base of potential customers for additional advanced services. Providing basic video services is a competitive and highly penetrated business, and, as a result, TWC continues to expect slower incremental growth in the number of basic video subscribers compared to the growth in TWC’s advanced service offerings. Video programming costs represent a major component of TWC’s expenses and are expected to continue to increase, reflecting contractual rate increases, subscriber growth and the expansion of service offerings, and it is expected that TWC’s video product margins will decline over the next few years as programming cost increases outpace growth in video revenues.

 

High-speed data has been one of TWC’s fastest-growing products over the past several years and is a key driver of its results. At December 31, 2006, TWC had approximately 6.6 million residential high-speed data subscribers (including approximately 374,000 managed subscribers in the Kansas City Pool). TWC expects continued strong growth in residential high-speed data subscribers and revenues for the foreseeable future; however, the rate of growth of both subscribers and revenues is expected to slow over time as high-speed data services become increasingly well-penetrated. In addition, as narrowband Internet users continue to migrate to broadband connections, TWC anticipates that an increasing percentage of its new high-speed data customers will elect to purchase its entry-level high-speed data service, which is generally less expensive than TWC’s flagship service level. As a result, over time, TWC’s average high-speed data revenue per subscriber may decline reflecting this shift in mix. TWC also offers commercial high-speed data services and had approximately 245,000 commercial high-speed data subscribers (including approximately 15,000 managed subscribers in the Kansas City Pool) at December 31, 2006.

 

TWC’s voice service, Digital Phone, is TWC’s newest product, and approximately 1.9 million subscribers (including approximately 141,000 managed subscribers in the Kansas City Pool) received the service as of December 31, 2006. For a monthly fixed fee, Digital Phone customers typically receive the following services: unlimited local, in-state and U.S., Canada and Puerto Rico long-distance calling, as well as call waiting, caller ID and E911 services. TWC also is currently deploying a lower-priced unlimited in-state-only calling plan to serve those customers that do not use long-distance services extensively and, in the future, intends to offer additional plans with a variety of local and long-distance options. Digital Phone enables TWC to offer its customers a convenient package, or “bundle,” of video, high-speed data and voice services, and to compete effectively against similar bundled products available from its competitors. TWC expects strong increases in Digital Phone subscribers

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

and revenues and during 2007 intends to introduce a commercial voice service to small- to medium-sized businesses in most of the systems TWC owned before and retained after the transactions with Adelphia and Comcast (the “Legacy Systems”).

 

Some of TWC’s principal competitors, in particular, direct broadcast satellite operators and incumbent local telephone companies, either offer or are making significant capital investments that will allow them to offer services that provide features and functions comparable to the video, data and/or voice services that TWC offers and they are aggressively seeking to offer them in bundles similar to TWC’s. TWC expects that the availability of these service offerings will intensify competition.

 

In addition to the subscription services described above, TWC also earns revenues by selling advertising time to national, regional and local businesses.

 

As of July 31, 2006, the date the transactions with Adelphia and Comcast closed, the penetration rates for basic video, digital video and high-speed data services were generally lower in the systems acquired from Adelphia and Comcast (the “Acquired Systems”) than in TWC’s Legacy Systems. Furthermore, certain advanced services were not available in some of the Acquired Systems, and IP-based telephony service was not available in any of the Acquired Systems. To increase the penetration of these services in the Acquired Systems, TWC is in the midst of a significant integration effort that includes upgrading the capacity and technical performance of these systems to levels that will allow the delivery of these advanced services and features. Such integration-related efforts are expected to be largely complete by year-end 2007. As of December 31, 2006, Digital Phone was available in some of the Acquired Systems on a limited basis. TWC expects to roll out Digital Phone across the Acquired Systems during 2007.

 

Improvement in the financial and operating performance of the Acquired Systems depends in part on the completion of these initiatives and the subsequent availability of the Company’s bundled advanced services in the Acquired Systems. In addition, due to various operational and competitive challenges, the Company expects that the acquired systems located in the Los Angeles, CA and Dallas, TX areas will likely require more time and resources than the other acquired systems to stabilize and then meaningfully improve their financial and operating performance. As of December 31, 2006, the acquired Los Angeles and Dallas area systems together served approximately 2.0 million subscribers (about 50% of the subscribers served by the Acquired Systems). TWC believes that by upgrading the plant and integrating the Acquired Systems into its operations, there is a significant opportunity over time to stem subscriber losses, increase penetration rates of its service offerings, and improve Subscription revenues and Operating Income before Depreciation and Amortization in the Acquired Systems.

 

Filmed Entertainment.  Time Warner’s Filmed Entertainment businesses, Warner Bros. Entertainment Group (“Warner Bros.”) and New Line Cinema Corporation (“New Line”), generated revenues of $10.625 billion (22% of the Company’s overall revenues), $1.136 billion in Operating Income before Depreciation and Amortization and $784 million in Operating Income during 2006. The Filmed Entertainment segment experienced a decline in revenues and operating results in 2006 due to difficult comparisons to 2005, which was a record year.

 

One of the world’s leading studios, Warner Bros.  has diversified sources of revenues with its film and television businesses, combined with an extensive film library and global distribution infrastructure. This diversification has helped Warner Bros. deliver consistent long-term performance. New Line is the world’s oldest independent film company. Its primary source of revenues is the creation and distribution of theatrical motion pictures.

 

Warner Bros. continues to develop its industry-leading television business, including the successful releases of television series on home video. For the 2006-2007 television season, Warner Bros. has more current prime-time productions on the air than any other studio, with prime-time series on all five broadcast networks (including Two and a Half Men, ER, Without a Trace, Cold Case, Smallville, George Lopez and The New Adventures of Old Christine).

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

 

The sale of DVDs has been one of the largest drivers of the segment’s profit over the last several years, and Warner Bros.’ extensive library of theatrical and television titles positions it to continue to benefit from sales of home video product to consumers. However, the industry and the Company have recently experienced slowing DVD sales due to several factors, including increasing competition for consumer discretionary spending, piracy, the maturation of the standard definition DVD format and the fragmentation of consumer time.

 

Piracy, including physical piracy as well as illegal online file-sharing, continues to be a significant issue for the filmed entertainment industry. Due to technological advances, piracy has expanded from music to movies and television programming. The Company has taken a variety of actions to combat piracy over the last several years, including the launch of new services for consumers at competitive price points, aggressive online and customs enforcement, compressed release windows and educational campaigns, and will continue to do so, both individually and together with cross-industry groups, trade associations and strategic partners.

 

Networks.  Time Warner’s Networks segment comprises Turner Broadcasting System, Inc. (“Turner”) and Home Box Office, Inc. (“HBO”). On September 17, 2006, at the end of the 2005-2006 television season, Warner Bros. and CBS Corp. (“CBS”) ceased the stand-alone operations of The WB Network and UPN, respectively, and formed a new fully-distributed national broadcast network, called The CW, as discussed in more detail in “Recent Developments.” In 2006, the Networks segment delivered revenues of $10.273 billion (22% of the Company’s overall revenues), $3.026 billion in Operating Income before Depreciation and Amortization and $2.723 billion in Operating Income.

 

The Turner networks — including such recognized brands as TNT, TBS, CNN, Cartoon Network and CNN Headline News — are among the leaders in advertising-supported cable TV networks. For five consecutive years, more prime-time viewers have watched advertising-supported cable TV networks than the national broadcast networks. In 2006, TNT ranked second among advertising-supported cable networks in prime-time delivery of its key demographics, Adults 18-49 and Adults 25-54, and first in total-day delivery of Adults 18-49 and Adults 25-54. TBS ranked third among advertising-supported cable networks in prime-time delivery of its key demographic, Adults 18-34. As discussed in more detail in “Recent Developments,” in May 2006, the Company acquired the remaining 50% interest in Courtroom Television Network LLC (“Court TV”) that it did not already own from Liberty Media Corporation (“Liberty”). Court TV is now one of the Turner networks.

 

The Turner networks generate revenues principally from the sale of advertising time and monthly subscriber fees paid by cable system operators, direct-to-home satellite operators and other affiliates. Key contributors to Turner’s success are its continued investments in high-quality programming focused on sports, network movie premieres, licensed and original series, news and animation, leading to strong ratings and Advertising and Subscription revenue growth, as well as strong brands and operating efficiency.

 

HBO operates the HBO and Cinemax multichannel pay television programming services, with the HBO service ranking as the nation’s most widely distributed pay television network. HBO generates revenues principally from monthly subscriber fees from cable system operators, direct-to-home satellite operators and other affiliates. An additional source of revenue is the ancillary sales of its original programming, including such programs as The Sopranos, Sex and the City, Six Feet Under, Band of Brothers and Deadwood.

 

Publishing.  Time Warner’s Publishing segment consists principally of magazine publishing and a number of direct-marketing and direct-selling businesses. The segment generated revenues of $5.249 billion (12% of the Company’s overall revenues), $1.090 billion in Operating Income before Depreciation and Amortization and $911 million in Operating Income during 2006.

 

As of December 31, 2006, Time Inc. published over 145 magazines globally, including People, Sports Illustrated, In Style, Southern Living, Real Simple, Entertainment Weekly, Time, Cooking Light, Fortune and What’s on TV. It generates revenues primarily from advertising, magazine subscriptions and newsstand sales, and its growth is derived from higher circulation and advertising on existing magazines, new magazine launches, acquisitions and advertising from online properties. Time Inc. owns IPC Media, the U.K.’s largest magazine company (“IPC”), and

 

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the magazine subscription marketer Synapse Group, Inc. The Company has experienced slowing print advertising sales as advertisers are shifting advertising expenditures to online media. As a result, Time Inc. continues to invest in developing digital content, including the redesign of People.com and CNNMoney.com, the expansion of Sports Illustrated’s digital properties and the acquisition of Golf.com. Time Inc.’s direct-selling division, Southern Living At Home, sells home decor products through independent consultants at parties hosted in people’s homes throughout the U.S.

 

On January 25, 2007, the Company announced an agreement with a subsidiary of Bonnier AB, a Swedish media company, to sell Time Inc.’s Parenting and Time4 Media magazine groups, consisting of 18 of Time Inc.’s smaller niche magazines. Refer to “Recent Developments” for further discussion.

 

Recent Developments

 

Adelphia Acquisition and Related Transactions

 

On July 31, 2006, TW NY and Comcast completed their respective acquisitions of assets comprising in the aggregate substantially all of the cable assets of Adelphia (the “Adelphia Acquisition”). At the closing of the Adelphia Acquisition, TW NY paid approximately $8.9 billion in cash, after giving effect to certain purchase price adjustments, and shares representing approximately 16% of TWC’s outstanding common stock for the portion of the Adelphia assets it acquired. In accordance with Staff Accounting Bulletin (“SAB”) No. 51, Accounting for the Sales of Stock of a Subsidiary (“SAB 51”), in 2006, the Company recognized a gain of approximately $1.771 billion related to the shares of TWC Class A common stock issued in the Adelphia Acquisition, which has been reflected in shareholders’ equity as an adjustment to paid-in-capital.

 

On July 31, 2006, immediately before the closing of the Adelphia Acquisition, Comcast’s interests in TWC and TWE, a subsidiary of TWC, were redeemed. Specifically, Comcast’s 17.9% interest in TWC was redeemed in exchange for 100% of the capital stock of a subsidiary of TWC holding both cable systems serving approximately 589,000 subscribers and approximately $1.9 billion in cash (the “TWC Redemption”). In addition, Comcast’s 4.7% interest in TWE was redeemed in exchange for 100% of the equity interests in a subsidiary of TWE holding both cable systems serving approximately 162,000 subscribers and approximately $147 million in cash (the “TWE Redemption” and, together with the TWC Redemption, the “Redemptions”). The TWC Redemption was designed to qualify as a tax-free split-off under Section 355 of the Internal Revenue Code of 1986, as amended. For accounting purposes, the Redemptions were treated as an acquisition of Comcast’s minority interests in TWC and TWE and a disposition of the cable systems that were transferred to Comcast. The purchase of the minority interests resulted in a reduction of goodwill of $738 million related to the excess of the carrying value of the Comcast minority interests over the total fair value of the Redemptions. In addition, the disposition of the cable systems resulted in an after-tax gain of $945 million, included in discontinued operations, which is comprised of a $131 million pretax gain (calculated as the difference between the carrying value of the systems acquired by Comcast in the Redemptions totaling $2.969 billion and the estimated fair value of $3.100 billion) and a net tax benefit of $814 million, including the reversal of historical deferred tax liabilities of approximately $838 million that had existed on systems transferred to Comcast in the TWC Redemption.

 

Following the Redemptions and the Adelphia Acquisition, on July 31, 2006, TW NY and subsidiaries of Comcast swapped certain cable systems, most of which were acquired from Adelphia, in order to enhance TWC’s and Comcast’s respective geographic clusters of subscribers (the “Exchange” and, together with the Adelphia Acquisition and the Redemptions, the “Adelphia/Comcast Transactions”), and TW NY paid Comcast approximately $67 million for certain adjustments related to the Exchange. The Company did not record a gain or loss on systems TW NY acquired from Adelphia and transferred to Comcast in the Exchange because such systems were recorded at fair value in the Adelphia Acquisition. The Company did, however, record a pretax gain of $34 million ($27 million net of tax) on the Exchange related to the disposition of Urban Cable Works of Philadelphia, L.P. (“Urban Cable”). This gain is included as a component of discontinued operations in the accompanying consolidated statement of operations in 2006.

 

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The results of the systems acquired in connection with the Adelphia/Comcast Transactions have been included in the accompanying consolidated statement of operations since the closing of the transactions on July 31, 2006. The systems transferred to Comcast in connection with the Redemptions and the Exchange (the “Transferred Systems”), including the gains discussed above, have been reflected as discontinued operations in the accompanying consolidated statement of operations for all periods presented. See Note 4 to the accompanying consolidated financial statements for additional information regarding the discontinued operations.

 

As a result of the closing of the Adelphia/Comcast Transactions, TWC gained systems with approximately 3.2 million net basic video subscribers. As of February 23, 2007, Time Warner owns approximately 84% of TWC’s outstanding common stock (including approximately 83% of the outstanding TWC Class A common stock and all outstanding shares of TWC Class B common stock), as well as an approximate indirect 12% non-voting interest in TW NY. Comcast no longer has an interest in TWC or TWE.

 

On February 13, 2007, Adelphia’s Chapter 11 reorganization plan became effective and, under applicable securities law regulations and provisions of the U.S. bankruptcy code, TWC became a public company subject to the requirements of the Securities Exchange Act of 1934 on the same day. Under the terms of the reorganization plan, most of the shares of TWC Class A Common Stock that Adelphia received in the Adelphia Acquisition (representing approximately 16% of TWC’s outstanding common stock) are being distributed to Adelphia’s creditors.

 

At the closing of the Adelphia Acquisition, Adelphia and TWC entered into a registration rights and sale agreement (the “RRA”), which governed the disposition of the shares of TWC’s Class A common stock received by Adelphia in the Adelphia Acquisition. Upon the effectiveness of Adelphia’s plan of reorganization, the parties’ obligations under the RRA terminated (Note 2).

 

FCC Order Approving the Transactions with Adelphia and Comcast

 

In its order approving the Adelphia Acquisition, the Federal Communications Commission (the “FCC”) imposed conditions on TWC related to regional sports networks (“RSNs”), as defined in the order, and the resolution of disputes pursuant to the FCC’s leased access regulations. In particular, the order provides that neither TWC nor its affiliates may offer an affiliated RSN on an exclusive basis to any multichannel video programming distributor (“MVPD”). In addition, TWC may not unduly or improperly influence: (i) the decision of any affiliated RSN to sell programming to an unaffiliated MVPD; or (ii) the prices, terms, and conditions of sale of programming by an affiliated RSN to an unaffiliated MVPD. If an MVPD and an affiliated RSN cannot reach an agreement on the terms and conditions of carriage, the MVPD may elect commercial arbitration to resolve the dispute. In addition, if an unaffiliated RSN is denied carriage by TWC, it may elect commercial arbitration to resolve the dispute. With respect to leased access, if an unaffiliated programmer is unable to reach an agreement with TWC, that programmer may elect commercial arbitration to resolve the dispute, with the arbitrator being required to resolve the dispute using the FCC’s existing rate formula relating to pricing terms. The application and scope of these conditions, which will expire in July 2012, have not yet been tested. TWC retains the right to obtain FCC and judicial review of any arbitration awards made pursuant to these conditions.

 

Dissolution of Texas/Kansas City Cable Joint Venture

 

TKCCP is a 50-50 joint venture between Time Warner Entertainment-Advance/Newhouse Partnership (“TWE-A/N”) (a partnership of TWE and the Advance/Newhouse Partnership) and Comcast. In accordance with the terms of the TKCCP partnership agreement, on July 3, 2006, Comcast notified TWC of its election to trigger the dissolution of the partnership and its decision to allocate all of TKCCP’s debt, which totaled approximately $2 billion, to the pool of assets consisting of the Houston cable systems (the “Houston Pool”). On August 1, 2006, TWC notified Comcast of its election to receive the Kansas City Pool. On October 2, 2006, TWC received approximately $630 million from Comcast due to the repayment of debt owed by TKCCP to TWE-A/N that had been allocated to the Houston Pool. Since July 1, 2006, TWC has been entitled to 100% of the economic interest in

 

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the Kansas City Pool (and has recognized such interest pursuant to the equity method of accounting), and it has not been entitled to any economic benefits of ownership from the Houston Pool.

 

On January 1, 2007, TKCCP distributed its assets to its partners. TWC received the Kansas City Pool, which served approximately 788,000 basic video subscribers as of December 31, 2006, and Comcast received the Houston Pool, which served approximately 795,000 basic video subscribers as of December 31, 2006. TWC began consolidating the results of the Kansas City Pool on January 1, 2007. As a result of the asset distribution, TKCCP no longer has any assets, and TWC expects that TKCCP will be formally dissolved in 2007. For accounting purposes, the distribution of TKCCP’s assets has been treated as a sale of the Company’s 50% interest in the Houston Pool, and, as a result, the Company expects to record a pretax gain of approximately $150 million in the first quarter of 2007.

 

As a result of the pending TKCCP dissolution, TWC presents its managed subscriber numbers including only the managed subscribers in the Kansas City Pool. Accordingly, the subscribers from the Houston Pool are not included in the managed subscriber numbers for any period presented (Note 2).

 

Parenting and Time4 Media

 

On January 25, 2007, the Company announced an agreement with a subsidiary of Bonnier AB, a Swedish media company (“Bonnier”), to sell Time Inc.’s Parenting and Time4 Media magazine groups, consisting of 18 of Time Inc.’s smaller niche magazines. The transaction, which is subject to customary closing conditions, is expected to close in the first quarter of 2007. For the year ended December 31, 2006, the Parenting and Time4 Media magazine groups had revenues and Operating Income of approximately $260 million and $20 million, respectively (Note 4).

 

TradeDoubler

 

On January 15, 2007, AOL announced a cash tender offer to acquire all outstanding shares of TradeDoubler AB (“TradeDoubler”), a European provider of online marketing and sales solutions. If AOL were to acquire all of the outstanding shares of TradeDoubler, the total value of the proposed transaction would be approximately $900 million. The price offered for the outstanding shares is denominated in Swedish Kronor and, as a result, the U.S. dollar amount of the transaction is subject to change as a result of fluctuation in the exchange rates. The completion of the offer is subject to the condition that at least 90% of TradeDoubler’s outstanding shares are tendered in the offer (which condition may be waived by AOL) as well as other customary closing conditions. If the tender offer is successfully completed, AOL’s purchase of TradeDoubler shares pursuant to the offer is expected to occur in the first half of 2007 (Note 4).

 

Claxson

 

On December 14, 2006, Turner announced an agreement with Claxson Interactive Group, Inc. (“Claxson”) to purchase seven pay television networks currently operating in Latin America for approximately $235 million (net of cash acquired). The transaction, which is subject to customary closing conditions, is expected to close in the first half of 2007 (Note 4).

 

Transactions with Liberty

 

In February 2007, the Company signed a non-binding letter of intent with Liberty regarding the exchange of a significant portion of Liberty’s interest in Time Warner for a subsidiary of Time Warner that contains a mix of non-strategic assets, including the Atlanta Braves franchise (the “Braves”) and Leisure Arts, Inc., and cash. The Company and Liberty have submitted to Major League Baseball (the “League”) documents related to the proposed transfer of the Braves. Any sale of a major league baseball team requires the prior approval of the League. There can

 

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be no assurance that the League will approve the proposed transfer or that the parties will reach a definitive agreement regarding the proposed transaction (Note 4).

 

Sale of AOL’s European Access Businesses

 

During September and October of 2006, the Company announced the sale of AOL’s European access businesses. On October 31, 2006, the Company completed the sale of AOL’s French access business to Neuf Cegetel S.A. for approximately $360 million in cash. On December 29, 2006, the Company completed the sale of AOL’s U.K. access business to The Carphone Warehouse Group PLC (“Carphone Warehouse”) for approximately $712 million in cash, $476 million of which was paid at closing and the remainder of which is payable over the eighteen months following the closing. The Company recorded pretax gains on these sales of $769 million. In connection with these sales, the Company entered into separate agreements to provide ongoing web services, including content, e-mail and other online tools and services, to the respective purchasers of these businesses.

 

On September 17, 2006, the Company announced an agreement to sell AOL’s German access business to Telecom Italia S.p.A. for approximately $870 million in cash (subject to a working capital adjustment), and to enter into a separate agreement to provide ongoing web services, including content, e-mail and other online tools and services, to Telecom Italia S.p.A. upon the closing of the sale. The Company expects to record a pretax gain on this sale of approximately $700 million. The contractual sales price and the related gain for the transaction are denominated in Euros and, as a result, the U.S. dollar amounts presented are subject to change as a result of fluctuation in the exchange rates. The transaction, which is subject to customary closing conditions, is expected to close in the first quarter of 2007. Accordingly, the assets and liabilities of AOL’s German access business have been reflected as assets and liabilities held for sale as of December 31, 2006 and included in Prepaid expenses and other current assets and Other current liabilities, respectively, in the accompanying consolidated balance sheet.

 

As a result of the historical interdependency of AOL’s European access and audience businesses, the historic cash flows and operations of the access and audience businesses are not clearly distinguishable. Accordingly, AOL’s European access businesses have not been reflected as discontinued operations in the accompanying consolidated financial statements (Note 4).

 

Warner Village Theme Parks

 

On July 3, 2006, the Company sold its 50% interest in Warner Village Theme Parks (the “Theme Parks”), a joint venture operating theme parks in Australia, to Village Roadshow Limited (“Village”) for approximately $191 million in cash, which resulted in a pretax gain of approximately $157 million (Note 4).

 

Sale of Turner South

 

On May 1, 2006, the Company sold the Turner South network (“Turner South”), a subsidiary of Turner, to Fox Cable Networks, Inc. for approximately $371 million in cash, resulting in a pretax gain of approximately $129 million. Turner South has been reflected as discontinued operations for all periods presented (Note 4).

 

Sale of Time Warner Book Group

 

On March 31, 2006, the Company sold Time Warner Book Group (“TWBG”) to Hachette Livre SA (“Hachette”), a wholly-owned subsidiary of Lagardère SCA (“Lagardère”), for $524 million in cash, resulting in a pretax gain of approximately $207 million after taking into account selling costs and working capital adjustments. TWBG has been reflected as discontinued operations for all periods presented (Note 4).

 

Court TV

 

On May 12, 2006, the Company acquired the remaining 50% interest in Court TV that it did not already own from Liberty for $697 million in cash, net of cash acquired. As permitted by GAAP, Court TV results have been

 

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consolidated retroactive to the beginning of 2006. Previously, the Company had accounted for its investment using the equity method of accounting. In 2006, Court TV had revenues and Operating Income of $253 million and $31 million, respectively (Note 4).

 

The WB Network

 

On September 17, 2006, at the end of the 2005-2006 television season, Warner Bros. and CBS ceased the stand-alone operations of The WB Network and UPN, respectively, and formed a new fully-distributed national broadcast network, called The CW. Warner Bros. and CBS each own 50% of the new network and have joint and equal control. In addition, Warner Bros. reached an agreement with Tribune Corp. (“Tribune”), a subordinated 22.25% limited partner in The WB Network, under which Tribune surrendered its ownership interest in The WB Network, was relieved of funding obligations and became one of the principal affiliate groups for the new network.

 

For the year ended December 31, 2006, The WB Network had revenues and an Operating Loss of $397 million and $321 million, respectively. The WB Network results for 2006 included a goodwill impairment charge of approximately $200 million and $114 million of shutdown costs. The shutdown costs included $87 million related to the termination of certain programming arrangements (primarily licensed movie rights), $6 million related to employee terminations and $21 million related to contractual settlements. Included in the costs to terminate programming arrangements is $47 million of costs related to terminating intercompany programming arrangements with other Time Warner divisions (e.g., New Line) that have been eliminated in consolidation, resulting in a net charge related to programming arrangements of $40 million for the year ended December 31, 2006.

 

The Company is accounting for its investment in The CW using the equity method of accounting. The Company views its interest in The CW to be the successor to the business previously conducted by The WB Network, and, as such, the Company’s remaining basis in The WB Network (including goodwill) is considered the beginning basis for its 50% interest in The CW. In conjunction with the formation and launch in September 2006 of The CW, the Company assessed The WB Network’s goodwill for impairment. Due to actual ratings levels being lower than had been previously estimated and a projected increase in certain programming costs, the forecasted cash flows associated with the Company’s interest had declined. The Company determined in late October 2006 that The WB Network’s goodwill was impaired. Accordingly, as noted above, the Company recorded a pretax impairment charge of $200 million in 2006 to reduce the carrying value of The WB Network’s goodwill prior to its contribution to The CW. The estimate of fair value was determined using a discounted cash flow valuation methodology. The Company’s net investment in The CW is classified as Investments, including available-for-sale-securities in the accompanying consolidated balance sheet (Note 4).

 

AOL-Google Alliance

 

During December 2005, the Company announced that AOL was expanding its strategic alliance with Google Inc. (“Google”) to enhance its global online advertising partnership and make more of AOL’s content available to Google users. In addition, Google agreed to invest $1 billion to acquire a 5% equity interest in a limited liability company that owns all of the outstanding equity interest in AOL. On March 24, 2006, the Company and Google signed definitive agreements governing the investment and the commercial arrangements. Under the alliance, Google will continue to provide search services to AOL’s network of Internet properties worldwide, and will provide AOL with an improved share in revenues generated through searches conducted on the AOL network, which AOL will continue to recognize as advertising revenue when such amounts are earned. Additionally, AOL will continue to pay Google a license fee for the use of its search technology, which AOL will continue to recognize as expense when such amounts have been incurred. Other key aspects of the alliance, and the related accounting, include:

 

 

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AOL and Google also agreed to collaborate in the future to expand on the alliance, including the possible sale by AOL of display advertising on the Google network.

 

On April 13, 2006, the Company completed its issuance of a 5% equity interest in AOL to Google for $1 billion in cash. In accordance with SAB 51, Time Warner recognized a gain of approximately $801 million, reflected in shareholders’ equity as an adjustment to paid-in-capital, in the second quarter of 2006 (Note 4).

 

Time Warner Telecom

 

As of December 31, 2005, the Company owned approximately 50 million shares of Class B common stock of Time Warner Telecom Inc. (“TWT”), a publicly traded telecommunications company. The Company accounted for this investment using the equity method of accounting, and, as a result of the Company’s share in losses of TWT and impairment losses recognized in previous years, the carrying value of the investment was zero. During 2006, the Company’s subsidiaries participated as selling shareholders in two TWT secondary offerings and converted all of their shares of TWT Class B common stock into TWT Class A common stock and sold the Class A common stock for an aggregate of approximately $800 million, net of underwriters’ commissions. The Company recognized a pretax gain of approximately $800 million, which is included as a component of Other income, net, in the accompanying consolidated statement of operations (Note 5).

 

Turner FTC Consent Decree

 

As previously reported, Time Warner was subject to the terms of a consent decree (the “Turner Consent Decree”) entered into in connection with the FTC’s approval of the acquisition of Turner by Historic TW Inc. (“Historic TW”) in 1996, which expired on February 10, 2007. The Turner Consent Decree required, among other things, that any Time Warner stock held by Liberty be non-voting stock, except that it would be entitled to a vote of 1/100 of a vote per share when voting with the outstanding common stock on the election of directors and a vote equal to the vote of the common stock with respect to corporate matters that would adversely change the rights or terms of the stock. On February 16, 2006, Liberty filed a petition with the FTC seeking to terminate the Turner Consent Decree as it applied to Liberty, including all voting restrictions on its Time Warner stock holdings. On June 14, 2006, the FTC issued an order granting Liberty’s petition. As a result, Liberty obtained the ability to request that the shares of Series LMCN-V common stock it holds be converted into shares of common stock of Time Warner. At Liberty’s request, on August 4, 2006, Time Warner converted 49,115,656 shares of Series LMCN-V common stock held by Liberty into shares of Time Warner common stock, and on August 14, 2006, Time Warner converted 24,744,621 shares of Series LMCN-V common stock held by Liberty into shares of Time Warner common stock. As of February 22, 2007, Liberty held 18,784,759 shares of Series LMCN-V common stock (Note 11).

 

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Common Stock Repurchase Program

 

Time Warner’s Board of Directors has authorized a common stock repurchase program that allows the Company to purchase up to an aggregate of $20 billion of common stock during the period from July 29, 2005 through December 31, 2007. Purchases under the stock repurchase program may be made from time to time on the open market and in privately negotiated transactions. Size and timing of these purchases is based on a number of factors, including price and business and market conditions. The Company purchased approximately $15.9 billion of its common stock under the program through the end of 2006. At existing price levels, the Company intends to continue purchases under its stock repurchase program within its stated objective of maintaining a net debt-to-Operating Income before Depreciation and Amortization ratio, as defined, of approximately 3-to-1 and expects it will complete the program during the first half of 2007. From the program’s inception through February 22, 2007, the Company repurchased approximately 953 million shares of common stock for approximately $17.3 billion pursuant to trading programs under Rule 10b5-1 of the Securities Exchange Act of 1934, as amended, including approximately 208 million shares of common stock for approximately $3.6 billion pursuant to prepaid stock repurchase contracts (Note 11).

 

Amounts Related to Securities Litigation

 

As previously disclosed, in July 2005, the Company reached an agreement in principle for the settlement of the securities class action lawsuits included in the matters consolidated under the caption In re: AOL Time Warner Inc. Securities & “ERISA” Litigation described in Note 17 to the accompanying consolidated financial statements. In connection with reaching the agreement in principle on the securities class action, the Company established a reserve of $2.4 billion during the second quarter of 2005. Ernst & Young LLP also agreed to a settlement in this litigation matter and paid $100 million. Pursuant to the settlement, in October 2005, Time Warner paid $2.4 billion into a settlement fund (the “MSBI Settlement Fund”) for the members of the class represented in the action. The court issued an order dated April 6, 2006 granting final approval of the settlement, and the time to appeal that decision has expired. In connection with the settlement, the $150 million previously paid by Time Warner into a fund in connection with the settlement of the investigation by the U.S. Department of Justice (“DOJ”) was transferred to the MSBI Settlement Fund. In addition, the $300 million the Company previously paid into an SEC Fair Fund as a condition of the settlement of its SEC investigation will be distributed to investors through the MSBI settlement process pursuant to an order issued by the U.S. District Court for the District of Columbia on July 11, 2006. The administration of the settlement is ongoing. The Company also established a reserve of $600 million in the second quarter of 2005 related to the securities litigation, derivative actions and the Employee Retirement Income Security Act (“ERISA”) actions other than the securities class action. Settlements have been reached in many of these cases, including the ERISA and derivative actions.

 

During the fourth quarter of 2006, the Company established an additional reserve of $600 million related to its remaining securities litigation matters, bringing the total reserve for unresolved claims to approximately $620 million at December 31, 2006. The prior reserve aggregating $3.0 billion established in the second quarter of 2005 had been substantially utilized as a result of the settlements resolving many of the other shareholder lawsuits that had been pending against the Company, including settlements entered into during the fourth quarter of 2006. During February 2007, the Company reached agreements in principle to pay approximately $405 million to settle certain of the remaining claims — amounts consistent with the estimates contemplated in establishing the additional reserve, including approximately $400 million for which agreement in principle was reached on February 14, 2007. However, additional lawsuits remain pending, with plaintiffs in these remaining matters claiming approximately $3.0 billion in aggregated damages with interest. The Company has engaged in, and may in the future engage in, mediation in an attempt to resolve the remaining cases. If the remaining cases cannot be resolved by adjudication on summary judgment or by settlement, trials will ensue in these matters. As of February 22, 2007, the remaining reserve of approximately $215 million reflects the Company’s best estimate, based on the many related securities litigation matters that it has resolved to date, of its financial exposure in the remaining lawsuits. The Company intends to defend the remaining lawsuits vigorously, including through trial. It is possible, however, that the ultimate

 

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resolution of these matters could involve amounts materially greater or less than the remaining reserve, depending on various developments in these litigation matters.

 

Additionally, when the Company established the prior reserve of $3.0 billion in the second quarter of 2005, it was unable to conclude at that time that it was probable that there would be a deduction for a portion of such reserve and, therefore, the Company established a tax reserve related to these matters of approximately $230 million. After review of an interpretation of tax law released by the Internal Revenue Service in the fourth quarter of 2006, circumstances surrounding the Company’s settlements of the consolidated securities class action and other securities litigations, applicable law and other factors, the Company has determined that amounts paid in connection with such settlements should be fully deductible for tax purposes and no reserve is required. Accordingly, during the fourth quarter of 2006, the Company reversed this tax reserve. The Company also believes it is probable that the additional reserve established in the fourth quarter of 2006 is deductible.

 

The Company recognizes insurance recoveries when it becomes probable that such amounts will be received. The Company recognized insurance recoveries of $57 million related to ERISA matters in 2006. In 2005, the Company reached an agreement with the carriers on its directors and officers insurance policies in connection with the securities and derivative action matters described above (other than the actions alleging violations of ERISA). As a result of this agreement, in 2005, the Company recorded a recovery of approximately $206 million.

 

Government Investigations

 

As previously disclosed by the Company, the SEC and the DOJ had conducted investigations into accounting and disclosure practices of the Company. Those investigations focused on advertising transactions, principally involving the Company’s AOL segment, the methods used by the AOL segment to report its subscriber numbers and the accounting related to the Company’s interest in AOL Europe prior to January 2002. During 2004, the Company established $510 million in legal reserves related to the government investigations, the components of which are discussed in more detail in the following paragraphs.

 

The Company and its subsidiary, AOL, entered into a settlement with the DOJ in December 2004 that provided for a deferred prosecution arrangement for a two-year period. In December 2006, in accordance with the deferred prosecution arrangement, the DOJ’s complaint against AOL was dismissed. As part of the settlement with the DOJ, in December 2004, the Company paid a penalty of $60 million and established a $150 million fund, which the Company could use to settle related securities litigation. During October 2005, the $150 million was transferred by the Company into the MSBI Settlement Fund for the members of the class covered by the MSBI consolidated securities class action described above under the heading “Amounts Related to Securities Litigation.”

 

In addition, on March 21, 2005, the Company announced that the SEC had approved the Company’s proposed settlement with the SEC. In connection with the settlement, the Company paid a $300 million penalty in March 2005 that was not deductible for income tax purposes. As described above under the heading “Amounts Related to Securities Litigation,” the $300 million will be distributed to investors in connection with the distribution of proceeds from the settlement of the consolidated securities class action.

 

Pursuant to the SEC settlement, the Company restated its financial statements for each of the years ended December 31, 2000 through December 31, 2003 to adjust the accounting for certain transactions related to its historical accounting for Advertising revenues in certain transactions, primarily in the second half of 2000 and in 2001 and 2002, and its historical accounting for its investment in and consolidation of AOL Europe. In addition, an independent examiner was appointed to determine whether the Company’s accounting for certain additional transactions was in conformity with GAAP. During the third quarter of 2006, the independent examiner completed his review and, in accordance with the terms of the SEC settlement, provided a report to the Company’s audit and finance committee of his conclusions. As a result of the conclusions, the Company’s consolidated financial results were restated for each of the years ended December 31, 2000 through December 31, 2005 and for the three months

 

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ended March 31, 2006 and the three and six months ended June 30, 2006. The impact of the adjustments made was reflected in amendments filed with the SEC on September 13, 2006.

 

RESULTS OF OPERATIONS

 

 

 

The Company has adopted the provisions of FAS 123R as of January 1, 2006. The provisions of FAS 123R require a company to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. That cost is recognized in the statement of operations over the period during which an employee is required to provide service in exchange for the award. FAS 123R also amends FASB Statement No. 95, Statement of Cash Flows, to require that excess tax benefits, as defined, realized from the exercise of stock options be reported as a financing cash inflow rather than as a reduction of taxes paid in cash flow from operations.

 

Prior to the adoption of FAS 123R, the Company had followed the provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation (“FAS 123”), which allowed the Company to follow the intrinsic value method set forth in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees, and disclose the pro forma effects on net income (loss) had the fair value of the equity awards been expensed. In connection with adopting FAS 123R, the Company elected to adopt the modified retrospective application method provided by FAS 123R and, accordingly, financial statement amounts for all prior periods presented herein reflect results as if the fair value method of expensing had been applied from the original effective date of FAS 123. The Company also has made certain immaterial corrections to the amounts presented in prior years. Such corrections involved recording approximately $58 million of tax expense related to deferred income taxes on stock options for the year ended December 31, 2005, and other corrections related to the expensing of stock options that had an aggregate effect of approximately $70 million, net of tax, over the ten-year period ended December 31, 2002, and approximately $20 million, net of tax, over the three-year period ended December 31, 2005 (Note 1).

 

Prior to the adoption of FAS 123R, the Company recognized stock-based compensation expense for awards with graded vesting by treating each vesting tranche as a separate award and recognizing compensation expense ratably for each tranche. For equity awards granted subsequent to the adoption of FAS 123R, the Company treats such awards as a single award and recognizes stock-based compensation expense on a straight-line basis (net of estimated forfeitures) over the employee service period. Stock-based compensation expense is recorded in costs of revenues or selling, general and administrative expense depending on the employee’s job function.

 

Additionally, when recording compensation cost for equity awards, FAS 123R requires companies to estimate the number of equity awards granted that are expected to be forfeited. Prior to the adoption of FAS 123R, the Company recognized forfeitures when they occurred, rather than using an estimate at the grant date and subsequently adjusting the estimated forfeitures to reflect actual forfeitures. Accordingly, the Company recorded a benefit of $25 million, net of tax, as the cumulative effect of a change in accounting principal upon the adoption of FAS 123R in 2006, to recognize the effect of estimating the number of awards granted prior to January 1, 2006 that

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

are not ultimately expected to vest. Total equity-based compensation expense recognized in 2006, 2005 and 2004 was as follows:

 

 

 

 

 

Effective January 1, 2006, the Company changed its methodology for recognizing programming inventory costs (for both theatrical and original programming) at its HBO division. Previously, the Company recognized HBO’s programming costs on a straight-line basis in the calendar year in which the related programming first aired on the HBO and Cinemax pay television services. Now the Company recognizes programming costs on a straight-line basis over the license periods or estimated period of use of the related shows, beginning with the month of initial exhibition. The Company concluded that this change in accounting for programming inventory costs was preferable after giving consideration to the cumulative impact that marketplace and technological changes have had in broadening the variety of viewing options and period over which consumers are now experiencing HBO’s programming.

 

Since this change involves a revision to an inventory costing principle, the change is reflected retrospectively for all prior periods presented, including the impact that such a change had on retained earnings for the earliest year presented (Note 1).

 

Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans

 

On December 31, 2006, the Company adopted the provisions of FASB Statement No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Benefits (“FAS 158”). FAS 158 addresses the accounting for defined benefit pension plans and other postretirement benefit plans (“plans”). Specifically, FAS 158 requires companies to recognize an asset for a plan’s overfunded status or a liability for a plan’s underfunded status as of the end of the company’s fiscal year, the offset of which is recorded, net of tax, as a component of accumulated other comprehensive income in shareholders’ equity. As a result of adopting FAS 158, on December 31, 2006, the Company reflected the funded status of its plans by reducing its net pension asset by approximately $655 million to reflect actuarial and investment losses that had been deferred pursuant to prior pension accounting rules and recording a corresponding deferred tax asset of approximately $240 million and a net after-tax charge of approximately $415 million in accumulated other comprehensive income, net, in shareholders’ equity.

 

Reclassifications

 

Certain reclassifications have been made to the prior year’s financial information to conform to the December 31, 2006 presentation.

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

 

Recent Accounting Standards

 

Accounting for Sabbatical Leave and Other Similar Benefits

 

In June 2006, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF Issue No. 06-02, Accounting for Sabbatical Leave and Other Similar Benefits (“EITF 06-02”). EITF 06-02 provides that an employee’s right to a compensated absence under a sabbatical leave or similar benefit arrangement in which the employee is not required to perform any duties during the absence is an accumulating benefit. Therefore, such arrangements should be accounted for as a liability with the cost recognized over the service period during which the employee earns the benefit. The provisions of EITF 06-02 became effective for Time Warner as of January 1, 2007 with respect to certain sabbatical leave and other employment arrangements that are similar to a sabbatical leave and are expected to result in an increase to accumulated deficit of approximately $75 million ($46 million, net of tax).

 

Income Statement Classification of Taxes Collected from Customers

 

In June 2006, the EITF reached a consensus on EITF Issue No. 06-03, How Taxes Collected from Customers and Remitted to Governmental Authorities Should Be Presented in the Income Statement (That Is, Gross versus Net Presentation) (“EITF 06-03”). EITF 06-03 provides that the presentation of taxes assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer on either a gross basis (included in revenues and costs) or on a net basis (excluded from revenues) is an accounting policy decision that should be disclosed. The provisions of EITF 06-03 became effective for Time Warner as of January 1, 2007. EITF 06-03 is not expected to have a material impact on the Company’s consolidated financial statements.

 

Accounting for Uncertainty in Income Taxes

 

In June 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109 (“FIN 48”), which clarifies the accounting for uncertainty in income tax positions. This Interpretation requires that the Company recognize in the consolidated financial statements the tax benefits related to tax positions that are more likely than not to be sustained upon examination based on the technical merits of the position. The provisions of FIN 48 became effective for Time Warner as of the beginning of the Company’s 2007 fiscal year. The cumulative impact of this guidance is expected to result in a decrease to accumulated deficit on January 1, 2007 of approximately $500 million.

 

Consideration Given by a Service Provider to Manufacturers or Resellers of Equipment

 

In September 2006, the EITF reached a consensus on EITF Issue No. 06-01, Accounting for Consideration Given by a Service Provider to Manufacturers or Resellers of Equipment Necessary for an End-Customer to Receive Service from the Service Provider (“EITF 06-01”). EITF 06-01 provides that consideration provided to the manufacturers or resellers of specialized equipment should be accounted for as a reduction of revenue if the consideration provided is in the form of cash and the service provider directs that such cash be provided directly to the customer. Otherwise, the consideration should be recorded as an expense. EITF 06-01 will be effective for Time Warner as of January 1, 2008 and is not expected to have a material impact on the Company’s consolidated financial statements.

 

Quantifying Effects of Prior Years Misstatements in Current Year Financial Statements

 

In September 2006, the SEC issued SAB No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 requires that registrants quantify errors using both a balance sheet and statement of operations approach and evaluate whether either approach results in a misstated amount that, when all relevant quantitative and qualitative factors are considered, is

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

material. SAB 108 became effective for Time Warner in the fourth quarter of 2006 and did not have a material impact on the Company’s consolidated financial statements.

 

Fair Value Measurements

 

In September 2006, the FASB issued FASB Statement No. 157, Fair Value Measurements (“FAS 157”). FAS 157 establishes a single authoritative definition of fair value, sets out a framework for measuring fair value, and expands on required disclosures about fair value measurement. FAS 157 is effective for Time Warner on January 1, 2008 and will be applied prospectively. The provisions of FAS 157 are not expected to have a material impact on the Company’s consolidated financial statements.

 

Fair Value Option for Financial Assets and Financial Liabilities

 

In February 2007, the FASB issued FASB Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“FAS 159”). FAS 159 permits companies to choose to measure, on an instrument-by-instrument basis, financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The Company currently is evaluating whether to elect the option provided for in this standard. If elected, FAS 159 would be effective for Time Warner as of January 1, 2008.

 

Significant Transactions and Other Items Affecting Comparability

 

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

 

 

The Company’s tax provision also includes certain items affecting comparability. These items include approximately $1.4 billion of tax benefits related primarily to the realization of tax attribute carryforwards of $1.1 billion and the reversal of approximately $230 million of tax reserves associated with litigation settlements in 2006, $423 million of tax benefits related to changes in certain state tax laws and state tax methodologies and the realization of tax attribute carryforwards in 2005, and a $110 million tax benefit associated with the realization of tax attribute carryforwards in 2004.

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

 

Amounts Related to Securities Litigation and Government Investigations

 

The Company recognized legal and other professional fees related to the SEC and DOJ investigations into certain of the Company’s historical accounting and disclosure practices and the defense of various shareholder lawsuits, as well as legal reserves, totaling $762 million, $3.071 billion and $584 million in 2006, 2005 and 2004, respectively. In addition, the Company recognized insurance recoveries of $57 million, $206 million and $48 million in 2006, 2005 and 2004, respectively.

 

Merger-related, Restructuring and Shutdown Costs

 

During the year ended December 31, 2006, the Company incurred restructuring costs of approximately $295 million, primarily related to various employee terminations and other exit activities, including $222 million at the AOL segment, $18 million at the Cable segment, $5 million at the Filmed Entertainment segment, $45 million at the Publishing segment and $5 million at the Corporate segment. The total number of employees terminated across the segments in 2006 was approximately 5,600. In addition, during the year ended December 31, 2006, the Cable segment expensed approximately $38 million of non-capitalizable merger-related and restructuring costs associated with the Adelphia Acquisition. The results for the year ended December 31, 2006 also include shutdown costs of $114 million at The WB Network in connection with the agreement between Warner Bros. and CBS to form the new fully-distributed national broadcast network, The CW. Included in the shutdown costs for the year ended December 31, 2006 are charges related to terminating intercompany programming arrangements with other Time Warner divisions, of which $47 million, respectively, has been eliminated in consolidation, resulting in a net pretax charge of $67 million (Note 14).

 

During the year ended December 31, 2005, the Company incurred restructuring costs of approximately $109 million primarily related to various employee terminations, including approximately 1,330 employees across the segments. Specifically, the AOL and Cable segments incurred restructuring costs primarily related to various employee terminations of $17 million and $35 million, respectively, which were partially offset by a $7 million and a $1 million reduction in restructuring costs, respectively, reflecting changes in estimates of previously established restructuring accruals. Additional restructuring costs, primarily related to various employee terminations, of $33 million at the Filmed Entertainment segment, $4 million at the Networks segment and $28 million at the Publishing segment were also incurred during 2005. In addition, during the year ended December 31, 2005, the Cable segment expensed approximately $8 million of non-capitalizable merger-related costs associated with the Adelphia Acquisition (Note 14).

 

During the year ended December 31, 2004, the Company incurred restructuring costs at the AOL segment related to various employee terminations of $55 million, which were partially offset by a $5 million reduction in restructuring costs, reflecting changes in estimates of previously established restructuring accruals. The total number of employees terminated in 2004 was approximately 860 (Note 14).

 

Asset Impairments

 

During the year ended December 31, 2006, the Company recorded a noncash impairment charge of approximately $200 million at the Networks segment to reduce the carrying value of The WB Network’s goodwill. Refer to “Recent Developments” for further discussion. In addition, the Company recorded a $13 million noncash asset impairment at the AOL segment related to asset writedowns and the closure of several facilities primarily as a result of AOL’s revised strategy.

 

During the year ended December 31, 2005, the Company recorded a $24 million noncash impairment charge related to goodwill associated with America Online Latin America, Inc. (“AOLA”). As previously disclosed, AOLA had been operating under Chapter 11 of the U.S. Bankruptcy Code since June 2005 and has been in the process of winding up its operations. On June 30, 2006, AOLA emerged from bankruptcy pursuant to a joint plan of reorganization and liquidation. Under the plan, AOLA was reorganized into a liquidating limited liability company

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

jointly owned by Time Warner (60%) and the Cisneros Group (40%). In partial satisfaction of debt and obligations held by Time Warner or AOL, the assets representing the AOL Puerto Rico business were transferred to Time Warner or AOL, as applicable, pursuant to the plan.

 

During 2004, the Company recognized a $10 million impairment charge related to a building that was held for sale at the AOL segment.

 

In the fourth quarter of each year, the Company performs its annual impairment review for goodwill and intangible assets. The 2006, 2005 and 2004 annual impairment reviews for goodwill and intangible assets did not result in any impairment charges being recorded (Note 1).

 

Gains on Disposal of Assets, Net

 

For the year ended December 31, 2006, the Company recorded a $769 million gain on the sales of AOL’s French and U.K. access businesses and a $2 million gain from the resolution of a previously contingent gain related to the 2004 sale of Netscape Security Solutions (“NSS”) at the AOL segment, a gain of approximately $20 million at the Corporate segment related to the sale of two aircraft and a $5 million gain on the sale of a non-strategic magazine title at the Publishing segment.

 

For the year ended December 31, 2005, the Company recorded a $5 million gain related to the sale of a property in California at the Filmed Entertainment segment, an approximate $5 million gain related to the sale of a building and a $5 million gain from the resolution of previously contingent gains related to the 2004 sale of NSS at the AOL segment and an $8 million gain at the Publishing segment related to the collection of a loan made in conjunction with the Company’s 2003 sale of Time Life Inc. (“Time Life”), which was previously fully reserved due to concerns about recoverability.

 

For the year ended December 31, 2004, the Company recognized a $13 million gain related to the sale of AOL Japan and a $7 million gain related to the sale of NSS at the AOL segment and an $8 million gain at the Publishing segment related to the sale of a building, partially offset by an approximate $7 million loss at the Networks segment related to the sale of the winter sports teams.

 

Investment Gains, Net

 

For the year ended December 31, 2006, the Company recognized net gains of $1.051 billion primarily related to the sale of investments, including an $800 million gain on the sale of the Company’s investment in Time Warner Telecom, a $157 million gain on the sale of the Company’s investment in the Theme Parks and a $51 million gain on the sale of the Company’s investment in Canal Satellite Digital. For the year ended December 31, 2006, investment gains, net also include $10 million of gains resulting from market fluctuations in equity derivative instruments.

 

For the year ended December 31, 2005, the Company recognized net gains of $1.011 billion primarily related to the sale of investments, including a $925 million gain on the sale of the Company’s remaining investment in Google, a $36 million gain, which had been previously deferred, related to the Company’s 2002 sale of a portion of its interest in Columbia House and an $8 million gain on the sale of its 7.5% remaining interest in Columbia House and simultaneous resolution of a contingency for which the Company had previously accrued. Investment gains were partially offset by $16 million of writedowns to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value, including a $13 million writedown of the Company’s investment in n-tv KG (“NTV-Germany”), a German news broadcaster. The year ended December 31, 2005 also included $1 million of losses resulting from market fluctuations in equity derivative instruments.

 

For the year ended December 31, 2004, the Company recognized net gains of $424 million, primarily related to the sale of investments, including a $188 million gain related to the sale of a portion of the Company’s interest in Google and a $113 million gain related to the sale of the Company’s interest in VIVA Media AG (“VIVA”) and VIVA Plus and a $44 million gain on the sale of the Company’s interest in Gateway Inc. (“Gateway”). Investment

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

gains were partially offset by $15 million of writedowns to reduce the carrying value of certain investments that experienced other-than-temporary declines in market value and $14 million of losses resulting from market fluctuations in equity derivative instruments.

 

Gain (Loss) on WMG Option

 

For the year ended December 31, 2005, the Company recorded a $53 million net gain, reflecting a fair value adjustment related to the Company’s option in Warner Music Group (“WMG”). For the year ended December 31, 2004, the Company recorded a $50 million fair value adjustment to increase the option’s carrying value (Note 4).

 

Minority Interest Impact

 

For the year ended December 31, 2006, income of $27 million was attributed to minority interest, which primarily reflects Google’s share of the gain on the sales of AOL’s European access businesses net of restructuring costs at the AOL segment.

 

Income Tax Impact

 

The income tax impact reflects the estimated tax or tax benefit from the items affecting comparability. Such estimated taxes or tax benefits vary based on certain factors, including deductibility of the amounts and foreign tax on gains.

 

2006 vs. 2005

 

Consolidated Results

 

Revenues.  The components of revenues are as follows (millions):

 

 

The increase in Subscription revenues for the year ended December 31, 2006 was primarily related to increases at the Cable and Networks segments, offset partially by a decline at the AOL segment. The increase at the Cable segment was driven by the impact of the Acquired Systems, the continued penetration of advanced services (primarily high-speed data services, digital video services and Digital Phone), video price increases and growth in basic video subscriber levels in the Legacy Systems. The increase at the Networks segment was due primarily to higher subscription rates, an increase in the number of subscribers at Turner and HBO and the impact of the Court TV acquisition. Revenues at the AOL segment declined primarily as a result of lower domestic AOL brand subscribers and declines at AOL Europe.

 

The increase in Advertising revenues for the year ended December 31, 2006 was due to growth across the segments, primarily at the AOL, Cable and Networks segments. The increase at the AOL segment was due to growth in sales of advertising run on third-party websites generated by Advertising.com and display and paid-search advertising on AOL’s network of interactive properties and services. The increase at the Cable segment was due to the Acquired Systems, primarily related to growth in local and national advertising. The increase at the Networks segment was primarily driven by the impact of the Court TV acquisition and higher CPMs (advertising cost per one thousand viewers) and sellouts across Turner’s other networks, partly offset by a decline at The WB Network as a result of lower ratings and the shutdown of the network on September 17, 2006.

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

 

The decrease in Content revenues for the year ended December 31, 2006 was principally due to a decline at the Filmed Entertainment segment, partially offset by an increase at the Networks segment. The decline at the Filmed Entertainment segment was primarily driven by a decline in theatrical product revenues due to difficult comparisons to 2005. The increase at the Networks segment was primarily due to HBO’s domestic cable television sale of The Sopranos.

 

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

 

Costs of Revenues.  For 2006 and 2005, costs of revenues totaled $25.175 billion and $24.408 billion, respectively, and as a percentage of revenues were 57% and 58%, respectively. The improvement in costs of revenues as a percentage of revenues related primarily to improved margins at the Filmed Entertainment segment. The segment variations are discussed in detail in “Business Segment Results.”

 

Selling, General and Administrative Expenses.  For 2006 and 2005, selling, general and administrative expenses increased 1% to $10.560 billion in 2006 from $10.439 billion in 2005. The segment variations are discussed in detail in “Business Segment Results.”

 

Amounts Related to Securities Litigation and Government Investigations.  As previously discussed in “Recent Developments,” the Company recognized legal and other professional fees, including legal reserves, related to the SEC and DOJ investigations into certain of the Company’s historical accounting and disclosure practices and the defense of various shareholder lawsuits totaling $762 million for the year ended December 31, 2006 and $3.071 billion for the year ended December 31, 2005. In addition, the Company recognized insurance recoveries of $57 million for the year ended December 31, 2006 and $206 million for the year ended December 31, 2005, respectively (Note 1).

 

Reconciliation of Operating Income before Depreciation and Amortization to Operating Income.

 

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

 

 

Operating Income before Depreciation and Amortization.  Time Warner’s Operating Income before Depreciation and Amortization was $10.941 billion in 2006 compared to $7.112 billion in 2005. Excluding the items previously discussed under “Significant Transactions and Other Items Affecting Comparability” totaling

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

$522 million and $2.983 billion of net expense for 2006 and 2005, respectively, Operating Income before Depreciation and Amortization increased $1.368 billion principally as a result of growth at the Cable and Networks segments, partially offset by a decline at the Filmed Entertainment and Publishing segments.

 

The segment variations are discussed in detail under “Business Segment Results.”

 

Depreciation Expense.  Depreciation expense increased to $2.974 billion in 2006 from $2.541 billion in 2005. The increase in depreciation expense primarily related to an increase at the Cable segment primarily due to the impact of the Acquired Systems and demand-driven increases in recent years of purchases of customer premise equipment, which generally have a significantly shorter useful life compared to the mix of assets previously purchased.

 

Amortization Expense.  Amortization expense increased to $605 million in 2006 from $587 million in 2005. The increase in amortization expense primarily related to the Cable segment driven by the amortization of intangible assets associated with customer relationships acquired as part of the Adelphia/Comcast Transactions, partially offset by a decrease at the Publishing segment as a result of certain short-lived intangibles, such as customer lists, becoming fully amortized in the latter part of 2005.

 

Operating Income.  Time Warner’s Operating Income increased to $7.362 billion in 2006 from $3.984 billion in 2005. Excluding the items previously discussed under “Significant Transactions and Other Items Affecting Comparability” totaling $522 million and $2.983 billion of net expense for 2006 and 2005, respectively, Operating Income increased $917 million. This amount reflects the changes in Operating Income before Depreciation and Amortization, offset partially by the increase in depreciation expense as discussed above.

 

Interest Expense, Net.  Interest expense, net, increased to $1.675 billion in 2006 from $1.266 billion in 2005 reflecting higher average outstanding balances of borrowings as a result of the Company’s stock repurchase program and the Adelphia/Comcast Transactions, increased interest rates on variable rate borrowings and lower interest income on cash investments.

 

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

 

 

The changes in investment gains, net, and the gain on the WMG option are discussed under “Significant Transactions and Other Items Affecting Comparability.” Excluding the impact of these items, Other income, net, increased primarily due to an increase in income from equity method investees, primarily due to an increase in the profitability of TKCCP, as well as changes in the economic benefit of TWC’s partnership interest in TKCCP due to the pending dissolution of the partnership. Beginning in the third quarter of 2006, the income from TKCCP reflects 100% of the operations of the Kansas City Pool and does not reflect any of the economic benefits of the Houston Pool. In addition, it reflects the benefit from the allocation of all the TKCCP debt to the Houston Pool, which reduced interest expense for the Kansas City Pool. This increase in equity income was partially offset by the absence of Court TV equity income as a result of the consolidation of Court TV (an equity method investee of the Company through December 31, 2005) retroactive to the beginning of 2006 as a result of the Company acquiring the remaining 50% interest it did not already own in the second quarter of 2006.

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

 

Minority Interest Expense, Net.  Time Warner had $375 million of minority interest expense, net in 2006 compared to $244 million in 2005. The increase related primarily to the 5% minority interest in AOL issued to Google in the second quarter of 2006, which includes Google’s 5% share in the $769 million of gains recognized by AOL on the sales of its France and U.K. access businesses, and to larger profits recorded by the Cable segment, in which Comcast had an effective 21% minority interest until the closing of the Adelphia/Comcast Transactions on July 31, 2006 and in which Adelphia received an approximate 16% minority interest upon such closing.

 

Income Tax Provision.  Income tax expense from continuing operations was $1.337 billion for the year ended December 31, 2006, compared to $1.051 billion for the year ended December 31, 2005. The Company’s effective tax rate for continuing operations was 21% for the year ended December 31, 2006 compared to 29% for the year ended December 31, 2005. In 2006, certain items affected the Company’s income tax provision, including the recognition of tax attribute carryforwards of approximately $1.1 billion (including approximately $660 million for the three months ended December 31, 2006, related primarily to the sale of AOL’s access businesses in the U.K. and France) and the reversal in the fourth quarter of 2006 of approximately $230 million of tax reserves associated with litigation settlements. Included in income taxes for the year ended December 31, 2005, were the favorable impact of state tax law changes in Ohio and New York, an ownership restructuring in Texas and certain other methodology changes totaling approximately $350 million (approximately $100 million for the three months ended December 31, 2005), partially offset by the establishment of approximately $230 million in tax reserves related to the non-deductibility of certain litigation settlements. Excluding these items, the effective tax rate increased for the year ended December 31, 2006, primarily due to higher taxes attributable to foreign operations.

 

Income before Discontinued Operations and Cumulative Effect of Accounting Change.  Income before discontinued operations and cumulative effect of accounting change was $5.114 billion in 2006 compared to $2.548 billion in 2005. Basic and diluted net income per share before discontinued operations and cumulative effect of accounting change were $1.22 and $1.21 in 2006, respectively, compared to $0.55 and $0.54, respectively, in 2005. Excluding the items previously discussed under “Significant Transactions and Other Items Affecting Comparability” totaling $74 million of income and $1.401 billion of net expense in 2006 and 2005, respectively, income before discontinued operations and cumulative effect of accounting change increased by $1.091 billion primarily due to higher Operating Income, partially offset by higher interest expense, net and higher minority interest expense, net as discussed above.

 

Discontinued Operations.  The financial results for the years ended December 31, 2006 and 2005 included the impact of treating the Transferred Systems, TWBG and Turner South as discontinued operations. Included in the results for 2006 are a pretax gain of approximately $165 million on the Transferred Systems and a tax benefit of approximately $807 million comprised of a tax benefit of $814 million on the Redemptions, partially offset by a provision of $7 million on the Exchange. The tax benefit of $814 million resulted primarily from the reversal of historical deferred tax liabilities that had existed on systems transferred to Comcast in the TWC Redemption. The TWC Redemption was designed to qualify as a tax-free split-off under Section 355 of the Internal Revenue Code of 1986, as amended; and as a result such liabilities were no longer required. However, if the IRS was successful in challenging the tax-free characterization of the TWC Redemption, an additional cash liability on account of taxes of up to an estimated $900 million could become payable by the Company. For a discussion of risks related to certain tax characterizations, see Item 1A, “Risk Factors — Risks Relating to Time Warner’s Cable Business,” in Part I of this report.

 

Also included in 2006 are a pretax gain of approximately $129 million and a tax benefit of $21 million related to the sale of Turner South and a pretax gain of approximately $207 million and a tax benefit of $24 million related to the sale of TWBG. The tax benefits on the TWBG and Turner South transactions resulted primarily from the release of a valuation allowance associated with tax attribute carryforwards offsetting the tax gains.

 

Cumulative Effect of Accounting Change, Net of Tax.  The Company recorded a benefit of $25 million, net of tax, as the cumulative effect of a change in accounting principle upon the adoption of FAS 123R in 2006, to

 

TIME WARNER INC.

MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

recognize the effect of estimating the number of awards granted prior to January 1, 2006 that are not ultimately expected to vest.

 

Net Income and Net Income Per Common Share.  Net income was $6.552 billion in 2006 compared to $2.671 billion in 2005. Basic and diluted net income per common share were $1.57 and $1.55, respectively, in 2006 compared to $0.57 for both in 2005.

 

Business Segment Results

 

AOL.  Revenues, Operating Income before Depreciation and Amortization and Operating Income of the AOL segment for the years ended December 31, 2006 and 2005 are as follows (millions):

 

 

 

 

The reduction in Subscription revenues reflects a decline in domestic Subscription revenues (from $4.993 billion in 2005 to $4.084 billion in 2006) and a decline in Subscription revenues at AOL Europe (from $1.675 billion in 2005 to $1.632 billion in 2006). AOL’s domestic Subscription revenues declined due primarily to a decrease in the number of domestic AOL brand subscribers and related revenues. The decline in AOL Europe’s Subscription revenues was driven by a decrease in dial-up Subscription revenues, the sale of AOL’s French access business in October 2006 and the unfavorable impact of foreign currency exchange rates ($19 million), partially offset by an increase in broadband and telephony revenues.

 

On August 2, 2006, AOL announced that it was implementing the next phase of its business strategy, which is designed to accelerate AOL’s transition to a global web services company. A significant component of this strategy is to permit access to most of AOL’s services, including use of the AOL client software and an AOL e-mail account, without charge. Therefore, as long as an individual has a means to connect to the Internet, that person can access and use most of the AOL services for free.

 

AOL continues to serve customers with dial-up Internet access in the U.S. by providing dial-up connectivity to the Internet and customer service for subscribers. AOL also continues to develop and offer price plans with varying service levels. In connection with the strategy announcement, AOL implemented new $25.90 and $9.95 price plans in the U.S. with varying levels of dial-up access service, storage and other tools and services. However, AOL has

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

substantially reduced its marketing and customer service efforts previously aimed at attracting and retaining subscribers to the dial-up AOL service.

 

The number of AOL brand domestic and European subscribers is as follows at December 31, 2006, September 30, 2006, and December 31, 2005 (millions):

 

 

AOL includes in its subscriber numbers individuals, households and entities that have provided billing information and completed the registration process sufficiently to allow for an initial log-on to the AOL service. Domestic subscribers to the AOL brand service include subscribers participating in introductory free-trial periods and subscribers that are paying no or reduced monthly fees through member service and retention programs. Total AOL brand domestic subscribers include free-trial and retention members of approximately 6% at both December 31, 2006 and September 30, 2006, and 11% at December 31, 2005. Individuals who have registered for the free AOL service, including subscribers who have migrated from paid subscription plans, are not included in the AOL brand domestic subscriber numbers presented above. As of December 31, 2006, AOL Europe subscriber numbers exclude subscribers in France and the U.K., as the sales of the access operations in both of these countries were completed in the fourth quarter of 2006. The remaining AOL Europe subscribers will be excluded from AOL’s subscriber numbers upon the closing of the sale of AOL’s German access business.

 

The average monthly Subscription revenue per subscriber (“ARPU”) for each significant category of subscribers, calculated as average monthly subscription revenue (including premium subscription services revenues) for the category divided by the average monthly subscribers in the category for the applicable period, is as follows:

 

 

During the second quarter of 2006, AOL improved its methodology for attributing AOL brand domestic Subscription revenues to the $15 and over per month and under $15 per month price plan categories. This methodology improvement, which resulted from better system data, had no impact on total AOL brand domestic ARPU for the year ended December 31, 2006. The impact of the improved methodology to the $15 and over per

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

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month and under $15 per month subscriber categories (as reflected in the table above), as compared to the ARPU calculated for these categories under the old methodology, for the year ended December 31, 2006, is as follows:

 

 

The decline in AOL brand domestic subscribers on plans priced $15 and over per month resulted from a number of factors, including the effects of AOL’s revised strategy, which resulted in the migration of subscribers to the free AOL service offering, declining registrations for the paid service in response to AOL’s reduced marketing and retention campaigns and competition from broadband access providers. Further, during the period, subscribers migrated from the premium-priced unlimited dial-up plans, to lower-priced plans, including the new $9.95 plans.

 

The decrease in AOL brand domestic subscribers on plans below $15 per month was driven principally by the effects of AOL’s revised strategy, which resulted in the migration of subscribers to the free AOL service offering. This decrease was partially offset by the migration of subscribers from plans $15 and over per month to the plans below $15 per month, primarily to the new $9.95 plans.

 

Excluding the impact of the methodology improvement discussed above, the $15 and over per month subscriber category ARPU increased $1.86 in 2006, as compared to 2005. This increase was due primarily to the price increases implemented by AOL late in the first quarter and continuing into the second quarter of 2006, including the increase in the price of the $23.90 plan to $25.90, and an increase in the percentage of revenue generating customers, partially offset by a shift in the subscriber mix to lower-priced subscriber price plans. Premium subscription services revenues included in ARPU for the year ended December 31, 2006 and 2005 were $85 million and $87 million, respectively.

 

Excluding the impact of the methodology improvement discussed above, the under $15 per month subscriber category ARPU decreased $0.59 in 2006 as compared to 2005. This decrease was due to a decrease in revenues generated by members on limited plans who exceeded their free time and a shift in the subscriber mix to lower-priced subscriber price plans, including the $9.95 plan, partially offset by an increase in the percentage of revenue generating customers. Premium subscription services revenues included in ARPU for the year ended December 31, 2006 and 2005 were $31 million and $32 million, respectively.

 

The increase in total AOL brand domestic ARPU for the year ended December 31, 2006, as compared to the similar period in the prior year, was due primarily to the price increases described above and an increase in the percentage of revenue generating customers, partially offset by a shift in the subscriber mix to lower-priced subscriber price plans. AOL brand domestic members on price plans under $15 was 41% of total AOL brand domestic membership as of December 31, 2006 as compared to 30% as of December 31, 2005.

 

Until the sale of AOL’s German access business is completed, AOL Europe will continue to offer a variety of price plans, including bundled broadband, unlimited access to the AOL service using AOL’s dial-up network and limited access plans, which are generally billed based on actual usage. Refer to “Recent Developments” for additional information related to the divestitures of AOL’s French and U.K. access businesses and the pending divestiture of AOL’s German access business. AOL Europe intends to operate its German access business in the normal course until the sale transaction has closed.

 

The ARPU for European subscribers increased for the year ended December 31, 2006 primarily due to a shift in subscriber mix from narrowband to broadband and an increase in telephony revenues. The ARPU in 2006 was negatively impacted by the effect of changes in foreign currency exchange rates and broadband price reductions in France, Germany and the U.K. due to increased competition.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

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In addition to the AOL brand service, AOL has subscribers to other lower-priced services, both domestically and internationally, including the Netscape and CompuServe brands. These other brand services are not a significant source of revenues.

 

Advertising revenues improved for the year ended December 31, 2006, due to increased revenues from growth in sales of advertising run on third-party websites generated by Advertising.com and display and paid-search advertising on AOL’s network of interactive properties and services. Revenues generated by Advertising.com and paid-search revenues increased $196 million to $455 million and $139 million to $591 million, respectively, for the year ended December 31, 2006 as compared to the year ended December 31, 2005. Of the increase in Advertising.com revenues for the year ended December 31, 2006, approximately $122 million resulted from an expansion in the relationship with a major customer in the second quarter of 2006. AOL expects Advertising revenues to continue to increase during 2007 due to display and paid-search advertising on AOL’s network of interactive properties and services and expected growth in sales of advertising run on third-party websites generated by Advertising.com.

 

Other revenues primarily include revenues from licensing software for wireless devices, revenues generated by the sale of modems to customers in Europe in order to support high-speed access to the Internet, and revenues generated from mobile messaging via wireless devices utilizing AOL’s services. Other revenues increased slightly for the year ended December 31, 2006 primarily due to higher revenue at AOL Europe from increased modem sales and higher revenues from royalties associated with mobile messaging.

 

Costs of revenues decreased 4% and, as a percentage of revenues, was 47% in 2006 compared to 46% in 2005. The decrease in cost of revenues related primarily to lower network-related expenses and product development costs, partially offset by increases in traffic acquisition costs associated with advertising run on Advertising.com’s third-party publisher network. Network-related expenses decreased 10% to $1.163 billion in 2006 from $1.292 billion in 2005. The decline in network-related expenses was principally attributable to lower usage of AOL’s dial-up network associated with the declining dial-up subscriber base, improved pricing and network utilization and decreased levels of long-term fixed commitments. The decline in network costs was partially offset by $26 million of service credits at AOL Europe in 2005.

 

The decrease in selling, general and administrative expenses reflects a decrease in direct marketing costs of $503 million, primarily due to reduced subscriber acquisition marketing as part of AOL’s revised strategy, lower employee incentive compensation, including lower current year accruals due to headcount reductions and the reversal of previously established accruals that are no longer required, and other cost savings initiatives. The year ended December 31, 2005 included $23 million of benefits related to the favorable resolution of European value-added tax matters.

 

As previously discussed under “Significant Transactions and Other Items Affecting Comparability,” the 2006 results include $222 million in restructuring charges, primarily related to employee terminations, contract terminations, asset write-offs and facility closures, a $13 million noncash asset impairment charge related to asset writedowns and the closure of several facilities primarily as a result of AOL’s revised strategy, a $769 million gain on the sales of AOL’s French and U.K. access businesses and a $2 million gain from the resolution of a previously contingent gain related to the 2004 sale of NSS. The 2005 results include $17 million in restructuring charges, primarily related to a reduction in headcount associated with AOL’s efforts to realign resources more efficiently, partially offset by a $7 million reduction in restructuring charges, reflecting changes in previously established restructuring accruals. In addition, the 2005 results also reflected an approximate $5 million gain on the sale of a building, a $5 million gain from the resolution of previously contingent gains related to the 2004 sale of NSS and a $24 million noncash goodwill impairment charge related to AOLA.

 

The increases in Operating Income before Depreciation and Amortization and Operating Income are due primarily to the gain on the sales of the French and U.K. access businesses, higher Advertising revenues and lower costs of revenues and selling, general and administrative expenses, partially offset by lower Subscription revenues

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS

OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION — (Continued)

and higher restructuring costs. Excluding the gain on the sales of the French and U.K. access businesses, Operating Income before Depreciation and Amortization included an $82 million decline at AOL Europe in 2006 compared to 2005, reflecting a decline in revenues and higher costs, including restructuring costs. In addition, the increase in Operating Income reflected lower depreciation expense as a result of a decline in network assets due to membership declines.

 

In connection with AOL’s strategy, including its proactive reduction of subscriber acquisition efforts, AOL expects to continue to experience a decline in its subscribers and related Subscription revenues. In addition, in the upcoming year, AOL expects to continue to reduce its costs of revenues, such as dial-up network and customer service, and selling, general and administrative costs. The restructuring actions associated with this phase of the strategy will likely be finalized in 2007, and are expected to result in additional restructuring and related charges in 2007 ranging from $35 million to $70 million. The Company anticipates that, excluding the gains on the sales of AOL’s European access businesses, the AOL segment’s Operating Income before Depreciation and Amortization and Operating Income will increase in 2007.

 

As discussed in more detail in “Recent Developments,” consistent with its strategy, in October and December 2006, respectively, AOL Europe completed the sales of its French and U.K. access businesses and entered into separate agreements to provide ongoing web services, including content, e-mail and other online tools and services, to the respective purchasers of these businesses. In September 2006, AOL Europe also entered into an agreement to sell its German access business and will enter into a separate agreement to provide ongoing web services to the purchaser of this business upon the closing of the sale, which is expected to be completed in the first quarter of 2007.

 

As a result of the historical interdependency of AOL’s European access and audience businesses, the historic cash flows and operations of the access and audience businesses are not clearly distinguishable. Accordingly, AOL’s European access businesses have not been reflected as discontinued operations in the accompanying consolidated financial statements.

 

Cable.  As previously discussed, on July 31, 2006, the Company completed the Adelphia/Comcast Transactions and began consolidating the results of the Acquired Systems. The Transferred Systems have been reflected as discontinued operations for all periods presented and, accordingly, are not included in the Cable segment financial information presented below. Revenues, Operating Income before Depreciation and Amortization and Operating Income of the Cable segment for the years ended December 31, 2006 and 2005 are as follows (millions):